By Ryan Murphy, Managing Director, Transaction Advisory Services
For years, we have told SBA lenders that a quality of earnings report was never required but always advisable. As of October 1, 2026, half of that sentence is obsolete.
Change-of-ownership lending has grown into one of the largest categories of 7(a) volume, yet the underwriting stack has had a structural gap: nothing in the file independently tested the earnings figure on which everything else was calculated. The appraiser worked from financial information that was often self-reported, which was the assignment, not an oversight. Tax transcripts confirmed what was filed, not whether it was repeated or even valid in the first place. SOP 50 10 8.1 now closes that gap and, notably, does so by prescribing a floor on the work, not just the credential.
What the Change Actually Says
The new Appendix 15 consolidates all change-of-ownership policy and sorts transactions into four categories: Initial Acquisition, Business Expansion, Owner Buyout, and ESOP & Cooperative. Financial due diligence is required on all of them, scaled by Business Purchase Price.
The provisions worth flagging to your credit and BDO teams:
- The trigger: A QoE is required on Initial Acquisition and Business Expansion transactions where the Business Purchase Price (the price in the purchase and sale agreement, less any owner-occupied real estate at appraised value) is $3 million or more. Owner Buyouts and ESOP/Cooperative deals are exempt on the grounds that existing owners retain operational knowledge.
- It is yours, not theirs: The QoE must be performed by an independent, experienced financial professional and conducted for the benefit of the lender. It may not be prepared by or for the borrower or the seller. A seller-side report provided by a broker does not satisfy this requirement.
- It is in addition to the valuation, not a substitute for it.
- Prescribed content: The report must reconcile accountant-prepared statements, tax returns, internal financials, and IRS transcript data to produce a normalized earnings figure reflecting recurring, arm’s-length operations; document every add-back (for example, non-recurring items, above- or below-market owner compensation, related-party transactions, deferred maintenance, and cash-versus-accrual differences); and assess revenue quality, including, but not limited to, customer concentration, contract continuity, and the likelihood that margins hold post-sale.
- A cash proof is mandatory: A reconstruction of cash receipts and disbursements that reconciles bank statement data to the income statement and tax return for each period under review, performed on both a trailing twelve-month basis and for the last two fiscal years.
- It drives the credit decision: The lender must use the QoE earnings in the debt service coverage calculation and retain the report in the credit file. If the resulting DSC does not support the valuation and proposed debt structure, the loan amount must be reduced or the gap filled with additional equity. Minimum DSC is 1.25:1 for Initial Acquisitions and Owner Buyouts and 1.15:1 for Business Expansions.
- Timing under PLP: The valuation and QoE may be completed after the SBA loan number is issued and before closing, but both must be formally engaged (with a vendor retained and an engagement letter in place) at the time the number is issued. The credit memo must then be updated to reflect QoE findings and any DSC impact.
- Cost treatment: Out-of-pocket diligence costs may be charged to the borrower, may be financed with loan proceeds, and amounts the applicant pays count toward the equity injection.
The practical translation: on a $3M-plus acquisition, the QoE is no longer a nice-to-have that gets cut when the fee conversation gets tight. It is a gating item that sets the earnings number on which your DSC, your loan amount, and your guaranty all rest. And because engagement must be in place at loan-number issuance, provider selection moves earlier in your process.
The Role of a Quality of Earnings Report
A quality of earnings report is a financial due diligence engagement that asks one question: is the earnings figure real, repeatable, and supportable line by line? It validates and rebuilds adjusted EBITDA from the general ledger and source documents rather than accepting a broker’s or seller’s schedule, then further tests whether what was reported actually moved through the bank.
It is not an audit. An audit asks whether statements are fairly presented under GAAP at a point in time, at a materiality threshold usually far above the size of the add-backs you care about. It is not a valuation. A valuation concludes on price, using the earnings input it was given. The QoE is the only one of the three that interrogates the input itself.
Why the SBA Did This
De-risking, and specifically de-risking transactions where the government’s exposure is least connected to operating history. In a change of ownership, new debt is created that has nothing to do with the business’s operations, intangibles are recorded on the balance sheet, and the person who understood the business is walking out the door. Every downstream number in that credit memo, for example, the multiple, the concluded value, the coverage ratio, and the advance rate, is derived from a single earnings figure.
Consider a $4 million change of ownership. Carried through at a 4.0x multiple, a $200,000 overstatement in earnings inflates the supportable purchase price by roughly $800,000, double the entire 10% equity injection on the same deal. That same $200,000 flows directly into the debt service coverage calculation, and the SOP’s remedy language makes the intent plain: when the QoE-based DSC doesn’t support the structure, the loan gets smaller. The SBA is not asking for a document. It is asking for a number it can underwrite to.
What to Require in Scope, and What “Proof of Cash” Should Mean
The SOP sets a floor. It does not prescribe a report format, and there is still no licensing body, peer review, or standards board governing QoE work. With no rulebook, the firm you select is responsible for quality control in the process. Put the scope in the engagement letter rather than assuming it.
