Quality of earnings adjustments are the specific changes a diligence team makes to a company’s reported earnings so that the number reflects sustainable, recurring, transferable cash flow rather than an accounting result. In a deal, these adjustments rebuild reported EBITDA into an “adjusted” or “normalized” EBITDA by removing one-time items, correcting for below-market or above-market related-party costs, and stripping out anything that will not carry forward to the new owner. Because most private-company acquisitions are priced as a multiple of EBITDA, every dollar of accepted adjustment can move the purchase price by several dollars. Understanding how quality of earnings adjustments work is therefore central to both sides of a transaction.
This article explains what these adjustments are, walks through the main categories with concrete illustrative examples, and shows how each one moves the EBITDA figure a buyer actually underwrites. It is a companion to our seller-focused guide on preparing your quality of earnings before a sale; here the focus is the adjustments themselves and the mechanics of the EBITDA bridge.
Why Adjustments Exist: Reported EBITDA Is Not Sustainable EBITDA
EBITDA is not defined under U.S. GAAP. It is a non-GAAP measure, and companies calculate it in different ways, which is exactly why buyers do not simply accept a seller’s stated number. The Securities and Exchange Commission treats EBITDA and similar figures as non-GAAP financial measures precisely because there is no single authoritative definition. In a private deal, the practical consequence is that “EBITDA” only becomes meaningful once both parties agree on how it was built.
Reported earnings answer a historical question: what did the accounting records show last year? A buyer is asking a forward-looking question instead: if ownership changed tomorrow, how many of those dollars would still show up? Quality of earnings adjustments bridge that gap. They convert a backward-looking accounting result into a defensible run-rate the buyer can use to set price, size debt, and structure earnouts.
The output is usually shown as an “EBITDA bridge,” a schedule that starts with net income, adds back interest, taxes, depreciation, and amortization to reach reported EBITDA, and then layers on the quality of earnings adjustments to arrive at adjusted EBITDA. Each adjustment on that bridge should be documented, tied to source records, and testable. An adjustment that cannot be supported is an adjustment a buyer will reject.
The Main Categories of Quality of Earnings Adjustments
While every deal has its own quirks, quality of earnings adjustments fall into a handful of recurring categories. The categories overlap in practice, but keeping them distinct makes the logic of the bridge easier to test.
Non-Recurring and One-Time Items
These are gains, losses, revenues, or expenses that occurred in the period but are not expected to repeat. The premise is that a one-time event does not represent the ongoing earning power of the business, so it should be removed from the baseline.
Common examples include legal settlements, restructuring or severance costs, uninsured casualty losses, gains or losses on the sale of an asset, and professional fees tied to a specific event such as a financing or a prior sale process. Consider a company reporting $4.0 million of EBITDA that paid a $300,000 one-time settlement to resolve a lawsuit during the year. Adding that back lifts adjusted EBITDA to $4.3 million, because next year’s owner would not face that same payment.
The discipline here is direction-neutral. A non-recurring gain, such as a $200,000 insurance recovery, should be subtracted from EBITDA, since it also will not repeat. Sellers tend to remember the expenses and forget the gains, and a credible diligence process corrects for both.
Normalization Adjustments
Normalization adjustments address recurring items that are recorded at the wrong amount rather than items that will not recur. The cost or revenue happens every year, but it is priced differently than it would be under new, arm’s-length ownership. The goal is to restate those items to a market level.
The classic example is owner compensation. Suppose the founder pays herself $700,000 in salary but a market-rate replacement executive would cost $300,000. The $400,000 difference is added back, because a new owner could run the business with a market-salary manager. If instead the owner underpaid herself and took distributions in lieu of salary, the adjustment runs the other way: EBITDA is reduced to reflect the real cost of the role.
Related-party rent is another frequent normalization item. If the business leases its building from an entity the owner controls and pays $500,000 a year when comparable market rent is $350,000, the $150,000 excess is added back. As above, the correction can also be negative when the related-party terms are below market, and buyers will look for that.
Run-Rate and Pro Forma Adjustments
Run-rate and pro forma adjustments answer a different question: what would earnings look like on a full-period basis given the business as it exists today? These adjustments annualize or restate results for changes that happened partway through the period, so the baseline reflects the current shape of the company rather than a blended historical average.
A run-rate adjustment annualizes current operating conditions. If the company signed a customer contract in month nine that adds $50,000 of monthly gross profit, a run-rate view reflects twelve months of that contract rather than the three months actually in the results. A pro forma adjustment restates for a structural change such as a tuck-in acquisition completed mid-year, showing combined results as if the businesses had been together for the full period. Conversely, if a product line was discontinued, its earnings are removed so the run-rate reflects only continuing operations.
These are the adjustments buyers scrutinize most heavily, because they are forward-leaning and easy to overstate. A defensible run-rate adjustment is grounded in a signed contract, a completed transaction, or an executed price increase, not in a sales pipeline or a management forecast. Adjustments that rely on hoped-for future performance belong in a projection, not in the historical EBITDA bridge.
Owner and Related-Party Add-Backs
Closely related to normalization, this category captures discretionary or personal costs that flow through the business but would not exist under institutional ownership. In owner-operated private companies these items are common and often legitimate, but each one has to be verifiable.
Typical add-backs include personal vehicles, personal travel and entertainment run through the company, family members on payroll who do not perform a commensurate role, club memberships, and management fees paid to an owner’s other entities. If a company expenses $80,000 for an owner’s personal vehicles and $60,000 in wages for a family member with no operating role, those amounts are added back to reach the earnings a new owner would actually see.
