Quality of Earnings Report: Do You Need One to Buy a Business

Do you need a quality of earnings report to buy a small business?

A quality of earnings (QoE) report is a financial due diligence report that restates a business's earnings to a normalized figure, with one-time and owner-specific items removed. It is not a government form: a lender or a buyer asks for it. For an SBA 7(a) loan (the Small Business Administration's main loan program), the lender must obtain one when the business purchase price is $3 million or more (SBA lender manual, SOP 50 10 version 8.1, Appendix 15). Below that price SBA does not require one, and a lighter check may fit: a CPA tie-out, which compares the seller's tax returns, financial statements and bank deposits for the same periods (explained below). The lender still requires a business valuation and checks the seller's data against IRS transcripts.

The SBA price test uses the business purchase price: the contract price minus the appraised value of any owner-occupied commercial real estate, measured before buyer equity, seller debt or other financing. It applies to an initial acquisition (a new majority or largest owner, or an employee of under 24 months) and to a business expansion (an existing business buys another). Initial acquisition is the default category. An owner buyout covers current owners and employees of at least 24 months and, when an original owner stays, an outsider who takes less than half and does not become the largest owner; an outsider who takes half or more, or becomes the largest owner, is treated as an initial acquisition.

The manual also skips the QoE for an owner-occupied special purpose property (a limited-market building such as a storage facility or hotel) that cannot be separated from the business, whatever the price. A valuation is still required. SBA revises its manual from time to time, so confirm the threshold with the lender.

What makes a case not simple: the seller's profit and loss statement, tax return and bank deposits disagree; the business takes cash; the price is near the threshold or includes a building; the seller pays family members or related companies; you have signed, or are about to sign, a letter of intent and no one has compared the books with the returns; or a lender has already named a QoE. In those cases the adjustments usually call for a CPA's judgment. The lender sizes the loan on the report's earnings figure, so a lower figure can mean a smaller loan. If a letter of intent is signed, ask your attorney how long its diligence period runs.

What to gather: the letter of intent, three years of tax returns and financial statements, a current year-to-date statement and the same months of the prior year, monthly profit and loss statements, bank statements for the same months, and payroll and sales tax reports.

Quality of earnings vs due diligence: how is a QoE different from reviewing tax returns?

Due diligence is the buyer's whole check of a business: legal, tax, operations and financial. A QoE is the financial part, done by tying every record together. A review of tax returns reads only what the seller reported to the IRS.

SBA describes a QoE as a report that reconciles the business's accountant-prepared financial statements, tax returns, internal financial statements and IRS transcript data into one normalized, adjusted earnings figure (SBA lender manual). It also assesses how reliable the revenue is: customer concentration, contract continuity and whether revenue and margins are likely to hold after the sale. A return reports taxable income. It is not built to show what a new owner will earn.

A CPA's check of the seller's books and returns, which people also call accounting due diligence, bookkeeping due diligence or a CPA review, can be a tie-out or a full QoE. For an SBA deal at or above the threshold, only a QoE that meets the SBA's rules counts.

Is a CPA tie-out of the books and returns enough?

It can be enough when no rule or lender requires a QoE, such as an SBA deal below the threshold. Where an SBA lender requires one, only a report that meets the SBA's rules counts. A tie-out compares the seller's tax returns, financial statements and bank deposits for the same periods and lists what ties and what does not. It is not an audit or a review, and no rule defines its scope; the scope is what you and the CPA agree in writing.

1. Match each year's revenue on the profit and loss statement to the revenue on the return, and explain each gap.
2. Total the bank deposits for the same months and compare them with revenue, explaining each gap as in the cash proof below.
3. Compare payroll and sales tax reports with the wages and sales on the books.
4. Compare the return with the IRS transcript once the seller authorizes it.

As described here, a tie-out does not set out a normalized earnings figure. It can be the first step: if gaps stay unexplained, you decide with your lender and attorney whether to commission the full report, renegotiate the price or walk away.

A tie-out does not clear the seller's unpaid taxes. Some states hold a buyer liable for the seller's unpaid sales tax unless the buyer withholds from the price, as in California, or notifies the tax agency at least 10 days before paying or taking possession, as in New York. Those steps, and your own checks before a CPA is involved, are in checking a seller's books before you buy.

What does a quality of earnings report adjust?

A QoE adjusts the seller's reported earnings for items that will not repeat or will not look the same under a new owner. The SBA manual names five groups (SBA lender manual).

