Do I Need a Quality of Earnings Report to Buy a Small Business?

What a QoE Covers, and How It Differs From an Audit

A quality of earnings report examines a target business's financial statements to determine whether the reported earnings, and any add-backs the seller applies to arrive at adjusted earnings, hold up under closer review. It typically covers revenue quality and recurrence, customer concentration, the reasonableness of add-backs for owner compensation and discretionary expenses, and a normalized working capital level for the business.

A QoE is not an audit, a distinction covered in more depth in quality of earnings reports explained. An audit provides an opinion on whether the financial statements comply with an accounting framework, taken as a whole, and is backward-looking in a formal sense. A QoE is a diligence tool built for the buyer's specific transaction, focused on whether the numbers the seller is using to justify the price are supportable, and it is also distinct from the lender's own third-party business valuation, which values the business for loan-sizing purposes rather than testing the underlying earnings quality the way a QoE does.

Most small business sellers have never had their financials examined by anyone outside their own bookkeeper or tax preparer, so a QoE is often the first time the business's numbers face outside scrutiny. That can surface honest differences of opinion about how to normalize the earnings, such as whether a particular vehicle expense or family member's salary should be added back, as well as more serious problems, such as revenue recognized before it was actually collected or expenses moved between periods to smooth reported earnings.

When It Is Worth the Cost

A QoE is most valuable when the purchase price is large enough that a material misstatement in earnings would meaningfully change the deal economics, when the seller's earnings depend heavily on add-backs that are hard to verify from the financials alone, or when the business is owner-dependent in ways that make it difficult to separate the owner's personal expenses from the business's true operating costs.

Businesses with meaningful inventory or working capital needs also benefit from a QoE, since the working capital analysis that comes out of the report often becomes the basis for the working capital target and true-up mechanism written into the purchase agreement. A smaller, simpler acquisition with clean, easily verifiable financials may not justify the cost and time a full QoE requires, and a lighter-scope financial review can sometimes serve the purpose instead.

Deal timeline also factors into the decision. A full QoE takes real calendar time to complete, since the provider needs access to the target's books, time to test the data, and time to draft findings. A searcher weighing whether to commission one should factor that time into the overall diligence schedule and discuss with the seller, early, that a QoE is part of the process rather than an unexpected delay introduced late in negotiations.

How QoE Findings Change the Purchase Agreement

Findings from a QoE commonly flow directly into the purchase agreement. If the report identifies overstated add-backs or unsustainable revenue, the buyer typically uses that to renegotiate the purchase price before signing, as described in more detail in quality of earnings for small acquisitions. If the report establishes a normalized working capital level different from what the letter of intent assumed, that figure becomes the working capital peg and post-closing true-up mechanism in the purchase agreement.

A QoE can also surface issues that are better addressed through specific representations and indemnities than through a price adjustment, such as a customer concentration risk or an unresolved accounting practice. Structuring those findings as targeted reps and indemnities, rather than trying to capture every risk in the price alone, is typically where the buyer's legal due diligence and the QoE findings need to be coordinated together in drafting the purchase agreement.

Sequencing With the Lender's Third-Party Valuation

On an SBA-financed deal, the lender's required third-party business valuation and the buyer's QoE serve different purposes and are typically ordered on separate but overlapping tracks. The lender's valuation supports how much the SBA loan can finance, while the QoE supports whether the buyer should proceed at the negotiated price and on what terms. Ordering the QoE early enough in diligence that its findings can still influence the purchase agreement, rather than after the agreement is largely drafted, keeps the two processes useful to each other instead of working against the closing timeline.

Because the lender will also be reviewing the same underlying financials as part of its own SBA 7(a) diligence requirements, a QoE that surfaces a material issue can affect the lender's underwriting as well as the buyer's price negotiation, so it is worth sharing significant findings with the lender promptly rather than treating the QoE as a buyer-only document.

Who Pays, and Whether It Can Be Financed

The buyer typically pays for and commissions the QoE, since it is a diligence tool serving the buyer's decision to proceed, though the specific fee arrangement is a matter between the buyer and the provider it engages. Whether a QoE's cost can be included in the SBA loan's financed closing costs is a lender-specific and deal-specific question, so confirm with your lender early whether this expense fits within the sources-and-uses schedule for the transaction rather than assuming it does.

Some sellers commission a sell-side QoE before going to market, intended to give buyers confidence in the numbers up front and potentially reduce the scope of a buyer's own review. A buyer relying on a sell-side report should still have independent counsel and, in most cases, independent financial advisors review it, since a report the seller commissioned was scoped to serve the seller's sale process rather than the specific buyer's diligence questions.

A buyer relying on a sell-side report also benefits from confirming with the provider what scope of reliance the buyer is entitled to, since some engagement letters limit a report's use to the party that commissioned it. Clarifying reliance rights before the letter of intent is signed avoids discovering, after the deal has progressed, that the buyer cannot rely on the report's conclusions if a dispute arises later.

What to Do When the QoE Finds a Gap

A QoE finding is rarely a reason to walk away from a deal by itself. More often it changes how the deal is priced or structured. A buyer who receives a QoE identifying a working capital shortfall, unsupported add-backs, or a customer concentration risk should work with counsel to decide whether the right response is a price adjustment, a specific indemnity in the purchase agreement, an escrow holdback, or some combination, rather than treating the finding as purely a financial advisor issue separate from the legal documents.

Comparing the QoE's normalized earnings figure against the metric the seller originally used to price the deal, whether that is seller's discretionary earnings or EBITDA, also helps a buyer understand whether the gap reflects a genuine overstatement or simply a difference in how the two sides define normalized earnings, which changes how the conversation with the seller should be framed.

It also helps to decide in advance, ideally in the letter of intent, how a significant QoE finding will be handled procedurally rather than negotiating the process from scratch after the report is delivered. A letter of intent that gives the buyer a defined right to renegotiate or walk away if the QoE reveals a material discrepancy, above a threshold the parties agree on up front, tends to keep a difficult finding from turning into a breakdown in trust between buyer and seller partway through diligence.