Quality of earnings for a CPA firm: what the buyer's advisor will test

What question should the review answer?

A transaction earnings review asks what the practice has actually earned, why the result occurred, and which economics can continue under the proposed buyer. It should connect financial records with client work, labor, collections, and obligations. A spreadsheet of favorable adjustments does not answer those questions without reconciliation and an operating explanation.

The valuation hub connects CPA firm quality of earnings with underwriting. Define the business perimeter, periods, accounting basis, selected earnings measure, and intended use before commissioning the work. A review of an entire firm differs from one covering selected tax clients or a separately transferred advisory service line.

Agree scope, independence, access, deliverables, and limitations with the provider. Determine which procedures address cash proof, revenue, expenses, working capital, owner functions, and known exceptions. Do not assume the label QoE means every client file, professional claim, tax position, or forecast has been verified. Those responsibilities need explicitly assigned review.

How should financial records be reconciled?

Connect general-ledger activity, financial statements, tax returns, bank receipts, billing systems, payroll, and relevant entity records. Explain differences rather than force all documents to the same unexplained number. Accounting basis, timing, distributions, intercompany transfers, and nonoperating activity can produce legitimate differences that still affect the acquisition analysis.

Trace revenue into actual cash where suitable, considering merchant fees, deposits, advances, and receivable movements. A bank deposit is not automatically current earned revenue. It can relate to earlier work or a future obligation. Reconcile both the amount and economic period before using deposits to support sustainable earnings.

Keep an exception log with documents, explanations, unresolved amounts, and impact. If available evidence does not support a material balance, show the uncertainty and any additional procedures needed. A buyer can then decide whether to obtain more evidence, impose a condition, revise terms, or stop the review rather than rely on a concealed plug.

Which revenue distinctions matter in an accounting firm?

Separate recurring services, annual returns, projects, catch-up work, amendments, notices, and unusual engagements. Review fee changes, scope, credits, collections, and client status by cohort. Annual work can recur economically without monthly billing, while a monthly invoice can conceal an unstable or unusually demanding relationship.

The historical Journal of Accountancy valuation framework considers practice-specific profitability and transfer factors. Apply that analytical approach to the actual revenue record, without treating dated examples as current market evidence. Identify which relationships and fees support the continuing forecast and which depend on assumptions the buyer has not established.

Review concentration in client groups and service providers. Revenue supported by a few specialized engagements may require significant continuing expertise. A single summary percentage can hide different margin and transition risks. Compare client history with actual work delivery so apparently recurring billings are not valued without the labor and authority needed to sustain them.

How should labor and owner functions enter the review?

Map production, technical review, relationship leadership, supervision, management, and administrative work. Reconcile employee and contractor costs with the actual people and periods. Identify unpaid owner labor, related-party support, vacant positions, and unusually heavy overtime. A historical profit margin can be real while still depending on resources the buyer must replace.

Use the add-back guide to evaluate adjustments alongside continuing costs. Distinguish owner-operator economics from earnings after hired management. Show the responsibilities assumed personally by the buyer and test capacity. Do not display the same labor as both removed compensation and an uncosted function the successor is expected to perform indefinitely.

Examine whether recent earnings reflect a sustainable staffing model. A temporary vacancy can reduce wages while delaying work and harming collections. An unusually strong month may require seasonal contractors not yet recorded. Connect the earnings period with workload and payroll accruals so a timing benefit is not mistaken for permanent operating improvement.

What should the report distinguish explicitly?

The output should let a reader trace conclusions to evidence and assumptions. Different earnings measures can be useful if they are clearly defined and reconciled. A report becomes less useful when a heading changes while owner-work, cash timing, and obligation treatment remain implicit.

Why should working capital be reviewed alongside earnings?

Identify receivables, work in process, advance fees, client deposits, payroll accruals, payables, and other relevant balances. Determine which transfer and how the agreement allocates their economic benefit and service obligation. Earnings alone do not establish the cash required immediately after closing or during the first seasonal collection trough.

A buyer may acquire a profitable client portfolio while the seller retains its receivables and the buyer completes unfinished work. Conversely, transferred advance fees may arrive with continuing delivery costs. Review the actual scope and closing mechanism. Counting cash without its associated obligation can make both price and liquidity appear more favorable than supported.

The payroll-services valuation guide illustrates an additional distinction between service fees and client money passing through payment arrangements. Understand what balances belong to whom and whether they are part of the purchase. A large flow of funds is not evidence of corresponding operating revenue or discretionary buyer cash.

When can a lender require a formal report?

The current SBA SOP 50 10 8.1 requires a quality-of-earnings report for specified Initial Acquisition and Business Expansion transactions when Business Purchase Price reaches $3 million, subject to policy exceptions and defined conditions. The policy’s calculation excludes owner-occupied commercial real estate and is not reduced by equity or seller debt.

Confirm the actual classification, price calculation, report provider, scope, and lender requirements before commissioning. A deal below a program threshold can still benefit from proportionate independent review, and lenders may request additional work. A seller or buyer should not assume that the presence or absence of the threshold settles all diligence needs.

Provide the lender with the provider’s proposed engagement terms and access plan. Ask how the required cash proof and operating analysis will be assessed. Starting late can create an avoidable closing delay if the initial report does not satisfy the lender’s defined expectations. Budget the work and document what remains outside its scope.

How should confidentiality shape the review?

The IRS Section 7216 information center describes rules relevant to use and disclosure of tax-return information. Agree the information-handling process with qualified advisers before sharing taxpayer records. An NDA or a financial-review purpose is not universal authority for unrestricted disclosure; applicable state client-record and professional duties also need review.

Use appropriately limited business information where it answers the question. Establish access permissions, secure storage, retention, and deletion arrangements for review materials. Keep client-identifying records out of broadly circulated report versions when unnecessary. The review should preserve enough support for its conclusions without expanding exposure to people who do not need the underlying information.

Separate report findings from protected engagement documents. A buyer may need an aggregated risk conclusion without every private client detail. Where further technical review is necessary, assign suitable authorized professionals. Confidentiality requirements should shape procedures deliberately rather than become an excuse to accept unsupported earnings or distribute sensitive files casually.

How should findings change the transaction?

Translate each material finding into a price input, funding requirement, condition, disclosure, or operating action. Distinguish quantified adjustments from unresolved risks and buyer-specific forecasts. The advisory-revenue guide helps evaluate expertise and relationship dependence that a clean financial reconciliation alone cannot eliminate.

1. Reconcile the business perimeter, records and earnings basis.
2. Explain revenue, labor, normalization and working-capital findings.
3. Separate historical conclusions from buyer implementation assumptions.
4. Resolve material exceptions or reflect them in appropriate terms.
5. Carry funded actions into the postclosing operating plan.

A useful review improves the decision by making the earnings claim understandable and testable. It does not turn an uncertain handoff into a guaranteed result. The buyer still needs a feasible professional, staffing, client, and cash plan consistent with the report’s supported conclusions.