On the cash method a business includes income it actually or constructively received during the year; on an accrual method it generally reports income in the year it is earned (IRS Publication 538). A difference between a cash-method return and accrual statements is therefore not, by itself, a sign of an error; the reconciliation shows how much of a gap the method explains.

The lender uses the QoE's earnings figure to test whether the business earns enough to repay the loan (debt service coverage). If coverage does not support the valuation and the proposed debt, the loan amount must be reduced, and added equity can make up the difference (SBA lender manual).

For how each add-back is argued and supported, see add-backs and seller's discretionary earnings.

What is a cash proof, and how many periods does it cover?

A cash proof rebuilds the business's cash receipts and payments from bank statements and reconciles them to the income statement and the tax return for each period under review. Its purpose is to find discrepancies in income and undisclosed expenses.

SBA requires a cash proof inside every QoE, for the latest 12 months and for the last two fiscal years. If the business has operated for under two years, the scope can be reduced (SBA lender manual).

Revenue on the profit and loss statement, deposits in the bank and income on the return rarely match to the dollar. Common reasons are unpaid invoices at year end, refunds, processor fees netted out of payouts, sales tax collected, and transfers between the seller's own accounts. Each gap needs a document that explains it; how to trace them is in checking a seller's books before you buy.

If the seller says part of the sales were paid in cash, deposits will fall below sales. Ask for daily sales reports and point-of-sale records and compare them with deposits and the return. A transcript shows only what was reported, so sales that never reached a return or a bank cannot be confirmed from it; a CPA can help judge how much weight the earnings figure can carry.

Can you use the seller's report, or must the lender's or your own be used?

For an SBA loan, the QoE must be performed by an independent, experienced financial professional for the benefit of the lender, and it must not be prepared by or for the seller. A report the seller ordered to support the asking price cannot satisfy the requirement (SBA lender manual).

A buyer may commission a report before approaching a lender. The lender may then have it reviewed by one of its approved vendors, and the review findings go in the loan file with the original. The lender may not rely on a report prepared by another party without that vendor review. Ask the lender who must perform or review the report before you pay for one.

A seller's own report is a different tool, covered in quality of earnings for a small business sale.

What does a lender require if the deal is under the threshold or not SBA-financed?

Under the threshold SBA does not require a QoE, but it does require the checking. The manual requires financial due diligence on every change of ownership (SBA lender manual).

• A business valuation. An independent qualified source, such as an accredited business appraiser or valuation analyst, must value the business, and the valuation must be requested by and prepared for the lender. The lender may not use one prepared for the buyer or the seller. At a business purchase price of $350,000 or less, the lender may do its own valuation, unless the buyer and seller have a close relationship. If the price is above the valuation, equity must cover the difference.
• The seller's IRS transcripts. The lender must verify the seller's financial data, including a selling sole proprietor's Schedule C, against IRS transcripts. Except for SBA Express loans, the manual expects discrepancies to be reconciled before the first disbursement. If you buy only a division or location and neither the transcripts nor the seller's statements identify it, the lender must verify the seller's figures another way, such as CPA-prepared or reviewed statements or sales tax payment records.

A bank outside the SBA programs sets its own tests; the manual shows what one large program asks. Ask for the lender's requirements in writing before you pay for any report. Whether a tie-out or a full report is enough is for your lender, if there is one, and your attorney to say.

How do you get the seller's tax transcripts, and what must the seller sign?

The IRS gives tax records to a third party only with the taxpayer's consent (IRS IVES). A transcript is not a photocopy of the return: a corporate or partnership return transcript shows most line items as filed, without attached documents or statements and without changes made after filing; the tax account transcript shows account changes such as payments, penalties and any balance due (IRS business transcripts). A return transcript covers the current year and the prior 3 processing years (Form 4506-C), and the IRS says to allow 2 to 3 weeks after e-filing, or 6 to 8 weeks after mailing a paper return, before asking for a business transcript. Ask the seller early whether the latest return is processed.

When a lender asks. The lender requests the transcript through the IRS Income Verification Express Service with Form 4506-C, and the seller approves it (IRS IVES for taxpayers). The IRS must receive the signed form within 120 days of the signature date, so do not have the seller sign long before the lender submits it (Form 4506-C). Someone with authority for the business signs, such as a partner or an officer; the IRS lists the acceptable titles by return type.

If the seller is a sole proprietor, including a single-member LLC that reports on Schedule C, the figures are on the owner's personal Form 1040, so the request is for the owner's individual return transcript, signed by the owner, and by the spouse too if both are listed on a joint-return request (IRS; Form 4506-C).