Buyers separate genuine personal expenses from ordinary business costs that owners sometimes try to reclassify. Routine travel and entertainment incurred to win and keep customers is a real cost of the business and is generally not accepted as an add-back. The test is whether the expense would disappear under new ownership, not whether it feels discretionary.
Accounting-Policy and Non-Cash Differences
This category corrects for how the numbers were prepared. Two otherwise identical businesses can report very different earnings depending on accounting method, timing, and estimates, so diligence teams normalize for policy so that EBITDA reflects economic reality on a consistent basis.
The most significant example is cash-basis versus accrual-basis accounting. Many smaller private companies keep books on a cash or modified-cash basis, which can distort period earnings by recognizing revenue and expenses when cash moves rather than when it is earned or incurred. A quality of earnings analysis typically converts the results to accrual basis so revenue matches the period it relates to. Other policy items include revenue-recognition timing, inventory costing methods, and how the company capitalizes versus expenses certain costs. Under SEC rules for public filers, adjustments that effectively substitute an individually tailored accounting method for GAAP, such as accelerating revenue that GAAP requires to be recognized over time, are generally not permitted in reported non-GAAP measures. Private-deal diligence aims for comparability and accuracy rather than a formal non-GAAP filing, but the same caution against manufacturing revenue applies.
Non-cash items also live here. Because depreciation and amortization are already removed in computing EBITDA, the focus shifts to items such as stock-based compensation, changes in bad-debt or inventory reserves, and unrealized gains or losses. A large reserve release that inflated a period’s earnings, for instance, would be normalized out because it does not represent recurring cash generation.
Working-Capital-Related Items
Working capital is usually negotiated as a separate deal mechanism through a target working capital “peg,” but it interacts with the earnings analysis in important ways, and several working-capital findings surface directly in a quality of earnings review.
Diligence teams look for earnings that were flattered by unsustainable working-capital behavior: deferred vendor payments that inflated cash but not accrual earnings, stretched customer collections, or a spike in unbilled work near period-end. They also test reserves against reality, since an understated allowance for doubtful accounts or obsolete inventory overstates earnings. Where the review finds that ongoing capital expenditures were deferred to prop up short-term results, it may flag a normalized maintenance-capex level, since routine, recurring capital spending is a genuine cost of the business and is generally not an accepted EBITDA add-back.
The through-line for all of these categories is the same. A quality of earnings adjustment is credible only when it isolates something that is either non-recurring, mispriced relative to the market, or attributable to how the books were kept, and only when it can be traced to source documents. This is the heart of sell-side and buy-side diligence, and it is why we encourage owners to get ahead of it; see our guidance on controlling the narrative through sell-side due diligence.
How the Adjustments Move the Number: A Worked Illustration
To see the mechanics, walk through a simplified, hypothetical bridge. Start with a company that reports $4.0 million of EBITDA. The diligence team adds back $400,000 of above-market owner salary, $300,000 for a one-time legal settlement, $150,000 of excess related-party rent, and $140,000 of owner personal expenses. It then subtracts a $200,000 non-recurring insurance gain and reduces earnings by $100,000 to convert an aggressive revenue-recognition timing item to accrual basis.
Netting those together, adjusted EBITDA becomes roughly $4.69 million. The direction and size of each item matter enormously. At a 6x multiple, the $690,000 of net upward adjustment translates into more than $4 million of enterprise value, which is why buyers and sellers fight over individual line items and why documentation wins arguments.
It also explains why the same company can carry two very different EBITDA figures. The seller’s number in a marketing document reflects the adjustments the seller wants credit for; the number a buyer closes on reflects only the adjustments that survived testing. Quality of earnings work is what reconciles the two, and our transaction advisory team builds and defends these bridges on both sides of the table.
Frequently Asked Questions
What is the difference between adjusted EBITDA and normalized EBITDA?
The terms are often used interchangeably, and both describe reported EBITDA after quality of earnings adjustments. Some practitioners use “normalized EBITDA” more narrowly for recurring items restated to market, such as owner compensation, and “adjusted EBITDA” as the broader figure that also removes one-time items. In practice, what matters is that each adjustment is defined, documented, and agreed between the parties.
Are quality of earnings adjustments only add-backs that increase EBITDA?
No. Adjustments run in both directions. Non-recurring gains, below-market related-party costs, understated reserves, and accounting timing that pulled earnings forward all reduce adjusted EBITDA. A one-sided analysis that only adds back expenses is a warning sign, and a rigorous diligence process corrects downward items as readily as upward ones.
Which add-backs do buyers typically reject?
Buyers generally reject items that are really ongoing costs of the business, including routine marketing and customer-acquisition spending, recurring capital expenditures, ordinary business travel and entertainment, sales commissions, and normal employee bonuses. Speculative run-rate adjustments based on an unsigned pipeline or a management forecast are also commonly rejected because they cannot be traced to executed agreements.
How do quality of earnings adjustments affect purchase price?
Because most private-company deals are priced as a multiple of adjusted EBITDA, each accepted adjustment changes the price by roughly the adjustment amount times the multiple. A $250,000 accepted add-back at a 6x multiple is worth about $1.5 million of enterprise value. That leverage is why both sides invest in supporting or challenging individual adjustments.
Is EBITDA a GAAP measure?
No. EBITDA is not defined under U.S. GAAP, and it is treated as a non-GAAP measure. Because there is no single authoritative definition, companies calculate it differently, which is exactly why buyers rebuild it through a documented adjustment bridge rather than accepting a reported figure at face value.
When should a seller identify these adjustments?
Before going to market. Identifying and documenting legitimate adjustments early, ideally through sell-side diligence, lets a seller support the highest defensible EBITDA, avoid surprises during buyer diligence, and preserve credibility. Adjustments discovered late or unsupported by records tend to be discounted or removed entirely.
