A quality of earnings analysis does not audit your books. It re-cuts them: normalizing owner pay, stripping non-recurring items, moving revenue to the period it was earned. The result is the profit number a buyer negotiates from.
This article is educational and is not tax, legal, or investment advice. Consult your CPA, attorney, or licensed adviser about your specific situation.
Most owners meet the phrase “quality of earnings” late, usually after a letter of intent, when the buyer’s accountant asks for thirty-six months of detail and the practice’s reported profit starts moving in a direction nobody expected. The exercise is not an accusation and it is not an audit. It is a reconstruction: an independent read of what the business actually earns, on a consistent basis, once the owner’s discretion is taken out of the numbers. Every adjustment either survives because a record supports it, or disappears because none does. This article explains the adjustment categories, why cash-basis books get rewritten, what happens to an add-back that cannot be evidenced, and what to fix while there is still time to fix it.
What a quality of earnings analysis is, and who performs it
A quality of earnings analysis is a diligence procedure, commissioned by a buyer (sometimes by a seller in advance), and performed by an accounting firm engaged for that purpose. It is not an audit and it produces no opinion on whether financial statements are fairly presented. It is closer in spirit to a very thorough reconciliation: the analyst rebuilds earnings from source records and reports what they found and what they changed.
Two boundaries are worth naming plainly, because owners conflate them constantly.
A quality of earnings report is not a valuation. It produces an earnings figure. What multiple attaches to that figure, and what the business is therefore worth, is a separate question for a credentialed appraiser and the parties’ own negotiation.
The analyst is not your bookkeeper, and your bookkeeper is not the analyst. The buyer’s firm re-cuts your numbers. Your books are the raw material they work from. That division matters, because almost everything that determines how the analysis goes was decided months earlier, in how the books were kept. We keep the books; the analysis is performed by the firm the buyer engages.
Adjustment one: owner compensation, normalized
Nearly every owner-operated practice pays its owner something other than market wage for the work performed. Sometimes far more, sometimes far less, often in a mix of salary, distributions, and benefits that made sense for reasons that have nothing to do with operations.
A buyer does not care what you chose to pay yourself. They care what it will cost to have your job done after you leave. So the analyst replaces your actual compensation with a market-rate figure for the role, and the difference flows to adjusted earnings in whichever direction the facts require. An owner who took very little runs the risk of an adjustment against them; an owner who took a great deal may see earnings rise.
This is the single most common place where messy books cost money. When owner pay, owner benefits, and owner personal items are scattered through operating expense accounts rather than isolated, the analyst cannot cleanly separate them, and what cannot be separated does not get added back. The same structural fix that makes an overhead percentage comparable makes this adjustment provable: owner compensation and owner personal items belong in their own accounts, outside the operating expense block. We cover that structure in detail in average dental practice overhead, and the principle is identical in a medical practice, a pharmacy, or a law firm.
Adjustment two: discretionary and personal expenses
The category owners expect. The vehicle, the travel that was mostly not continuing education, the family member on payroll above market rate, the country club, the phone plan covering four people who do not work at the practice.
Each of these is a legitimate add-back in principle: the buyer will not incur the cost, so it should not reduce the earnings they are buying. In practice, each one is only an add-back if you can show it. This is where the conversation is won or lost, and it turns on documentation rather than argument.
An add-back supported by a coded account, a vendor name, and a consistent monthly pattern is accepted quickly. An add-back asserted in a meeting, with no coding behind it, against a general ledger where the same expense type is mixed with real operating cost, is usually removed. Not because anyone thinks you are lying, but because a buyer’s accountant cannot recommend an adjustment they cannot evidence, and the burden sits with the seller.
The arithmetic is unforgiving in a way that surprises people. Every dollar of add-back you cannot support reduces adjusted earnings by a dollar, and reduced earnings carry through the buyer’s whole model. A year of sloppy coding is not a bookkeeping inconvenience at that point. It is a negotiating position you handed away.
Adjustment three: non-recurring items
One-time events distort a year in both directions, and the analyst removes them so the trend reflects the ongoing business: an insurance settlement, a legal matter, a large equipment sale, the cost of a build-out, a one-off marketing campaign, a pandemic-era relief payment.
Two traps recur here. The first is the item that is called non-recurring for three consecutive years, which the analyst will read as recurring, and correctly. The second is asymmetry: owners tend to remember the one-time costs and forget the one-time gains. A credible package treats both the same way, and doing so is worth more than the individual dollars, because it tells the analyst the numbers were prepared honestly rather than argued.
