Breaking Down Common QoE Adjustments

The Most Common QoE Adjustments in a Quality of Earnings Report (and Why They Matter)

A Quality of Earnings (QofE/QoE) report is designed to separate reported performance from sustainable performance. While a company’s financial statements show what happened historically, they rarely represent the true earning power that a buyer, investor, or lender expects going forward. This is where QoE adjustments come in, and specifically, a QofE report to be used while negotiating purchase terms.

In our broader QoE guide, we explained how a QofE analyzes earnings, revenue quality, working capital, and operational performance. This article focuses specifically on the adjustments themselves: what they are, why they’re made, and how they support a clearer, more reliable valuation.

1. Accounting-Method Adjustments

These adjustments correct differences between how a company currently records transactions and how those transactions should appear for valuation and diligence purposes. They often have a material impact on normalized EBITDA.

Cash-to-Accrual Adjustments

Many private and middle-market companies use cash-basis accounting. A QoE normalizes results to accrual-basis by adjusting for:

• Unbilled revenue that was earned but not yet invoiced
• Expenses incurred but paid in later periods
• Customer deposits or prepayments recorded as revenue
• Prepaid expenses recorded incorrectly as current period activity

Why it matters:
Cash timing can distort profitability. Accrual adjustments create a more accurate depiction of operations.

Revenue Recognition Adjustments

Revenue is often one of the most scrutinized areas in a QoE report. Adjustments typically include:

Cut-Off Corrections

Reallocating revenue to the proper period when:

• Work was completed in a different period than it was billed
• Revenue was recorded early or late
• Receipts of cash artificially inflated revenue in a particular month or quarter

ASC 606 Compliance

Ensuring revenue aligns with completed performance obligations. Common corrections include:

• Upfront billing for work delivered over time
• Subscription or service revenue recognized inconsistently
• Pass-through charges that should not be recorded as revenue

Percentage-of-Completion (PoC) Adjustments

For long-term or project-based businesses, PoC adjustments recalibrate revenue and costs based on actual progress. These ensure that revenue isn’t overstated or understated due to aggressive or conservative billing.

Why it matters:
Revenue trends heavily influence valuation, and correcting recognition ensures stakeholders see the true pattern of performance.

Inventory & Cost of Goods Sold (COGS) Adjustments

COGS adjustments improve the accuracy of margins by correcting:

• Improper inventory valuation (e.g., FIFO, average cost, or standard cost misalignment)
• Obsolete or slow-moving inventory that requires write-downs
• Incorrect overhead or labor capitalization
• Inaccurate standard costing or bill-of-materials calculations
• Timing mismatches between inventory purchases and usage

Why it matters:
Inventory accounting can significantly affect margins. COGS adjustments prevent EBITDA inflation caused by overstated inventory.

2. Non-Recurring Income and Expense Adjustments

Non-recurring items distort historical performance by introducing one-time activity that does not reflect ongoing operations.

Common examples include:

• Litigation costs or settlements
• Transaction-related professional fees
• Unusual consulting or restructuring expenses
• Damage or disaster-related repairs
• Significant gains or losses from selling assets
• Large equipment purchases expensed instead of capitalized
• Government grants or subsidies not expected to repeat

Why it matters:
Removing non-recurring items isolates repeatable performance, which is critical for creating a fair valuation baseline.

3. Non-Operating and Non-Core Adjustments

These adjustments remove income or expenses recorded in the financials that are unrelated to the company’s primary operations.

Examples include:

• Rental income from unrelated real estate
• Investment gains or losses
• Foreign currency gains/losses unrelated to core business
• Income or expenses related to assets the buyer won’t acquire
• Activity tied to owner’s side businesses

Why it matters:
Buyers want to understand the earnings generated strictly from the operations being purchased. These adjustments ensure EBITDA reflects only those activities.

4. Owner, Management, and Related-Party Adjustments

In privately held companies, owner decisions often influence reported earnings. A QoE normalizes core operations by removing these distortions.

Owner Compensation Normalization

Adjusting compensation to reflect market rates:

• Increasing salary when the owner pays themselves below market
• Decreasing salary when the owner pays themselves above market
• Correcting compensation for family members on payroll

Personal or Discretionary Expenses

Expenses run through the business for owner benefit are added back, such as:

• Personal vehicle costs
• Family travel
• Household or lifestyle expenses
• Meals, entertainment, or subscriptions unrelated to the business

Related-Party Pricing Adjustments

Adjustments may include:

• Replacing related-party rent with market rent
• Adjusting vendor or contractor pricing to arms-length levels
• Removing costs charged by entities owned by the shareholder

Why it matters:
These adjustments convert owner-driven financial decisions into a market-based cost structure.

5. Run-Rate and Pro Forma Adjustments

These adjustments bridge historical results with forward-looking expectations, especially when the company has recently undergone meaningful change.

Run-Rate Adjustments

Annualize the financial impact of changes that happened mid-period, such as:

• Newly signed customer contracts
• Cost reductions or vendor renegotiations
• Staff hires or departures
• Rent increases or decreases
• Discontinuation of underperforming business lines

Pro Forma Adjustments

Reflect expected conditions under new ownership, such as:

• Replacing owner compensation with a market-rate manager
• Removing rent if the buyer will occupy their own space
• Adding costs required post-transaction (e.g., CFO role, compliance costs, new software)
• Removing expenses tied to assets not included in the sale

Why it matters:
These adjustments help define the “steady-state” earnings that valuation multiples are applied to.

6. Working Capital and Balance Sheet Adjustments

While EBITDA focuses on profitability, QoE adjustments often include corrections related to the balance sheet that reveal operational health.

Working Capital Normalization

Common adjustments include:

• Removing non-operating or owner-related AR/AP
• Writing off uncollectible accounts receivable
• Correcting unusually low payables that inflate cash temporarily
• Reclassifying items into their proper categories
• Adjusting inventory or receivables for seasonality
• Identifying under- or over-accrued liabilities

Accrual and Liability Corrections

QoE providers often adjust for:

• Missing payroll, bonus, or tax accruals
• Warranty or customer refund liabilities
• Deferred revenue adjustments
• Undisclosed obligations or contingent liabilities

Why it matters:
These adjustments prevent surprises during the purchase agreement phase and ensure normalized earnings align with proper working capital needs.

Final Thoughts

Every QoE report contains its own set of adjustments, but they nearly always fall within the categories above. These adjustments strip out noise, timing differences, owner influence, non-operating activity, and one-time events, revealing the company’s true earning power.

For buyers, these adjustments help prevent overpaying.
For sellers, they clarify and defend the company’s value.
For both, they create a cleaner, more reliable foundation for negotiation.

Interested in receiving a QofE report? CKH Group offers a free quote within 24 hours to help you determine the cost and scope. To get started, simply provide details about the target company’s accounting system, along with its Balance Sheet and Profit & Loss statements for the past three years.

Contact us today at 1-770-495-9077 or email us at [email protected]. You can also reach out through our website for more information and to receive your customized quote.

The above article only intends to provide general financial information and is based on open-source facts, it is not designed to provide specific advice or recommendations for any individual. It does not give personalized tax, financial, or other business and professional advice. Before taking any form of action, you should consult a financial professional who understands your particular situation. CKH Group will not be held liable for any harm/errors/claims arising from the articles. Whilst every effort has been taken to ensure the accuracy of the contents, we will not be held accountable for any changes that are beyond our control.