Quality of Earnings Reports in Lender Diligence: When a QoE Is Required, What It Covers, and How to Prepare

A borrower gets a term sheet, clears the initial credit screen, and then receives a diligence list with one line that stops the process cold: third-party quality of earnings report, borrower expense. The reaction is usually some version of "we already have reviewed financials — why is that not enough?"

It is a fair question, and the answer explains a great deal about how middle-market credit decisions are actually made. A quality of earnings report — universally shortened to QoE — is not a second audit. It asks a different question than an audit asks, and a different question than a field exam asks. Understanding which question each exercise answers is the difference between a QoE that confirms your story and a QoE that quietly costs you two turns of leverage.

What a Quality of Earnings Report Actually Is

An audit answers: are these financial statements fairly presented in accordance with GAAP? It is backward-looking, standards-driven, and concerned with whether the numbers are properly stated.

A QoE answers a different question entirely: how much of this reported earnings figure is real, repeatable, and available to service debt? It is forward-looking in purpose even though it works with historical data. A QoE team — typically a transaction advisory group at an accounting firm — takes the trailing twelve months of results and rebuilds them from the general ledger up, testing whether each dollar of EBITDA is recurring, whether it belongs in the period it was booked in, and whether the adjustments management proposed are defensible.

The deliverable is usually a databook plus a narrative report. The number everyone turns to first is adjusted EBITDA, but the more consequential content is the schedule of proposed adjustments the QoE team accepted, rejected, or reclassified — and the working-capital analysis that follows it.

Why a Lender Asks for One

Not every facility triggers a QoE requirement. The requests cluster around a recognizable set of situations:

• Leverage is doing real work in the structure. If a portion of the facility is sized off a multiple of EBITDA rather than purely off collateral — a term loan tranche, a stretch piece, an equipment term loan alongside the revolver — the lender is lending against the earnings number, so it wants that number independently tested.
• The adjusted EBITDA figure carries heavy add-backs. When management's bridge from reported to adjusted EBITDA involves a long list of one-time, owner-related, or pro-forma items, the aggregate adjustment becomes the credit question.
• The financials are compiled or reviewed rather than audited. A QoE is often the substitute comfort. Our guide to how lenders read audited, reviewed, and compiled statements covers why that distinction matters so much in underwriting.
• There is a transaction attached. Acquisitions, management buyouts, and dividend recapitalizations nearly always involve one, because proceeds are leaving the business and the lender needs conviction in the earnings base that remains.
• Recent results are inflected. A sharp margin improvement, a large new customer, or a rebound year invites the question of whether the trend is structural or timing.

In a pure collateral-led revolver with a springing financial covenant and modest advance rates, a QoE is frequently waived. The further the structure drifts from that, the more likely it appears on the list.

What the QoE Team Actually Examines

Revenue recognition and period cutoff

The team tests whether revenue landed in the right period. Shipments recorded before goods left the dock, invoices dated ahead of performance, deferred or unearned amounts booked as current revenue, bill-and-hold arrangements, percentage-of-completion estimates on long-cycle work — each gets sampled and traced. Cutoff testing around the fiscal year-end and around the TTM boundary is standard, because that is where timing pressure concentrates.

Add-backs and normalizing adjustments

This is where the report earns its fee. Management proposes; the QoE team disposes. Common categories and how they typically fare:

• Owner compensation normalization — generally accepted, but sized to a defensible market rate for the role, supported by comparable data rather than assertion.
• Genuinely non-recurring items — litigation settlements, one-time severance, a flood, a failed system implementation. Accepted when documented and when they truly do not recur.
• Personal expenses run through the business — accepted when they can be identified line by line in the GL. Rejected when the support is an estimate.
• Run-rate and pro-forma adjustments — new customers annualized, cost savings not yet realized, price increases announced but not implemented. These get the hardest scrutiny, and many are either rejected or carved into a separately captioned "management pro forma" column the lender is free to discount.
• Adjustments that recur every year — the strongest signal of a weak add-back. If "one-time" items appear in each of the last three years, the QoE team will say so plainly.

How the accepted number then translates into your loan documents is a separate negotiation. Our practitioner guide to EBITDA definitions and add-backs in ABL credit agreements walks through how the defined term, caps on add-back baskets, and look-forward periods can produce a covenant EBITDA meaningfully lower than the QoE's adjusted figure.

Working capital and net debt

The QoE quantifies a normalized working-capital level and identifies debt-like items sitting inside working capital: deferred revenue that will consume cash, accrued but unfunded payroll taxes, customer deposits, unrecorded rebate liabilities, and deferred capex. For a borrower pursuing a revolver, this section often matters more than the EBITDA number, because it speaks directly to whether the facility is sized correctly. It pairs closely with what a lender derives independently in the borrowing base build.

Revenue, customer, and margin quality

The team disaggregates revenue by customer, product, and channel; measures retention and churn; and tests gross margin by line. Concentration surfaced here reinforces the concentration analysis the lender is running on the collateral side — see our discussion of customer concentration limits and reserves. A QoE that reveals the top customer at 40 percent of revenue and declining volume is a structural finding, not an accounting one.