Adjustment four: accrual timing and revenue cut-off
Many owner-operated practices keep books on a cash basis. It is simpler, it usually matches the tax filing, and for running the business it is often enough.
A buyer’s analyst will not evaluate the business that way. Cash-basis results move with collection timing rather than with performance, so the analysis re-cuts revenue and expense into the periods they were actually earned and incurred. That means revenue recognized when the service was performed rather than when the payment landed, expenses matched to the period they belong to, accrued liabilities recognized whether or not anyone invoiced them yet.
For any practice with a payer-driven revenue cycle, this is the adjustment with the widest swing, because the gap between service, adjudication, and deposit can span months and the sum involved is rarely small. A practice that already reconciles what it billed, what the payer allowed, and what it actually collected can support the recast quickly, because the data exists at the right level of detail. A practice that only knows deposits will have the recast done for it, from records the analyst assembles and interprets, without the owner in the room. The mechanics of keeping that reconciliation are the subject of laboratory billing, and they apply well beyond a lab.
Working capital, and the adjustment nobody expects
Earnings get the attention. Working capital quietly moves real money at closing.
Most transactions require the business to be delivered with a normal level of working capital, and normal is derived from your own trailing history. If receivables are overstated because uncollectible balances were never written off, the target set from that history will be one the business cannot actually deliver, and the shortfall is typically settled in cash at or after closing.
That makes accounts receivable hygiene a financial matter rather than an administrative one. Aged balances that will never be collected, credit balances never cleared, patient or client responsibility never reconciled: each inflates the picture in a way that reverses against the seller later. The moment to clean an uncollectible receivable is long before anyone is measuring it.
What to fix, and when
Diligence looks back thirty-six months, so the honest answer is that most of what determines the outcome is already fixed by the time a buyer appears. The useful work happens on a longer runway.
- Isolate owner compensation and owner personal items now, in their own accounts outside operating expenses. This single change makes the two largest adjustment categories provable.
- Code discretionary expenses consistently, to the same account, every month. A pattern is evidence. A one-off entry is an assertion.
- Keep the reconciliation that ties billing to the books to the bank, monthly, so the accrual recast can be supported rather than reconstructed.
- Write off what will not be collected, when you know it, rather than carrying it.
- Keep the trend readable. Three years on one consistent chart of accounts is worth more than three years of individually defensible but incomparable books.
None of this requires anticipating a sale. It is the same structure that produces a usable monthly close, which is the point: books kept properly for running the practice are, without further work, books that hold up when someone examines them. That is the recurring core of dental practice bookkeeping and medical practice bookkeeping, and for groups, clinic and group practice bookkeeping. You can reach us at (818) 485-2669.
Where the line falls: we keep the books and the reconciliations a diligence process draws on. Valuation belongs to a credentialed appraiser, deal terms and structure to your attorney, and the tax treatment of a transaction to your tax preparer.
Booxmax is an accounting, consulting, and reporting firm, not a CPA firm, and does not prepare income tax returns, represent clients before the IRS, or provide tax, legal, or investment advice.
FAQ
What are quality of earnings adjustments?
They are the changes a buyer’s accountant makes to reported profit to show what the business actually earns on a consistent basis: owner compensation normalized to a market rate, discretionary and personal expenses removed, non-recurring items stripped out, and revenue and expense moved into the periods they were earned and incurred.
Is a quality of earnings report the same as an audit?
No. An audit expresses an opinion on whether financial statements are fairly presented. A quality of earnings analysis expresses no opinion; it rebuilds earnings from source records for a specific buyer and reports what was found and changed. It is a diligence procedure, and it carries none of the assurance an audit provides.
Why do add-backs get rejected?
Almost always for lack of evidence rather than disagreement. An add-back supported by its own account, a named vendor, and a consistent monthly pattern is straightforward to accept. The same expense mixed into general operating costs and explained verbally usually gets removed, because the analyst cannot recommend an adjustment they cannot support.
Do I need accrual books to sell my practice?
Not necessarily, but expect the analysis to recast cash-basis results onto an accrual basis regardless. The practical question is whether your records can support that recast. Practices that reconcile billed, allowed, and collected amounts monthly can; practices that track only deposits have the recast performed for them, from records someone else assembles.
How far in advance should books be cleaned up?
Diligence typically examines thirty-six months, so improvements made after a buyer appears reach only a fraction of the period under review. Isolating owner compensation, coding discretionary items consistently, and clearing uncollectible receivables are worth doing on a multi-year runway, and each of them also improves the monthly reporting in the meantime.