What SBA adds. The lender may instead use Form 8821, naming the lender on line 2 as the person allowed to receive the information, and it must request a transcript type that includes changes to the original return. SBA does not allow the borrower or the borrower's own tax preparer to file the Form 8821 for an SBA loan (SBA lender manual, Chapter 5).

For your own diligence. The seller can hand you transcripts from the IRS, or sign Form 8821 naming your CPA to inspect or receive the tax information listed on the form. Form 8821 does not request copies of a return or let your CPA speak for the seller. A Form 8821 signed for a lender's income check or a buyer's review must reach the IRS within 120 days of the signature date (Form 8821 instructions). The routes are in checking a seller's books before you buy.

Your attorney can write the seller's duty to supply records and sign the transcript authorization into the letter of intent.

Who pays for the report, and does it count toward the down payment?

On an SBA loan, the out-of-pocket cost of financial due diligence reports may be passed on to the borrower, and money the buyer pays for a report can count toward the equity injection. The manual separately lets loan proceeds cover a buyer's out-of-pocket expenses such as a valuation and a QoE (SBA lender manual). Ask the lender, before you order, how a report will be counted toward your equity, especially if loan proceeds pay for it.

Your down payment, which SBA calls the equity injection, must be at least 10% of total project cost (all costs of getting the business running, not just the price) for an initial acquisition, and it cannot be reduced or eliminated.

What a report costs is on the cost page. Whether diligence fees are expensed or added to the price is in due diligence and deal costs.

Example

These examples are illustrative; all figures are in US dollars.

A $900,000 purchase with SBA financing

A buyer signs a letter of intent for an HVAC company at $900,000, with no real estate in the price. The price is under $3 million, so SBA does not require a QoE. The lender requires an independent valuation, because the price is above $350,000, and verifies the seller's data against IRS transcripts. Before deciding how much more diligence to buy, the buyer has a CPA tie three years of returns, monthly profit and loss statements and bank deposits together. If a gap has no document behind it, the buyer can ask the seller for support, ask for a lower price, or decide with the lender and an attorney whether to order a full report.

A $4,000,000 purchase with SBA financing

An outside buyer, so an initial acquisition, is acquiring a restaurant group for $4,000,000, the business price with no real estate in it. The lender must obtain a QoE, and it cannot be prepared by or for the seller. If the buyer commissions a report first, the lender can use it only after its vendor reviews it. If the $4,000,000 contract price instead included an owner-occupied building appraised at $1,200,000, the manual subtracts the appraised value, not a split written into the contract, so the business purchase price would be $2,800,000, below the threshold. No QoE is then required, but the lender still needs the valuation, the transcript check and a real estate appraisal, and equity is still figured on the whole project, building included.

A cash proof with gaps

A seller shows profit and loss revenue of $1,200,000, a tax return with $1,150,000 and bank deposits of $1,090,000 for the same year. That is $50,000 between the statement and the return and $60,000 between the return and the deposits. The buyer's CPA asks for the documents behind each gap, such as unpaid year-end invoices, refunds and processor fees. Until each gap has a document, the earnings figure is unconfirmed.

Different for you?

• You have signed a letter of intent for a bank- or SBA-financed purchase, the seller's numbers do not tie to the returns or deposits, or a lender has named a QoE: a CPA can tie the seller's returns, statements and deposits together and list what does not tie. That gives you questions for the seller before you decide on a fuller report, which your lender may also require. See bookkeeping help.
• You are buying one location or division of a larger business: the seller's returns and transcripts cover the whole company, so the lender must verify the part you buy another way. A CPA can separate that part from the rest and tie it to the seller's books. See bookkeeping help.
• You are the seller: see quality of earnings for a small business sale and add-backs and seller's discretionary earnings.
• You want to run your own checks first: see checking a seller's books before you buy.
• The bank wants statements for a business loan, not a purchase: see financial statements for a bank loan.
• Investors, not a lender, are doing the diligence: see financial records investors ask for.
• You are asking how the price is split among assets and what tax follows: see buying a business and selling your business.
• The seller's returns were never filed, or the seller's books are behind: a transcript cannot verify a return that was never filed. Raise it with your lender and attorney before you rely on any earnings figure; see checking a seller's books before you buy.
• Your own books are behind (for example, you own a business and are buying another): the lender also checks your own statements against your returns and IRS transcripts, and an applicant that has not filed required federal returns is not eligible for SBA financial assistance; see catching up on overdue books and bookkeeping help.