When you receive a listing package for a small business, the headline earnings figure is almost never the raw number from the tax return. It has been recast — adjusted to remove expenses that a new owner wouldn't incur and to add back items the seller characterizes as discretionary or non-recurring.
Recasting is a legitimate and standard part of small business valuation. The problem is that there are no universal rules for what can be added back, and no third party is verifying the seller's math until you commission one. Understanding how recasting works — and where it gets abused — is one of the most important skills a buyer can develop.
What recasting actually does
Recasting produces a "seller's discretionary earnings" (SDE) or adjusted EBITDA figure that is meant to represent the true earning power of the business for a new owner. The logic is straightforward: if the current owner pays themselves above-market rent from a building they personally own, that excess rent is not a real business cost for a buyer who would pay market rate. Removing it gives a cleaner picture of what the business actually generates.
The most common legitimate recast adjustments:
- Owner compensation add-back. The seller's salary, payroll taxes, and benefits are added back — on the theory that the new owner will either work in the business themselves (taking the profit directly) or hire a replacement manager (whose cost can be modeled separately).
- Non-recurring expenses. One-time legal fees, a single equipment replacement, or a non-repeating marketing campaign can reasonably be excluded from normalized earnings.
- Personal expenses run through the business. Vehicle payments, travel, meals, and other personal expenses that were deducted as business costs but would not apply to a new owner.
- Above-market rent paid to a related party. If the seller owns the building and charges the business above-market rent, the excess above market rate is a legitimate add-back.
Where recasting goes wrong
The same flexibility that makes recasting useful also makes it the primary vehicle for overstating earnings. Here are the most common problems:
1. "Non-recurring" expenses that recur every year
The seller adds back a $45K equipment repair as a one-time expense. A review of three years of financials shows similar "one-time" equipment costs in each year. Recurring costs labeled as non-recurring inflate earnings permanently — and they show up in the QoE report when multiple years are reviewed side by side.
2. Owner compensation added back at below-market rates
The seller paid themselves $55K. They add back $55K and present the business as generating an additional $55K in free cash flow for the new owner. But a qualified manager for this type of business costs $90K at market rate. The real cost the buyer will incur is $90K — meaning the add-back overstates earnings by $35K, which at a 3x multiple translates to $105K of purchase price overpayment.
3. Revenue pulled forward to inflate the period being valued
The seller accelerates billing or prepays themselves for future work to inflate revenue in the 12 months before sale. This is harder to spot without a month-by-month revenue analysis — which is exactly what a QoE report provides.
4. Expenses deferred to make earnings look cleaner
Maintenance is delayed. Marketing spend is cut. Key hires are put on hold. The business looks more profitable in the year before sale — and less healthy immediately after close.
The pattern to watch for: If the recast earnings are significantly higher than what the tax returns show, and the seller cannot explain each adjustment with documentation, treat the gap as a red flag rather than a feature. Legitimate add-backs are always documentable.
How a QoE report evaluates recast financials
A quality of earnings report does not simply accept or reject the seller's add-back schedule. It independently verifies each adjustment:
- Is the expense documented in the books?
- Is it truly non-recurring, or does it appear in prior years?
- Is the owner compensation add-back realistic given market rates for a replacement?
- Does the revenue trend hold up month by month, or were there unusual spikes?
- Do the bank statements match the P&L revenue figures?
The result is a CPA-reviewed normalized earnings figure that you can underwrite with confidence — not the seller's version of the story, but an independent conclusion.
The practical takeaway: Recast financials are the starting point of the conversation, not the ending point. Every add-back is a claim that needs verification. The larger the gap between tax return earnings and recast earnings, the more important it is to have that verification done by someone who isn't selling you the business.
Not sure if the recast earnings hold up?
A ClearView QoE report independently verifies every add-back so you know exactly what you're paying a multiple on — before you're committed.
Talk to Nick