QoE, Audit, and Field Exam: Three Different Questions

Borrowers routinely conflate these, and the conflation causes real friction because each is scoped, staffed, and priced differently.

• Audit — Are the statements fairly presented under GAAP? Performed by an independent auditor, annual, opinion-based.
• Quality of earnings — Is the earnings stream real and repeatable? Performed by a transaction advisory team, transaction-driven, no opinion issued, focused on adjusted EBITDA and working capital.
• Field examination — Does the collateral exist, is it eligible, and does the borrowing base tie to the books? Performed by the lender's exam firm, recurring after closing, focused on AR, inventory, and reporting integrity. See what borrowers need to know about ABL field examinations and the typical field exam findings and adjustments.

On a leveraged ABL facility you may well go through all three. They do not substitute for one another. A clean audit does not eliminate a QoE, and a favorable QoE does not shorten the field exam — the exam is testing collateral, not earnings.

Cost, Timing, and Who Pays

Ranges vary by firm, geography, and complexity, but middle-market QoE engagements commonly run in the tens of thousands of dollars, with multi-entity, multi-currency, or carve-out situations running materially higher. Timelines of three to six weeks from kickoff to draft report are typical when the data room is ready, and considerably longer when it is not.

The borrower almost always pays, either directly or through a diligence deposit held by the lender. Two points worth negotiating early: whether the report will be issued with reliance language extended to the lender (and to lenders in a syndicate, if the facility may be syndicated or clubbed), and whether the report can be reused if you end up placing the deal with a different lender. A report scoped for one lender's reliance may need a reliance letter for another, and that is cheaper to arrange up front than to retrofit.

How to Prepare

The single highest-return preparation step is building your own add-back schedule before the QoE team arrives, with documentation attached to each line. Beyond that:

• Tie book to tax. Have a reconciliation from your internal financials to the filed returns for each year in scope. Unexplained variances consume days of fieldwork and erode confidence.
• Prepare a trial balance and detailed GL in exportable form. The team will ask for transaction-level detail, not summary PDFs.
• Document every proposed adjustment at the invoice or journal-entry level. Estimates get rejected. Support gets accepted.
• Disclose related-party activity proactively. Rent paid to an entity owned by the principal, intercompany management fees, loans to or from owners. Discovery is penalized; disclosure is not.
• Reconcile revenue by customer to the AR subledger. The QoE and the collateral analysis should tell a consistent story. When they diverge, both get questioned.
• Surface deferred revenue and customer deposits yourself. These become debt-like adjustments. Explaining them is far better than having them found.
• Assign one internal owner. Fieldwork stalls when requests bounce between the controller, the outside accountant, and the owner.

Much of this overlaps with the package you should already be assembling — see how to prepare for a lender meeting and the ABL closing checklist for how QoE fieldwork sequences against the rest of the timeline.

Where QoE Processes Go Wrong

The add-back list arrives without support. A schedule of adjustments with no documentation is treated as management assertion, and unsupported items are excluded. This is the most common and most expensive failure.

Data arrives in fragments. Every incomplete response extends the timeline and, in a competitive process, can put your facility behind a covenant expiration or a maturity date you cannot move.

The QoE contradicts the credit package. If the submission showed adjusted EBITDA of $9.4 million and the QoE lands at $7.1 million, the gap is not simply repriced — it raises a credibility question that colors every other section of the memo. It is far better to submit a conservative number and have the QoE confirm it.

Nobody negotiates the definition afterward. The QoE gets delivered, and the borrower treats it as the end of the exercise. In fact it is the beginning of the credit-agreement negotiation over how Consolidated EBITDA is defined, which add-backs are permitted going forward, and whether they are capped.

Scope is set without regard to the actual credit question. A full-scope QoE on a deal where the lender's real concern is dilution and collateral quality is wasted spend. Sometimes the right answer is a focused scope — and sometimes it is a dilution analysis instead.

Borrowers should consult their own accounting, tax, and legal advisors on scope, reliance, and reporting questions specific to their situation. Nothing here is accounting, tax, or legal advice.

How DCE Helps

We do not prepare quality of earnings reports — that is the role of an independent transaction advisory firm, and the independence is the point. What we do is make the exercise cheaper, faster, and less likely to surprise you.

Before a lender asks, we build the adjusted-EBITDA bridge the way a diligence team will test it, flag the add-backs that will not survive, and reconcile the earnings story to the collateral story so the two documents agree. Where the credit question is really about collateral rather than earnings, we make that case to the lender and often narrow or eliminate the scope. And when a report is required, we help set the scope, arrange reliance so the deliverable travels with the deal, and translate the accepted adjustments into the credit-agreement EBITDA definition where the long-term value actually sits.

Through our affiliation with ABLC (ablc.net), we know which lenders require a QoE at which structures — which means the placement decision itself can determine whether you spend the money at all.

Related Reading

• EBITDA Definitions and Add-Backs in ABL Credit Agreements
• Audited, Reviewed, and Compiled Financial Statements in ABL Underwriting
• ABL Field Examinations: What Borrowers Need to Know
• How to Compare ABL Refinancing Proposals and Term Sheets
• What Is Asset-Based Lending?