December 12, 2025
By:
Robert E. Harig
Quality of Earnings and Working Capital Disputes in M&A: What Every Buyer and Seller Should Know
In today’s Merger & Acquisition market, buyers and investors are scrutinizing the performance of target companies with a very sharp pencil. As a result, quality of earnings (“QoE”) reports and working capital adjustments have become frequent sources of tension between buyers and sellers. Understanding how these disputes arise, and how to prevent them, is essential for anyone planning a transaction.
What Is “Quality of Earnings”?
A Quality of Earnings report is a financial analysis, usually conducted by an accounting firm, that evaluates whether a company’s earnings truly reflect the performance of its core business. It digs beneath the numbers to identify items that might inflate or deflate earnings.
For example, a QoE report may adjust earnings for:
• One-time revenues or expenses.
• Non-recurring customer contracts.
• Aggressive revenue recognition.
• Under- or over-accrued expenses.
• Owner compensation that will not continue after closing.
In other words, QoE helps answer a simple question: “How much is this business really earning on a repeatable, sustainable basis?”
Buyers rely on QoE reports to confirm that the valuation they are paying matches the company’s real economic performance. Sellers use QoE to prepare for due diligence reviews and to reduce the risk of the buyer trying to renegotiate the price late in the process.
How QoE Issues Lead to Disputes
Disputes occur when the parties have different expectations about the company’s “true” earnings. For example:
• Adjustments for owner compensation or personal expenses may significantly impact earnings before interest, taxes, depreciation, and amortization (“EBITDA”).
• Non-recurring revenue, such as a one-off contract, may be included in earnings by the seller but excluded by the buyer.
• Aggressive accounting policies (e.g., early revenue recognition) may inflate profits.
These issues matter because most deals price the company based on a multiple of EBITDA. A disagreement of even a few hundred thousand dollars in normalized earnings can translate into millions of dollars in purchase price variance.
Understanding Working Capital Adjustments
Most deals require that at closing the target delivers a “normalized” level of working capital—typically enough receivables, inventory, and payables to operate the business smoothly following the closing. If the actual working capital at closing is higher or lower than this target, the purchase price adjusts accordingly.
This mechanism protects the buyer from overpaying if the seller has, for example:
• Delayed paying suppliers.
• Accelerated customer collections.
• Reduced inventory below sustainable levels.
Sellers, understandably, want to avoid leaving excess working capital in the business that benefits the buyer.
Why Working Capital Disputes Happen
Working capital disputes are common because they often depend on subjective judgments:
• Are the receivables collectible? Should reserves be increased?
• Is certain inventory obsolete and should it be written down?
• Were payables pushed into the post-closing period?
• Should accrued expenses be included?
• Does the target business naturally have higher or lower working capital at certain times of year?
Disagreements can escalate if the purchase agreement lacks clear definitions for key accounting terms or if historical practices differ from GAAP.
Best Practices to Reduce Disputes
1. Start early. Agree on accounting principles, methodologies, and sample calculations before signing the letter of intent.
2. Define everything. The purchase agreement should clearly define working capital, acceptable accounting policies, and permitted adjustments.
3. Use a strong QoE process. Sellers should conduct a pre-sale QoE. Buyers should commission their own independent QoE analysis.
4. Align on the closing balance sheet. Set expectations for reserves, accruals, inventory methodology, and cut-off timing.
5. Include a Dispute Resolution Plan. Include a straightforward process for resolving disagreements through neutral accountants.
Quality of earnings and working capital mechanics may seem technical, but they are critical to ensuring a fair and predictable transaction. With early alignment and careful drafting, buyers and sellers can significantly reduce the risk of dispute and protect the value of their deal.