A quality of earnings (QoE) report is an independent check on whether a business's profit is real and will repeat under a new owner. A provider rebuilds the numbers from bank statements, tax returns and the books, removes one-time items and restates owner pay. The result is a normalized earnings figure, usually adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), that you can price and finance against. This primer is for buyers deciding whether they need one, and for buyers who just received a draft.
The short answer
- A QoE asks one question: if I own this business next year, how much of the profit the seller reports will still be there? It is not an audit and it is not a valuation.
- The main work is testing add-backs (adjustments that raise earnings), restating owner pay and one-time items, proving cash, and checking revenue quality and working capital.
- In Small Business Administration (SBA) 7(a) Initial Acquisition and Business Expansion loans, the lender must obtain a QoE when the business purchase price is $3 million or more (not counting owner-occupied real estate). Below that, SBA does not require one, but a buyer, investor or lender may still want one.
- Insurance cost can be part of the normalization. If the seller carried a thin program, the go-forward cost may be higher than the historical expense. Not every QoE looks at it, so ask whether it is in scope.
- Fees depend on the size and complexity of the business, how clean the books are and how much is in scope. Providers quote each job separately, so ask two or three for a written scope and a fixed or capped quote, and ask your lender whether the cost can count toward your equity.
What does a quality of earnings report examine?
Most reports test five things: whether the numbers reconcile, whether profit turned into cash, which add-backs hold up, how reliable revenue is and what normal working capital looks like. Scope is set by the engagement, so two reports can look quite different. The table shows the pieces most reports include.
| Area | What the provider does | Why a buyer cares |
|---|---|---|
| Reconciliation | Ties tax returns, internal financials and accountant-prepared statements to each other | Three versions of profit that do not agree is a finding in itself |
| Cash proof | Rebuilds receipts and payments from bank statements and ties them to the income statement and tax return, for the trailing twelve months and the last two fiscal years (the SBA version) | Shows whether reported revenue turned into cash |
| Add-backs and normalization | Tests each adjustment to the seller's earnings and restates owner pay | Sets the earnings number the price rests on |
| Non-recurring items | Removes one-time gains and adds back one-time losses | Keeps a windfall or a bad year from distorting run-rate earnings |
| Revenue quality | Looks at customer concentration, contract terms and the likelihood revenue holds after the sale | A profitable business that depends on one customer is a different risk |
| Working capital | Measures the normal level of receivables, inventory and payables over time | Feeds the target used at closing. See working capital and the peg |
| Debt-like items | Looks for obligations that behave like debt (for example unpaid taxes, deferred revenue, customer deposits) | Can change what you really pay at closing. Definitions are negotiated, so ask your accountant |
| Pro forma adjustments | Restates past results as if expected changes (new standalone costs, a different insurance program) had applied from the start | Shows what the business may earn under you, not under the seller |
For SBA 7(a) loans that require a report, the rulebook is specific: the report must reconcile the accountant-prepared statements, tax returns, internal financials and IRS tax transcripts to a normalized earnings figure, include a "cash proof" (a rebuild of cash receipts and payments from bank statements), identify all add-backs and adjustments, and assess customer concentration, contract continuity and the likelihood that revenue and margins hold after the sale. Outside the SBA program, the scope is whatever buyer and provider agree.
In smaller owner-operated deals, earnings are often discussed as seller's discretionary earnings (SDE) instead of EBITDA, so a report may be framed either way. The work is similar, but SDE adds back the owner's pay, so ask which measure the report uses and whether it includes a market wage for a replacement manager. See how small businesses are valued.
Who needs a quality of earnings report, and when is it worth it?
If you are using an SBA 7(a) loan to buy a business for $3 million or more (not counting owner-occupied real estate), the lender must obtain a QoE. That is the rule for Business Expansion and Initial Acquisition loans in the SBA's Standard Operating Procedure (SOP) 50 10 8.1 (effective October 1, 2026). Below that, it is your call.
- The $3 million is measured before buyer equity, seller debt or other financing.
- Owner buyouts, employee stock ownership plan and cooperative deals, and acquisitions of an owner-occupied special purpose property are not subject to it.
Debt capacity is where it bites. For change of ownership loans, SBA measures debt service coverage on EBITDA, with minimum ratios of 1.25 to 1 for Initial Acquisitions and owner buyouts and 1.15 to 1 for Business Expansions, and the lender must use the QoE earnings when a QoE is required. A lower tested number can mean a smaller loan.
