conducting-quality-of-earnings-analysis

# Conducting Quality Of Earnings Analysis

Adjusts reported earnings for non-recurring items, accounting policy choices, and run-rate normalizations to derive a defensible adjusted EBITDA that buyers and lenders can underwrite.

## When To Use

- Buy-side or sell-side due diligence requiring normalized earnings validation
- Evaluating a seller's CIM or management-prepared adjusted EBITDA
- Preparing or reviewing a QofE report for a letter of intent, financing package, or board presentation
- Assessing earnings sustainability when a target has lumpy revenue, owner-dependent operations, or recent acquisitions

## Inputs To Gather

- **Financial statements**: 3 years of audited/reviewed P&L, balance sheet, and cash flow statements; trailing twelve months (TTM) interim financials
- **Trial balance and general ledger detail**: Monthly GL exports for the analysis period, with account-level detail sufficient to trace individual adjustments
- **Management adjustments schedule**: Seller's own pro forma or add-back schedule with supporting documentation
- **Revenue detail**: Customer-level revenue by month, contract backlog, and pipeline data
- **Cost detail**: Payroll registers, rent rolls, vendor invoices for material expense categories
- **Tax returns**: Corporate returns (or K-1s for pass-throughs) to cross-check reported income
- **Related-party transaction list**: All intercompany or owner-related transactions, compensation, leases, and service agreements

## Workflow

1. **Establish the reported earnings baseline**
   - Map the P&L to a standard chart of accounts (revenue, COGS, gross profit, SG&A, EBITDA)
   - Reconcile reported net income to tax returns; flag discrepancies
   - Confirm D&A, interest, and tax add-backs match supporting schedules

2. **Identify and categorize adjustments**
   - **Non-recurring items**: Litigation settlements, one-time consulting projects, asset write-downs, PPP/EIDL forgiveness, natural disaster costs. Each item requires documentation proving it is truly one-time
   - **Owner/related-party adjustments**: Above-market owner compensation, personal expenses run through the business, below-market rent on owner-held real estate, related-party service fees. Benchmark replacement cost using market data [VERIFY comparable compensation benchmarks against industry surveys]
   - **Accounting policy normalizations**: Revenue recognition timing (ASC 606 vs. cash basis), inventory valuation method changes (FIFO/LIFO), capitalization vs. expensing thresholds, lease treatment under ASC 842 [VERIFY applicable GAAP standards if target uses IFRS or tax-basis accounting]
   - **Run-rate / pro forma adjustments**: Full-year impact of mid-period hires, price increases, facility openings/closings, lost or won contracts, cost savings from completed initiatives. Require evidence that the run-rate event has already occurred — do not accept projected synergies

3. **Build the adjustment bridge**
   - Present adjustments in a waterfall from reported EBITDA to adjusted EBITDA
   - Categorize each adjustment by type (non-recurring, owner/related-party, normalization, run-rate)
   - Show the impact by period (each fiscal year + TTM) to reveal trends
   - Assign a confidence tier to each adjustment: **Supported** (documented), **Reasonable** (management representation with partial backup), **Unsupported** (no documentation — flag for further diligence)

4. **Analyze revenue and working capital quality**
   - Assess customer concentration (top 10 customers as % of revenue); flag if any single customer exceeds 10-15%
   - Evaluate revenue sustainability: recurring vs. non-recurring mix, contract renewal rates, churn
   - Review net working capital trends; identify seasonal swings and normalize for a peg calculation
   - Check for channel stuffing indicators: revenue spikes at quarter-end, abnormal receivables aging, credit memo patterns

5. **Stress-test and sensitize**
   - Model adjusted EBITDA under conservative, base, and management cases
   - Quantify the aggregate dollar impact of unsupported or borderline adjustments
   - Compare adjusted EBITDA margin to industry benchmarks [VERIFY industry margin data source and peer set]

6. **Compile the QofE deliverable**
   - Executive summary with headline adjusted EBITDA range and key risk findings
   - Detailed adjustment schedule with line-item support references
   - Revenue and working capital analysis sections
   - Appendices: data request tracker, open items list, management representation gaps

## Output

The final QofE deliverable should include:

- **Adjusted EBITDA summary table**: Reported vs. adjusted for each period analyzed, with a clearly labeled TTM figure
- **Adjustment detail schedule**: Each adjustment with description, amount by period, category, confidence tier, and supporting reference
- **Revenue quality analysis**: Concentration table, recurring revenue breakdown, trend commentary
- **Net working capital analysis**: Monthly NWC with seasonal normalization and proposed peg
- **Key findings and risk factors**: Bullet-point summary of material issues (unsupported add-backs, concentration risk, accounting policy concerns, pending litigation exposure)
- **Open items list**: Unresolved data requests or items requiring further investigation

## Quality Checks

- Every adjustment ties to a specific GL account and has a cited source document or management representation
- Adjusted EBITDA reconciles cleanly from reported net income through each add-back layer
- No projected synergies or uncommenced cost savings are included in adjusted EBITDA (these belong in a separate synergy analysis)
- Customer concentration and revenue sustainability findings are consistent with the adjustment conclusions
- Tax return income reconciles to book income within an explainable variance
- All figures marked [VERIFY] have been flagged for jurisdiction-specific or data-source-dependent confirmation
- The deliverable has been reviewed for internal consistency: totals foot, periods align, and narrative matches the numbers