Quality of earnings and EBITDA adjustments before a sale

A quality of earnings report is an independent analysis of whether a company's earnings are real, repeatable and fairly stated. In most sale processes, it is where the seller's adjusted EBITDA, the number the price is built on, gets tested line by line. This guide is for owners and founders who expect to sell in the next year or two, and for buyers who want to understand what they are reading.

What a quality of earnings report is

A quality of earnings (QoE) report takes the reported financial statements and asks a narrower question than an audit: how much of this profit will a new owner actually get?

QoE work is typically performed by the transaction advisory group of an accounting or advisory firm. It is not a standardized report, so scope and format vary by firm and by deal.

Buy-side and sell-side QoE

• Buy-side QoE. Commissioned by the acquirer, or by its lenders, after a letter of intent. Its job is to protect the buyer: confirm the earnings being paid for and find anything that should lower the price or change the terms.
• Sell-side QoE. Commissioned by the seller before going to market. Its job is to find and fix issues early, document the adjustments, and give buyers a credible starting point. A buyer will usually still run its own work, but a good sell-side report narrows what is left to argue about.

How a QoE report differs from an audit

An audit looks backward at whether the financial statements are fairly presented under the accounting framework the company uses. It ends in a formal opinion on those statements.

A QoE report starts where the audit stops. It does not issue an opinion. It asks whether the earnings are sustainable, what a normalized year looks like, and what a buyer is really acquiring. A company with clean audited financials can still have a difficult QoE, because an audit can accept an expense as properly recorded while a buyer argues that it will recur every year. The reverse is also true: companies without audits regularly go through a QoE.

What a QoE report examines

Scope varies, but most reports cover the same core areas.

• Revenue quality. How revenue is recognized, whether it ties to contracts and invoices, and how it trends by month, product and customer.
• Recurring versus one-time revenue. Subscription and contracted revenue is valued differently from project work, implementation fees or a single large order.
• Customer concentration. How much revenue depends on the largest customers, and what happens to earnings if one of them leaves.
• Normalized EBITDA. Reported EBITDA restated for owner-specific, non-recurring and non-operating items. This is the center of the report.
• Margins and cost structure. Gross margin trends, how costs scale with revenue, and whether any costs were deferred to flatter the most recent period.
• Net working capital. Receivables, inventory, payables and accruals, measured month by month to set the working capital peg.
• Debt-like items. Obligations a buyer will treat as debt and deduct from the price, such as unpaid bonuses, deferred payroll taxes, customer deposits or overdue payables. Deferred revenue that still needs to be delivered is often negotiated as debt-like too.
• Proof of cash. Reconciling reported revenue and expenses to actual bank activity. If the books say revenue grew and the bank statements do not show it, that question comes first.

Common EBITDA adjustment categories

An EBITDA adjustment, often called an add-back, restates reported EBITDA to show what the business earns under normal ownership and operations. Adjustments can go in both directions.

Owner compensation normalization

If the owner pays themselves well above or below what a hired executive in the same role would cost, the difference is adjusted. An owner taking a large salary produces a positive adjustment. An owner taking little or no salary produces a negative one, because a buyer will have to pay someone to do that job.

Personal and discretionary expenses

Personal vehicles, travel, family phone plans or club memberships run through the company. These are accepted when they are clearly personal and documented, and questioned when they are estimated.

One-time and non-recurring items

A lawsuit settlement, a one-time recruiting push, costs of a system migration, or the legal and advisory fees of the sale process itself. The test is simple: did it happen once, and will a buyer never pay it again?

Related-party transactions

Rent paid to a building the owner also owns, services bought from a relative's company, or family members on payroll. The adjustment brings these costs to a market rate. A buyer will want to know whether the arrangement continues after closing, and on what terms.

Pro forma and run-rate adjustments

These restate the past as if a recent change had been in place all year: a price increase, a new contract, a cost cut, or a hire. They are the most contested category because they describe a future the business has not yet delivered.

Which adjustments buyers push back on, and why

Buyers do not reject adjustments by category. They reject adjustments they cannot verify or do not believe will hold under their ownership.