Outside those rules, the choice is yours. Use this guide as a starting point and talk to your accountant and lender.
| Situation | Leaning |
|---|---|
| SBA 7(a) Initial Acquisition at $3 million or more (not counting owner-occupied real estate) | Required by the SBA rulebook |
| Investor-backed search fund or holding company deal | Investors and lenders may ask for one |
| Owner runs personal expenses through the business | Commonly a reason to get one |
| Books are cash-basis, thin or recently changed accountants | Commonly a reason to get one |
| One or two customers drive most revenue | Worth it, with revenue quality in scope |
| Small deal, clean accountant-prepared statements, tax returns that match the bank | A lighter review by your accountant may be enough. Ask them |
On cost, fees depend on the size and complexity of the business, how clean the records are and how much is in scope. Providers quote each engagement separately, so ask two or three for a written scope and a fixed or capped quote. SBA lets the lender pass the cost of required financial diligence reports on to the borrower, and money the applicant spends on a lender-required report counts toward the equity injection. Ask your lender how that works for your loan.
Who prepares one, and what do they need from the seller?
A QoE is usually prepared by an independent accounting or advisory firm. A buy-side report is commissioned for you or your lender. A sell-side report is commissioned by the seller, and a lender or investor may still want its own. Under the SBA rulebook the report must be done by an independent, experienced financial professional for the benefit of the lender, not prepared by or for the seller, so a report the seller commissions cannot stand in for it. A report you commission can be used only if one of the lender's approved vendors reviews it.
Timing depends on how fast the seller delivers bank statements, ledgers, payroll records and tax returns. Before you start, ask the provider for a timeline and a data request list, and ask whether debt-like items and the working capital level are in scope.
What are add-backs, and where do they go wrong?
An add-back is an adjustment that raises the seller's reported earnings because an expense will not continue under the new owner. The SBA names these categories: non-recurring revenue or expenses, above or below market owner compensation, related party transactions, deferred maintenance and accounting method differences. Typical examples from advisors are owner perks and personal expenses, a family member on payroll who does not work in the business, and one-time costs.
Add-backs must be supportable, because a buyer's advisors will test each one. Advisors commonly look for problems in both directions. A seller counts an expense as personal when the business actually needs it. A seller claims a one-time cost that has shown up every year. Owner pay is added back in full with no allowance for a manager you will have to hire. Maintenance has been put off, which flatters earnings today and will cost you later.
A hypothetical example. A seller presents adjusted earnings of $1,200,000. A QoE provider tests each piece. The numbers are round and illustrative.
| Item | Seller's version | After testing |
|---|---|---|
| Reported earnings | $1,000,000 | $1,000,000 |
| Owner's vehicle and personal travel | +$60,000 | +$45,000 (some business use) |
| One-time lawsuit settlement (not insured, no similar claims) | +$90,000 | +$90,000 |
| Spouse on payroll with no duties | +$50,000 | +$50,000 |
| Owner paid below a market replacement manager | None | -$50,000 |
| Insurance restated to the program the business needs | None | -$30,000 |
| Adjusted earnings | $1,200,000 | $1,105,000 |
The insurance line is negative because the seller's thin program flattered earnings, so a fuller program lowers them. The $30,000 is an illustrative round number, not an expected premium difference. The settlement is a clean add-back only if insurance did not pay it and similar claims do not recur, so ask the seller for the claim file and loss runs.
The gap between $1,200,000 and $1,105,000 is $95,000. At an illustrative multiple of 4 times earnings, that is about $380,000 of price. That is why buyers read every line of the bridge, and why they ask the seller to support each add-back with an invoice, a payroll record or a contract. See how small businesses are valued for how earnings measures and multiples fit together.
How is insurance cost handled in a quality of earnings report?
Insurance is an operating cost, so it can show up in three places:
- Normalizing the historical premium. One accounting firm lists "normalizing corporate insurance cost over the historical period" and "one-time insurance credits" among the usual adjustments.
- Non-recurring items. A one-time insurance recovery comes out of adjusted earnings as a non-recurring gain, and an uninsured casualty loss can be added back as a one-time loss, if it was truly one-time.
- Pro forma adjustments. These restate past results as if expected changes had applied from the start, such as a different go-forward insurance program if the seller was underinsured or your lender requires added coverage. Whether a given report includes it depends on the provider and the engagement, so do not assume it does.