What the SOP Requires
Read together, the QoE provisions set out five things a compliant report must do (paraphrased directly from the SOP):
- Examine earnings quality independently. The report must test the reliability, sustainability, and accuracy of the business’s historical and projected earnings and must be performed by an independent, qualified financial professional for the benefit of the lender, not prepared by or for the borrower or seller.
- Reconcile four sources into one number. Accountant-prepared statements, tax returns, internal financials, and IRS transcript data must be reconciled into a normalized earnings figure reflecting recurring, arm’s-length operations.
- Document every adjustment. All add-backs and deductions to seller-reported earnings must be identified and supported, including non-recurring items, above- or below-market owner compensation, related-party transactions, deferred maintenance, and cash-versus-accrual differences.
- Assess revenue quality. This includes customer concentration, contract continuity, and the likelihood that existing revenue and margins hold post-sale.
- Perform a cash proof. A reconstruction of cash receipts and disbursements that reconciles bank statement data to the income statement and tax return for each period under review, designed to surface discrepancies in reported income and undisclosed expenses on both a trailing twelve-month basis and over the last two fiscal years.
That is the floor, and it is a meaningful one.
Why Our Scope Goes Further
Every LCG engagement is built around the following, and we would encourage you to require the same of any provider:
- Proof of cash: The workstream described below is monthly for every account, in both directions, across the full period.
- Income statement and EBITDA bridge analysis: Monthly trend analysis across two fiscal years plus the trailing twelve months, with every adjustment traced back to an invoice, contract, or payroll record rather than asserted on a schedule.
- Net working capital: A normalized NWC target and an analysis of seasonality and fluctuations in NWC over the review period to determine what’s needed to maintain the business.
- Debt-like items: Accrued PTO, sales and use tax, unremitted payroll tax, deferred revenue, and related-party balances. These obligations transfer quietly and surface after closing.
- Revenue quality and customer concentration: Revenue by customer over time, retention and contract continuity, and what the base looks like if the largest relationships move.
- Margin and ratio analysis: Gross and EBITDA margins by month, plus the operating and coverage ratios that indicate whether performance is durable or drifting.
- Analyst-ready Excel databook: Every schedule is delivered in a workable form, so your credit team can rebuild the numbers rather than take them on faith.
Our experienced team of due diligence professionals includes licensed CPAs whose full-time discipline is transaction diligence. Our professionals are dedicated to transaction diligence rather than balancing the work alongside valuation, tax, or other engagements. The same senior-level professional who is on your calls maintains ownership of the workpapers, with documented independence from everyone else at the table and a commitment to immediate notice of any deal-breaking finding.
Why Proof of Cash Deserves Closer Scrutiny
The proof of cash is one area where scope quietly gets cut, and it is the workstream the SOP now names explicitly.
Our proof of cash is built to a different standard. We take every monthly bank statement for each bank account over the full two-to-three-year period and reconcile deposits and withdrawals to monthly reported revenues and expenses, accounting for changes in balance sheet activity throughout. Revenues and expenses are each reconciled within a 1% margin of error. From that, we construct a monthly operating cash flow model and reconcile operating cash flows to the EBITDA reported in the company’s general ledger.
That bidirectional, full-period, all-accounts approach surfaces what a one-directional test misses: revenue booked that never landed, expenses paid that never got recorded, deposits that turn out to be owner contributions or loan draws, and seasonality that a fiscal-year view flattens into a run rate it shouldn’t support.
How a Rigorous QoE Produces a Better SBA Valuation
The two reports are now required to be used together and should not be viewed in isolation. The appraiser applies a multiple to an earnings measure. If that measure is untested, the valuation inherits every weakness in it, and under the new SOP, so do the DSC, the loan amount, and the guaranty.
When the QoE is done properly, the appraiser receives a normalized earnings figure with documented support for every adjustment, a monthly view that distinguishes durable performance from a single strong quarter, and a named, quantified read on concentration and contract continuity. That is a defensible conclusion of value rather than an arithmetic exercise on a broker’s schedule, and it holds up to a credit committee, an SBA review, and a servicing action three years from now.
About LCG
LCG Advisors has provided third-party due diligence and transaction advisory services since 2003. Our Transaction Advisory practice completes 350 to 400+ Quality of Earnings engagements annually, with thousands completed across the firm’s history, primarily in the lower middle market.
Importantly for SBA transactions, much of that work is performed for private equity funds and institutional lenders, where transaction diligence is subject to a high level of financial and credit scrutiny. Our team largely comes from Big Four audit and transaction advisory, commercial credit, and loan underwriting backgrounds, bringing an understanding of how financial performance is evaluated from both a transaction and credit perspective. With established Quality of Earnings and SBA Business Valuation capabilities under one roof, LCG is positioned to support both requirements through a coordinated platform of services.
Have questions about the new requirements or need to get started on a Quality of Earnings engagement? Contact Ryan Murphy at [email protected] to discuss your transaction.