• "One-time" items that recur. A different one-time cost every year is a recurring cost. Three years of "non-recurring" consulting fees will usually be treated as part of the cost base.
• Undocumented personal expenses. An estimate of how much of the travel line was personal is hard to defend. A list of transactions with receipts is not.
• Pro forma revenue. Credit for a price increase or a new contract before it shows up in actual results is the adjustment most likely to be cut or moved into deal terms such as an earnout.
• Cost savings not yet achieved. Planned headcount reductions or vendor renegotiations are a buyer's opportunity to price, not a seller's earnings to claim.
• One-directional adjustments. A schedule with only positive adjustments invites skepticism. Below-market owner pay, an unfilled role or underpaid related-party rent all reduce EBITDA, and leaving them out undermines the rest of the schedule.

Because businesses are often valued as a multiple of EBITDA, every disputed dollar of adjustment costs the seller more than a dollar of price.

An illustrative EBITDA bridge

The table below walks from reported net income to adjusted EBITDA, first as the seller presents it, then as a buyer's diligence team might accept it.

Illustrative figures, not client data.

The gap of 230 comes from two lines. The consulting fees appear every year, so the buyer treats them as an operating cost. The price increase has one quarter of history, so the buyer leaves it out of EBITDA and, at most, discusses it as part of the deal terms. The related-party rent adjustment holds only if the lease is reset to market at closing. Note the negative line for the vacant controller role: including it is what makes the rest of the schedule credible.

The working capital peg

Most deals assume the business is delivered with a normal level of working capital, enough receivables, inventory and payables to keep operating without the buyer injecting cash on day one. That normal level is the working capital peg.

The peg is usually set from an average of recent monthly net working capital, adjusted for seasonality and for items that are really cash or debt. At closing, actual working capital is compared to the peg. If it comes in below, the price typically goes down; if above, it may go up, depending on how the purchase agreement is written.

For a seller, the peg matters because it is negotiated after the headline price, often under time pressure. A seller who already understands monthly working capital, and why it moves, negotiates the peg from knowledge rather than from the buyer's first draft.

How to prepare 6 to 12 months before a sale

The aim is simple: a buyer's diligence team should find what the seller already found and explained.

1. Close the books monthly, on time, on an accrual basis. Diligence runs on monthly data. Cash-basis or quarterly books force someone to rebuild history under deadline.
2. Reconcile revenue to the bank. Run a proof of cash for the periods a buyer will review, and resolve anything that does not tie.
3. Build the adjustment schedule now. List every proposed adjustment with its amount, the reason, and the support behind it: invoices, payroll records, contracts, board approvals. Include the negative adjustments.
4. Separate recurring from one-time revenue. Report revenue by type and by customer, with consistent definitions month after month.
5. Measure monthly net working capital. Track at least the last 12 to 24 months so the peg conversation starts from data.
6. List debt-like items. Accrued bonuses, deferred taxes, customer deposits and anything else a buyer will deduct, plus deferred revenue, which is often negotiated as debt-like.
7. Clean up related-party arrangements. Put leases and services on paper at market terms, or decide how they will be handled at closing.
8. Consider a sell-side QoE. For many sellers, an independent sell-side report finds issues while there is still time to fix them.
9. Organize the data room. Contracts, financial statements, tax returns, payroll and key customer files in one place, labeled the way a buyer will ask for them. The due diligence checklist lists the financial documents buyers request and what each one tests.

Common diligence findings

The issues that most often move adjusted EBITDA are rarely dramatic. They are usually:

• Revenue recognized when invoiced instead of when earned, especially annual contracts billed upfront.
• Accruals missing at period end, so expenses land in the wrong month and margins look better than they are.
• Add-backs without documentation, or with documentation that does not match the general ledger.
• Customer concentration that was not disclosed upfront.
• Deferred revenue or customer deposits not treated as a liability.
• Metric definitions that changed between the marketing materials and the financials.

None of these is fatal on its own. Each one, found late, costs price, time or trust.

How a buyer reads your adjustments

A buyer's diligence team reads an adjustment schedule as evidence of how the finance function works, not only as a list of numbers. Beyond the push-back points above, two things shape that read quickly:

• Is the reasoning consistent across years? The same type of cost treated as recurring one year and one-time the next will be noticed.
• How fast do answers come back? A request that takes two weeks to answer suggests the numbers are held together by attention rather than process.

Decipher's view, from sitting on both sides of acquisitions, is that the best-prepared sellers build their adjustment schedule the way a buyer will rebuild it. When the buyer's number lands close to the seller's, diligence becomes a confirmation rather than a renegotiation. Decipher's Strategic Projects include sell-side readiness and quality of earnings support, working alongside the firm that performs the QoE.