Test the one-time add-back. Losses a business keeps absorbing through deductibles, retentions or missing coverage may recur, and if you will also carry that risk, an add-back overstates earnings.
Practical steps:
- Ask the provider in writing whether insurance cost, claims and recoveries are in scope.
- Give your broker the policies and loss runs early and ask what a program that fits the business may cost under you. A quote is not coverage and depends on carrier underwriting, but it gives your model a better starting point than a guess.
- Split any difference into recurring items (a higher premium every year) and one-time items (a past audit bill, or a deal cost such as a tail policy that the purchase agreement may allocate to the seller).
For the full treatment, see insurance in your quality of earnings review and the seller was underinsured, so true EBITDA is lower. To build the cost into your model, see budgeting insurance in your acquisition model.
How do you read the report and use it in the deal?
- Start with the bridge. Find the table that goes from reported earnings to adjusted earnings. Every dollar between the two should have a description and evidence.
- Check what is out of scope. The report lists what the provider did not test. If insurance, payroll compliance or customer calls were excluded, decide who covers them.
- Compare to the seller's figure. A difference is a negotiation. Show the lines to the seller and ask for support or a price discussion.
- Look at working capital. The normal level over time informs the target in the purchase agreement.
- Share it with your lender and investors. The lender may need its own approved vendor to review a report you commissioned.
- Use it after closing. The findings tell you where to look first: the customers that drive revenue, the expenses that were deferred and the costs that will be higher under you.
If findings change the price or terms, that conversation often refers back to the earnings basis written in the letter of intent (see what is a letter of intent) and is settled in the purchase agreement. A short list of what to ask your accountant: which add-backs did you reject, which did you accept on thin support, and what would change your number?
Keep reading
- Insurance in Your Quality of Earnings Review: What to Adjust and Ask
- The Seller Was Underinsured, So True EBITDA Is Lower
- How Small Businesses Are Valued: SDE, EBITDA and Multiples
- Due Diligence Checklist for Buying a Small Business
- Reading a Small Business's Financial Statements Before You Buy
- All guides for new business owners
Frequently asked questions
What is a quality of earnings report in simple terms?
It is an independent check on whether a business's reported profit is real and likely to repeat under a new owner. A provider tests the numbers against bank statements and tax returns, adjusts for one-time and owner-specific items, and reports a normalized earnings figure.
Is a quality of earnings report the same as an audit?
No. An audit gives an opinion on whether financial statements are fairly presented. A quality of earnings report focuses on the earnings a buyer can expect and what adjustments to make. Its scope is set by the engagement.
Do I need a quality of earnings report to buy a small business?
Not always. For SBA 7(a) Initial Acquisition and Business Expansion loans, the lender must obtain one when the business purchase price is $3 million or more (not counting owner-occupied real estate). Below that, SBA does not require one, but your lender, investors or accountant may still want one.
How much does a quality of earnings report cost?
It depends on the size and complexity of the business, the number of entities and locations, how clean the records are and how much the scope includes, for example a cash proof covering several years. Providers quote each engagement separately, so ask two or three for a written scope and a fixed or capped quote. If you use an SBA 7(a) loan, the lender may pass the cost to you, and money you spend on a lender-required report counts toward your equity injection.
Does a quality of earnings report include insurance?
Sometimes. Providers may normalize insurance cost over the historical period, remove one-time recoveries and add back one-time uninsured losses. Whether a go-forward insurance adjustment is included depends on the provider and the engagement, so ask.
What is the difference between add-backs and normalization?
Add-backs are specific adjustments that raise the seller's reported earnings because an expense will not continue. Normalization is the broader process of restating earnings to a typical, repeatable level, which includes add-backs, owner pay at a market rate and one-time items in both directions.
References
- U.S. Small Business Administration: SOP 50 10 8.1, Appendix 15, Quality of Earnings and Financial Due Diligence (effective October 1, 2026)
- The Bonadio Group: What to Expect in a Quality of Earnings Analysis (October 2, 2024)
- Pease Bell: Quality of Earnings Adjustments, How They Change EBITDA in a Deal (October 3, 2026)
- Morgan & Westfield: Acquired, Ch. 4, Calculating EBITDA (sell-side advisory firm, 2026)
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This article is general information, not legal, tax or financial advice, and not a coverage determination. Coverage depends on the actual policy wording, carrier underwriting, your purchase agreement and your contracts. Ask your attorney and accountant about deal and legal questions.