Quality of Earnings (QoE) Report Cost: What Sets the Fee

How much does a quality of earnings report cost?

No government rule sets a price for a quality of earnings (QoE) report, and the SBA lender manual states no fee, so there is no standard price or official average. The financial professional who prepares the report (the reviewer) quotes a fee for the work your records require, and the condition of those records is the part you control.

Check first whether anyone requires one. An SBA 7(a) loan (the Small Business Administration's main loan program) requires a report only on an initial acquisition or expansion at $3 million or more, real estate excluded. The report must be for the lender, so one the seller orders does not count. On other deals the buyer, the lender and the purchase agreement decide. Details are under "When does an SBA lender require a quality of earnings report?" below.

What makes a case not simple: books that do not tie to the tax return, personal spending run through the business, cash sales never deposited, or sales that arrive through several platforms. Each one turns a check of finished books into a rebuild from bank statements. If a buyer, broker or lender has already asked for a report and any of these fits, the books need reconciling and closing month by month before the reviewer starts. See "Different for you?" at the end.

What to gather first: the last three years of business tax returns, monthly statements for every bank, card and payment account, and payroll and sales tax reports. The full list is under "What will the reviewer ask for first?" further down.

Before you accept a quote, get the scope and the fee in writing: the periods covered, the accounts included, whether the fee is fixed or hourly, and what happens to it if the records need rebuilding. A fee quoted before the reviewer has seen your records usually rests on assumptions about them. Ask which ones, and what changes if every account is reconciled and each month closed first.

What makes a quality of earnings fee go up or down?

The fee follows the amount of reconstruction: more periods, more accounts and more gaps between the books, the return and the bank mean more work. The SBA lender manual lists what a required report must cover. How a reviewer turns that into a price is the reviewer's own method.

What does a quality of earnings report cover?

A quality of earnings report tests whether the earnings a seller reports are reliable and likely to continue. The SBA defines it as an independent financial due diligence report on the reliability, sustainability and accuracy of a business's historical and projected earnings (SBA lender manual). A required report has four parts:

• A reconciliation. It ties the accountant-prepared statements, tax returns, internal statements and IRS transcript data into one adjusted earnings figure that reflects recurring, arm's-length operations: no one-time items and no deals on friendly terms, such as with a relative.
• A cash proof. It rebuilds cash receipts and payments by reconciling bank statement data to the income statement and the tax return, over the most recent 12 months and the last two fiscal years.
• Every add-back and adjustment. An add-back is a cost the owner ran through the business that a new owner would not have. The list covers non-recurring revenue or expenses, owner pay above or below market, related-party transactions, deferred maintenance, and cash versus accrual differences.
• A look at the revenue base. Customer concentration, contract continuity, and whether revenue and margins are likely to hold after the sale.

Outside an SBA loan, the buyer and the reviewer set the scope. The SBA list shows what a lender-grade report involves, not a rule for every deal. For recasting owner pay and personal costs, see add-backs and seller's discretionary earnings. For the seller's step-by-step preparation, see getting books ready for a quality of earnings review.

Who pays for a quality of earnings report: the buyer, the seller or the lender?

On an SBA 7(a) acquisition, the lender may pass the out-of-pocket cost of financial due diligence reports to the buyer, and funds the buyer spends on the report can count toward the required equity. The loan may also fund these costs (SBA lender manual). Who pays usually follows who orders the report.

Outside an SBA loan, the SBA manual does not apply. The purchase agreement or the reviewer's engagement letter usually settles who pays, so agree on it before the report is ordered.

When does an SBA lender require a quality of earnings report?

An SBA 7(a) lender must obtain one for an Initial Acquisition or a Business Expansion when the Business Purchase Price is $3 million or more. Owner buyouts and ESOP and cooperative deals are not subject to the requirement (SBA lender manual, Appendix 15).

The Business Purchase Price is the contract price less the appraised value of owner-occupied commercial real estate in the deal. The lender measures it before buyer equity, seller financing or any other funding, so a smaller loan does not avoid the requirement.

The lender assigns the deal's category, and Initial Acquisition is the default, so a buyer new to the business should expect it. An Owner Buyout is for current owners and employees who have worked in the business for at least 24 months. A buyer without that time is limited to under half the equity and cannot become the largest owner, or the deal is treated as an Initial Acquisition. For the deal types and the exceptions, see whether you need a report or a CPA review.

One exception is easy to misread. The manual requires no report, at any price, for an owner-occupied Special Purpose Property: limited-market real estate with a unique design, construction or layout, bought as an integral part of the business. The lender documents why the property qualifies, so ask the lender whether yours does. A valuation is still required.

Below the threshold, the manual requires no quality of earnings report. It does require financial due diligence on every change of ownership, including a business valuation and a check of the seller's data against IRS transcripts. A lender's own credit policy may ask for a report on a smaller deal, so ask.

The manual is revised often. Ask the lender which version it applies. A bank outside the SBA programs sets its own tests. See what an SBA lender asks the borrower for.

What is the difference between a quality of earnings report and a business valuation?

A quality of earnings report tests what the business earns. A business valuation estimates what it is worth. An SBA lender needs both on a larger acquisition, and the valuation must support the price.

If the earnings figure cannot support the valuation and the proposed debt, the manual requires the loan amount to be reduced, and extra equity can make up the difference (SBA lender manual). A report that finds lower earnings than the seller claimed can therefore shrink the loan, not only change the price talk.

How do clean monthly books lower a quality of earnings fee?

