Quick answer: The quality of earnings findings that most often reduce a sale price are rejected add-backs, revenue cut-off and recognition errors, expenses missing from the books, working capital measured at the wrong time, concentration in a few customers or channels, liabilities that were never recorded, and one-time items that recur. Some lower adjusted EBITDA, some add deductions to proceeds and some change the multiple or the terms. Most can be found and corrected or documented before a buyer’s accountants reach them.
Key points
- A finding reaches price by one of four routes: lower adjusted EBITDA multiplied by the multiple, a deduction from proceeds, a different working capital target, or changed terms such as an escrow or an earnout.
- Add-backs that recur, revenue recorded in the wrong period and costs never booked are the findings that most often move adjusted EBITDA.
- The costliest findings are the ones the seller did not find first, because a buyer that discovers a problem also questions every other number in the package.
- Pre-emption means running the buyer’s tests in advance, then correcting the books, documenting the item or dropping the claim before launch.
How a finding turns into a price change
A quality of earnings finding is a gap between the figure the seller presented and the figure the reviewer can support. The gap reaches the price by one of four routes, and the route matters as much as the amount.
- Lower adjusted EBITDA. The reviewer accepts less of the add-back schedule or finds a cost that was never booked. The change is multiplied by the buyer’s multiple, so each dollar costs the seller several dollars of price.
- A deduction from proceeds. The reviewer finds an obligation that behaves like debt, such as unpaid bonuses or customer deposits. It comes off the price dollar for dollar. The guide to debt and debt-like items covers how these are argued.
- A different working capital target. The reviewer’s monthly balances set a higher target than the seller expected, and the shortfall at closing reduces the payment. The net working capital peg guide explains the mechanics.
- Changed terms. A risk the buyer cannot price, such as dependence on one customer, moves into an escrow, an earnout or a specific indemnity.
Reports separate two kinds of adjustment. Management adjustments are the seller’s add-backs. Diligence adjustments are the reviewer’s own, and they are mostly deductions that the seller did not propose. Sellers who have built an add-back schedule are usually ready for the first kind. The second kind is where a first-time seller learns what a buyer’s accountants can do.
Findings, the tests that surface them and the pre-emption steps
Each row names the test a buyer’s accountants use, so that an owner can run it first.
| Finding | Test that surfaces it | Where it lands | How to get ahead of it |
|---|---|---|---|
| Rejected or recurring add-backs | Lines up each add-back across every period under review and traces it to invoices and vendor history | Adjusted EBITDA, multiplied | Run the same comparison first, attach support, and drop any item that returns every year |
| Revenue cut-off and recognition | Matches the last shipments and invoices before each period end, and the first after, to delivery records and later credit memos | Adjusted EBITDA for the period, and sometimes the trend | Test period-end sales yourself, write down the recognition policy and apply it consistently |
| Understated expenses | Searches payments made after each period end for costs that belong to the earlier period, and compares accruals month to month | Adjusted EBITDA, or a deduction if a one-time catch-up | Book bonus, commission, vacation and warranty accruals monthly, and price owner-performed roles at replacement cost |
| Working capital seasonality | Builds monthly balances, ages receivables and tests inventory reserves | The target, and so the closing payment | Build your own monthly series, define the accounts early and write off what will not be collected |
| Customer or channel concentration | Splits revenue and margin by customer and channel, and reads contract terms and renewal history | The multiple, an earnout or an escrow | Show tenure, contract terms and margin by customer before the buyer asks |
| Unrecorded liabilities | Reads contracts, leases, notices and payroll records for obligations that are not on the balance sheet | A deduction from proceeds, or an indemnity | List every obligation yourself in a debt-like schedule and agree the definitions early |
| One-time items that recur | Compares each non-recurring label across periods and asks for the closing document of each event | Adjusted EBITDA | Keep only events with a defined start, end and document, and treat the rest as operating cost |
Four rows have deeper guides. The standards for add-backs are in the EBITDA add-back guide, and the recurrence test is developed in non-recurring items in adjusted EBITDA. Timing and recognition problems are the subject of revenue recognition in diligence. The pricing of concentration is explained in customer concentration and valuation.
What the price effect looks like
The route changes the cost of a finding as much as its size. The example below follows five findings through to the check at closing.
Illustrative example: From the headline price to the check at closing
A letter of intent values a company at 6.0x adjusted EBITDA of $3,000,000, an enterprise value of $18,000,000. A buyer’s accountants report five findings.
| Finding | Route | Change in EBITDA | Effect on price |
|---|---|---|---|
| Consulting fees labeled one-time appear in every year | Adjusted EBITDA | ($150,000) | ($900,000) |
| Year-end sales recorded before delivery | Adjusted EBITDA | ($100,000) | ($600,000) |
| Bonus and vacation earned but unrecorded at closing | Deduction | $0 | ($200,000) |
| Customer deposits received and already spent | Deduction | $0 | ($250,000) |
| Delivered working capital below the reviewer’s target | Closing adjustment | $0 | ($300,000) |
| Total | ($250,000) | ($2,250,000) |
Adjusted EBITDA falls to $2,750,000, so the enterprise value at 6.0x is $16,500,000, which is $1,500,000 lower. The three deductions take a further $750,000, leaving $15,750,000 before debt, cash, expenses and escrow. The two EBITDA findings cost six times their size, and the other three cost their face amount. That is why sellers argue about the route: a one-time catch-up belongs in a deduction, and only a cost that keeps recurring belongs in EBITDA. The multiple, the amounts and the findings are invented to show the mechanics and are not benchmarks.
