Anonymised, illustrative composite. A buyer’s quality-of-earnings review traced 24.0% gross margin back to a single cheque — and found two-thirds of it did not belong in the year it landed in.
At a glance
A private equity search fund had a signed letter of intent on an Ontario industrial-supplies distributor: three years of steady growth, a loyal contractor customer base, and a gross margin the seller’s broker kept describing as “best in category.” The confidential information memorandum showed $9.6 million in trailing-twelve-month (TTM) revenue and a 24.0% gross margin — comfortably above the sector norm the buyer had seen on comparable deals. The asking multiple was pitched directly off that margin.
The buyer engaged a Chartered Business Valuator to run a quality-of-earnings review before committing further diligence spend. Chartered Business Valuators work under CBV Institute’s Valuation Practice Standards, in force for engagements beginning on or after 1 January 2026, which exist so a valuator can “establish a credible and properly supported conclusion of value” and which include Standard No. 130, the file-documentation standard — in practice, that every normalizing adjustment has to be traceable to a document, not an assertion. That standard is what turned a single line item into a real finding.
The month-by-month general ledger showed cost of goods sold dropping sharply in month eleven of the TTM period, driven by one $360,000 credit memo from the distributor’s largest supplier. The seller’s controller described it, accurately, as a volume rebate. What the CIM did not say was that the supplier had renegotiated its rebate program that year and the $360,000 cheque was a retroactive true-up covering three years of purchases — the current year and the two before it — paid out in a single lump sum because the supplier had been slow to formalize the new terms.
Booked as received, the $360,000 credit reduced TTM cost of goods sold from $7,656,000 to $7,296,000 on $9,600,000 of revenue — a reported gross profit of $2,304,000, or 24.0%. Only one of the three years the rebate covered was the TTM period itself, so only one-third of the cheque, $120,000, belonged in that year’s cost of goods sold. The remaining $240,000 was a one-time catch-up for purchases made in the two prior years and would not recur.
Adding that $240,000 back into TTM cost of goods sold moved it from $7,296,000 to $7,536,000. Gross profit fell from $2,304,000 to $2,064,000 — still positive, still a real business, but a gross margin of 21.5%, not 24.0%. On $9.6 million of revenue, a 2.5-point margin difference is $240,000 of annual profit that was never going to repeat, sitting directly inside the number the seller’s asking multiple was calculated against.
Nothing about the $360,000 cheque was improper or hidden — it was in the general ledger, it was a real payment from a real supplier, and the seller’s controller answered every question about it accurately. The issue was purely one of period matching: a non-recurring, multi-year catch-up landed entirely in a single trailing-twelve-month window that the buyer was about to pay a multiple against. A quality-of-earnings adjustment does not accuse anyone of anything; it asks a narrower question — if this event is unlikely to repeat next year, does it belong in the number the price is built on?
The buyer took the 21.5% figure back to the negotiating table, not the 24.0% one. The seller’s broker did not dispute the arithmetic once it was walked through month by month — the rebate’s own supplier correspondence confirmed the three-year catch-up characterization. The parties settled on a price built off the adjusted $2,064,000 gross profit figure rather than a walk-away. The price moved by considerably more than $240,000, and the distinction is worth stating precisely: a $240,000 overstatement of annual profit reduces enterprise value by $240,000 multiplied by the agreed multiple. Treating the two as the same number is the arithmetic mistake that most often survives an otherwise correct quality-of-earnings finding. The distributor still closed. What changed was which gross margin the buyer was actually paying for.
The same normalization discipline is what a bank-statement cross-check is built to catch on the revenue side rather than the cost side — see three years of statements, two sets of books. For how a financing screen can end a deal even earlier than a quality-of-earnings review does, see walking away in week two on a single number.
Had the buyer priced off the reported 24.0% margin, the deal would have closed too expensive by $240,000 multiplied by the agreed multiple — not by $240,000, which is the annual profit overstatement rather than the price overstatement. That is capital that does not show up as a mistake on day one, only as a return that never quite catches up to the model. Worse, the buyer’s own lender would likely have underwritten debt service against the inflated EBITDA figure, since gross margin flows straight through to it, leaving the business one normal year away from tripping a covenant it was never actually strong enough to carry.
The signal was not the size of the rebate — distributors run rebate programs constantly, and most rebate income is entirely legitimate, recurring revenue. The tell was a single unusually large credit memo concentrated in one month of a twelve-month trailing window, from a supplier that had recently renegotiated terms. Any adjustment that arrives as one lump sum rather than a steady monthly pattern is worth asking “what period does this actually belong to” before it is allowed to set the multiple.
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