Clean books give the reviewer less to rebuild. Each account that already reconciles is one the reviewer can test instead of reconstruct. No set of books guarantees a lower fee. These five habits line up with what the cash proof tests:

1. Reconcile every account every month. The IRS says to reconcile the business checking account each month so the statement, the checkbook and the books agree (Publication 583). Do the same for card and payment-processor accounts.
2. Keep one set of books. The report ties together the statements, the tax return and the internal figures. They agree more easily when they come from one ledger, not a side spreadsheet.
3. Keep personal spending out. The IRS says to keep the business account separate from the personal one and use it for business only. It suggests noting whether each deposit is business income, personal funds or a loan (Publication 583). A personal charge becomes an adjustment the reviewer must find and the lender must accept. See personal expenses paid from the business account.
4. Close each month. Finish the month, then lock it. See the month-end close checklist.
5. Keep the source documents. Receipts, invoices, deposit slips and bank statements support each entry (Publication 583). For how long, see how long to keep business records.

If the months under review are not reconciled, finishing them before the reviewer starts is catch-up work. See what catch-up bookkeeping costs and cleaning up or starting fresh.

What will the reviewer ask for first?

Tax returns and bank statements, because they are the outside proof the books are tested against. Expect a list like this:

• Business tax returns for the last three years. An SBA lender analyzes the three most recent year-ends.
• Profit and loss statements and balance sheets, monthly if you have them, plus the latest year-to-date statement and the same period a year earlier.
• Bank and card statements for every account, covering at least the most recent 12 months and the last two fiscal years.
• Payment-processor and marketplace payout reports for the same months.
• Payroll reports and sales tax returns.
• Signed consent for IRS transcripts. The IRS gives a taxpayer's records to a third party only with the taxpayer's consent, through the service lenders use to get transcripts (IVES). A lender asks for Form 4506-C or Form 8821. The IRS must receive a signed Form 4506-C within 120 days, and a Form 8821 signed for a lender within 120 days, of the signature date, so signing long before the lender submits it can let the window run out (Form 8821 instructions).

The first three items come from the SBA lender manual. The others are what the cash proof and the transcript check need.

What if my books, tax returns and bank deposits do not agree?

A reviewer will usually list each gap by period and ask what caused it. Unexplained gaps tend to add work. An SBA 7(a) lender must verify the seller's financial data against IRS return transcripts, including the data the valuer relied on, and reconcile any discrepancies (SBA lender manual), so an unexplained gap will surface. Except under SBA Express, that happens before the lender first disburses the loan; SBA Express lenders may verify afterward.

A gap on a filed return, such as income left off or personal costs deducted, is a tax question as well as a bookkeeping one. Have a CPA look at it before you change a filed year in the books.

A year with no return filed is more than a gap: there is no transcript to test that year against. Outside SBA Express, the manual bars disbursing the loan while the IRS has no record of a year the lender must verify, unless the lender holds proof the return was filed and the tax paid or refunded (SBA lender manual). Filing the missing year is a tax job; settle it first. See catching up on unfiled business returns.

Example

These examples use US dollars and round figures.

A landscaping company with year-end books

A landscaping owner with US$1.2 million of revenue keeps the books once a year from a shoebox of receipts. A buyer asks for a quality of earnings report covering 24 months. The company has two bank accounts and two cards, so the reviewer must rebuild four accounts over 24 months: 96 monthly statements, each transaction sorted by hand. A landscaper with the same revenue whose four accounts reconcile every month hands over closed months, and the reviewer tests them instead of building them. In a case like this, the owner's records, more than the size of the sale, drive the work.

A US$3.5 million HVAC purchase with an SBA 7(a) loan

A buyer new to the business plans to buy an HVAC company for US$3.5 million, none of it real estate. That buyer falls in the Initial Acquisition category, and at or above $3 million the lender requires a quality of earnings report and a valuation, both for the lender. The lender may pass the report's cost to the buyer, and it can count toward the buyer's equity.

Suppose instead that US$0.8 million of the price is the building the company operates from, at its appraised value. The Business Purchase Price is US$2.7 million, below $3 million. The lender does not require a quality of earnings report, but it still requires a valuation and the seller's data checked against IRS transcripts.

A US$4 million partner buyout

Two partners agree that one buys out the other for US$4 million, none of it real estate. If the buying partner has worked in the business for at least the last 24 months, the deal can be an Owner Buyout, and the quality of earnings requirement does not apply. The lender must still verify the seller's data against IRS transcripts, so any gap between the books and the returns will surface. If the buying partner has less time in the business, taking the whole interest makes that partner the largest owner, so the manual requires the Initial Acquisition rules, including the report at this price. The lender documents the category, so ask how it classifies the deal.

Different for you?

• A buyer, broker or lender has asked for a report, or your books will not tie to the return or the bank deposits: the question is whether every account and month under review can be reconciled and closed before the reviewer starts, and what that covers. See bookkeeping help and what a clean-up involves.
• A return for a year under review was never filed: the lender cannot verify that year. File the missing return first (catching up on unfiled business returns), then reconcile the books around it (bookkeeping help).
• You are the seller and want the preparation steps, or are deciding whether to order your own report first: use getting books ready for a quality of earnings review.
• You are the buyer deciding whether to order a report: see whether you need a report or a CPA review and checking a seller's books before you buy.
• You run personal spending through the business, or a filed return may be off: for personal spending, see add-backs and seller's discretionary earnings. A filed return that may be off is a tax question for a CPA; get the books in order around it (bookkeeping help).
• You want the tax on the sale: see selling your business.
• You paid lawyers and accountants on the deal: see due diligence and deal costs.
• Your lender wants the borrower's statements: see SBA loan financial statements.