Finding them first
The order below puts the cheapest tests first.
- Re-run the add-back schedule across every period. An item labeled one-time that appears in more than one period either gets a documented event or leaves the schedule.
- Test the edges of each period. Pull the last and first shipments around each year-end and quarter-end, and tie each to a delivery record and an invoice.
- Search for costs that were not booked. Review payments made after each period end, and compare accruals month by month.
- Build monthly working capital. Show the swings and the reasons for them.
- Cut revenue and margin by customer and channel. Add tenure, contract terms and any notice of termination.
- List the obligations that are not loans. Deposits, deferred revenue, accrued compensation, unpaid taxes, leases and pending claims.
- Write the explanation for what remains. A finding the seller disclosed with its analysis is a negotiating point. A finding the buyer discovered is also a question about the rest of the package.
An outside firm can run the same tests with a buyer’s eyes, which is the purpose of a sell-side quality of earnings report.
When the buyer finds one anyway
Start by separating fact from judgment. A bonus that was never accrued is a fact, and the contest is over the amount and the route. Whether a cost is non-recurring is a judgment, and documents decide it. For judgment items the seller answers with the agreement, the invoices and the dates, and partial acceptance is a common result. For findings of fact, the seller’s room lies in the route and the terms: whether the item is a one-time deduction or a recurring cost, and whether an escrow or a specific indemnity can stand in for a price cut when the risk may never materialize.
A reviewer may also find items that raise earnings, such as revenue or margin the seller never claimed, and those belong on the schedule too. Findings that arrive after the letter of intent are the subject of the guide to retrades and price reductions, and the problems buyers find outside the numbers are covered in red flags buyers find in diligence. The roadmap for the whole review is the guide to due diligence in a business sale.
Frequently asked questions
What is the difference between management adjustments and diligence adjustments?
Management adjustments are the add-backs and deductions the seller proposes to reach adjusted EBITDA. Diligence adjustments are the reviewer’s own changes after testing the records, and they are mostly deductions the seller did not propose, such as missing accruals or revenue moved between periods. The buyer’s price usually rests on the reviewer’s final figure, which combines both.
How does a quality of earnings finding become a price reduction?
Through one of four routes: lower adjusted EBITDA multiplied by the multiple, a deduction from proceeds for debt-like items, a higher working capital target, or changed terms such as an escrow. The same dollar costs a seller more through EBITDA than through a deduction, so the route is negotiated along with the amount.
Can a seller dispute a quality of earnings finding?
Yes. Findings of fact, such as an unrecorded accrual, are hard to contest, but the amount and the route can be negotiated. Findings of judgment, such as whether a cost is one-time, turn on documents: the agreement, the invoices and the dates. Partial acceptance is a common result, so a seller should arrive with support for each disputed item.
Do quality of earnings findings always lower the price?
No. A reviewer can also find revenue that was understated, costs that were overstated or add-backs the seller never claimed. A report that confirms the seller’s figures raises a buyer’s confidence in everything else, which helps terms as well as price. The risk lies in findings the seller did not anticipate.
How can a seller find these issues before a buyer does?
Run the buyer’s tests first: compare add-backs across every period, check sales around each period end, search payments made after period end for unbooked costs, and build monthly working capital. A sell-side quality of earnings report does the same work through an outside firm and gives buyers documented support.
Preparing a company for sale or a buyer's diligence?
The Impetus Group offers fractional investment banking support, including earnings normalization, financial projections, CIM preparation and help navigating buyer diligence, with an engagement scoped to what the business needs.
Related guides
- Quality of Earnings Report: What It Is and What Buyers Test: A quality of earnings report tests whether a company’s reported profit is real and repeatable. See what buyers examine, how it affects price and how sellers prepare.
- EBITDA Add-Backs: What Buyers Accept and What They Reject: Learn which EBITDA add-backs buyers accept in a sale, which they reject, and how adjusted EBITDA changes enterprise value, with a worked illustration.
- Retrades in M&A: Why Buyers Cut the Price After the LOI and How a Seller Responds: A retrade is a buyer’s price cut after the letter of intent. Learn the fair and tactical triggers, how to prepare, a response playbook and when to walk away.
- Sell-Side Quality of Earnings Report: Scope, Timing and How to Use It: What a sell-side quality of earnings report covers, when an owner should commission it, who should perform it and how to use it in the CIM and with buyers.
- Managing the Diligence Process as a Seller: Request Lists, Q&A and Response Discipline: How a seller runs due diligence: one point of contact, a request tracker, staged disclosure, a Q&A log and response discipline while the business keeps performing.
- Proof of Cash: How Buyers Test Revenue and Expenses Against the Bank: A proof of cash reconciles bank deposits and disbursements to reported revenue and expenses. See how buyers run it, what the gaps reveal and how a seller prepares.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.