Start with a bridge from the accounts
Set out the reported result for each period before making adjustments. Reconcile management figures to the annual accounts and explain material reclassifications. Otherwise the buyer may be comparing a headline presentation with a different accounting starting point.
Keep separate schedules for accounting corrections, genuinely non-recurring items and prospective changes. These categories answer different questions. An error in revenue recognition is not the same as a one-off legal cost, and neither establishes that a proposed saving will be achieved.
Test whether revenue belongs in the period
Look at how goods or services are delivered, invoiced and recognised. Compare contract milestones, delivery evidence, credit notes and receipts around period ends. Strong final-month revenue deserves explanation where it is followed by cancellations or unusually slow collection.
For recurring contracts, distinguish contracted revenue, invoiced amounts and cash received. A customer prepayment improves cash but does not necessarily belong entirely in current profit. The applicable accounting treatment and materiality should be assessed for the company and engagement.
Challenge add-backs in both directions
In a hypothetical bridge, £240,000 reported EBITDA plus £25,000 of evidenced exceptional cost and £70,000 of owner pay, less an £85,000 replacement role, produces £250,000. The owner adjustment reduces part of the claimed benefit. This illustrates the process, not an accepted market valuation.
Check whether costs recur under a different description. Annual recruitment, recurring system work or normal repairs may be necessary to operate. Also look for income that is unusual or costs missing from the records. A balanced review considers negative adjustments as well as seller claims.
Investigate cash conversion and balance-sheet support
Compare earnings with operating cash movements and examine debtors, stock and supplier balances. Increasing profit accompanied by rising overdue debtors may indicate collection or recognition issues that need investigation. Do not infer the cause from a single ratio.
Ageing schedules should reconcile to the ledger and show disputes, credit notes and subsequent receipts where available. Separate working capital analysis from the price mechanism ultimately negotiated. A review can highlight the issue without deciding the contractual treatment of every balance.
Prepare an adjustment evidence register
For each proposed adjustment record the period, amount, ledger reference, supporting document, explanation and expected future treatment. Identify whether the supporting record has actually been reviewed or is still requested. Preserve the original accounts alongside the revised analysis.
This register makes discussion more productive: the buyer can disagree with a judgement without losing the underlying fact. Track open questions and whether they change earnings, cash, the balance sheet or the scope. Avoid silently replacing an earlier schedule when a material assumption changes.
A practical test for an adjustment claim
Take the largest proposed add-back and ask someone outside its preparation to reproduce the amount from the ledger. Then ask whether the continuing business still needs the underlying activity. These are separate tests: an accurately calculated cost can still be recurring. Record disagreements as judgements to resolve, rather than changing the schedule until everyone appears to agree.
| Area | Evidence to examine | Question to resolve |
|---|---|---|
| Existence | Ledger entry, invoice and relevant period | Can the amount be traced without a verbal explanation? |
| Recurrence | History and description of the underlying activity | Is the cost genuinely unusual or merely irregular? |
| Replacement | Future operating role or supplier requirement | What cost remains after the seller leaves? |
Agree an output that supports the transaction
Specify the periods, entities, financial areas and intended users before work starts. A seller preparation exercise and a buyer-commissioned diligence report can have different access, reliance and reporting terms. Neither should be described as providing audit assurance unless that is the actual engagement.
Consult EFC is led by Kishen Patel, BFP ACA, an ICAEW Chartered Accountant. Discuss the proposed sale and records available so the work can be scoped appropriately. A useful output explains the earnings bridge, evidence limits and unanswered questions rather than offering an unsupported clean bill of health.
Your preparation checklist
- Reconcile the earnings starting point to the accounts.
- Separate corrections, exceptional items and future changes.
- Document replacement costs and negative adjustments.
- Agree scope, intended users and open-question reporting.
Frequently asked questions
Is quality of earnings an audit?
No. A scoped quality of earnings review is different from a statutory audit and should state its procedures, limitations and intended use.
Will buyers accept every documented add-back?
No. Evidence supports discussion, but buyers can reasonably disagree about recurrence, replacement costs and future operating assumptions.
Should we prepare this before approaching buyers?
Early preparation can reveal evidence gaps. Agree the level of work proportionate to the proposed transaction and avoid implying a buyer must rely on a seller’s report.
Sources and scope
This is general preparation guidance. Worked examples are original hypothetical illustrations, not client outcomes, market multiples or individual advice. Agree the purpose, evidence and scope before commissioning professional work.
Professional background: ICAEW technical resources. These links provide context and do not imply endorsement, assurance or compliance for an individual engagement.
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