Red Flags in Financial Statements: What a ‘Quality of Earnings’ Analysis Can Reveal That You Might Have Missed!

In the high-stakes world of mergers and acquisitions, even seasoned investors can be blindsided by hidden financial pitfalls. A striking example is Hewlett-Packard’s 2011 acquisition of UK-based software company Autonomy. HP paid over $11 billion for Autonomy, only to write down $8.8 billion a year later, citing “accounting improprieties, misrepresentations and disclosure failures” by Autonomy’s management.

This debacle underscores the critical importance of conducting a thorough Quality of Earnings (QoE) analysis during the due diligence process. Not as a protocol, but under a precision financial microscope. While standard financial statements may present a company’s performance in a favorable light, a QoE analysis delves deeper, uncovering anomalies such as aggressive revenue recognition, unsustainable earnings, and other red flags that could jeopardize an investment. It digs beyond the obvious to ask tough questions:

“Is this revenue recurring? Are all the costs accurately accounted for? How much cash is actually flowing in?”

This article will help understand the red flags that a QoE analysis can reveal, issues that might be overlooked in financial reviews, and suggest how identifying these concerns early can safeguard your investments and ensure more successful deal outcomes.

Understanding Quality of Earning

Unlike an audit that focuses on the accuracy of accounting and financial statements, a Quality of Earnings (QoE) analysis that dives beyond surface-level numbers to uncover the true earning power of a business. In M&A, valuations often hinge on headline figures like EBITDA or net income, but these can be misleading without proper context. A QoE analysis digs deeper, distinguishing between recurring and one-time earnings, exposing aggressive or inconsistent accounting practices, and highlighting operational or financial risks.

• For Buyers, this means avoiding overpayment, negotiating with greater confidence, and, if necessary, walking away from problematic deals.
• For Sellers, it’s a powerful pre-market tool to pre-emptively address red flags, justify valuation, and build buyer confidence by presenting a cleaner, more transparent financial narrative.

A typical QoE review includes an in-depth analysis of revenue quality, reported EBITDA, working capital, customer concentration to effect normalisation for non-recurring items or related-party transactions. It also assesses the integrity of accounting practices and identifies potential integration challenges post-acquisition. Whether conducted pre-emptively on the sell-side or post-LOI on the buy-side, QoE ultimately refines deal terms, impacts pricing or earnouts, and plays a pivotal role in validating financial claims, ensuring smoother transactions and closure, and portraying a more accurate picture of financial sustainability.

5 Crucial Red Flags Uncovered by QoE

Some insights from QoE not only validate financial performance but also empower investors to ask the right questions, adjust valuations, and avoid post-closure surprises. Some key areas that a QoE typically uncovers:

Accounting Practices & Policy Consistency

• Red flag: Aggressive or inconsistent practices (e.g., recording future income early or delaying expense recording), which can distort profits and make year-to-year comparisons unreliable.
• QoE: Reviewing if standard accounting rules (GAAP/IFRS) are followed consistently over time, pointing out any aggressive methods, and identifying where profits may have been adjusted to look better for a potential deal. 

Revenue Quality

• Red Flag: Premature revenue recognition or dependence on one-time sales aimed at boosting topline figures across financial statements.
• QoE: Evaluating how revenue is earned, recognised, and sustained, helping buyers assess sustainability and exposure to churn or seasonal drops.

Customer & Supplier Concentration

• Red flag: Overreliance on a few clients or suppliers that threaten business continuity if the relationships end, which can lead to significant revenue loss or operational disruption if even one major partner exits.
• QoE: It highlights the percentage of revenue tied to major clients or key suppliers and evaluates associated contracts, enabling a clearer risk assessment of the business’s stability.

Cost Structure & Margin Analysis

• Red flag: Hidden cost pressures or deteriorating gross margins masked by short-term gains. This includes tactics such as delaying essential hires, slashing marketing spend or underinvesting in maintenance.
• QoE: A detailed margin analysis helps distinguish between fixed and variable costs, and whether current profitability is driven by temporary cost suppression.

Adjusted EBITDA and Add-Backs

• Red Flag: Unjustified add backs that artificially inflate profitability, such as removing understating regular costs, or understating management compensation.
• QoE: Scrutinises non-recurring items and adjustments made to EBITDA, challenging subjective or non-recurring items, and recalculating a more reliable and normalised earnings base, with the most common examples including non-business related travel and entertainment, personal automobile expenses, inflated office or utilities beyond fair market price, etc.

How QoE Shaped Outcomes in Actual Market Transactions

• A €24B payments unicorn, Wirecard collapsed in 2020 after a QoE-style review revealed nearly €1.9B of missing cash tied to third-party acquirers, a classic example of “round-tripping” and revenue inflation. The collapse wiped out investor value and highlighted gross misrepresentation.
• In 2025, Japan’s Aeon Financial invalidated its acquisition of SeABank’s lending business (approx. $182M), citing “inappropriate accounting transactions” that significantly contradicted pre-deal disclosures. This case highlights how discrepancies in financial statements detected post-acquisition can lead to deal termination or legal action.

How MARC Provides Value through QoE

At MARC, we specialise in delivering comprehensive Quality of Earnings (QoE) analysis that provides clarity and confidence in complex transactions. Our expertise lies in uncovering the true financial health of a business, enabling stakeholders to make informed decisions. The example below reflects MARC’s ability to help clients make better, informed investment decisions.

Case Study: QoE Analysis of XYZ LLC

Background: XYZ LLC, a U.S.-based Contract Research Organisation (CRO), engaged in a QoE review ahead of a potential transaction. The analysis aimed to assess the sustainability and accuracy of reported earnings.

Key Findings and Analysis derived:

• EBITDA Decline: Normalised EBITDA dropped sharply from negative 2% in FY24 to negative 14% in YTD Sep-24, driven by declining revenue and rising costs.
• Revenue Concentration: 62% of revenue stemmed from the core revenue generation, Phase 1 income, half of which was at a low margin. Other revenue segments 38%, were either non-sustainable or being phased out.
• Customer Weakness: Customer acquisition fell from 58% in FY23 to 13% in YTD Sep-24, reflecting reduced market traction.
• Expense Surge: Employee benefits rose despite reduced headcount; General and Admin expenses increased significantly without sufficient justification. Additionally, inconsistencies were identified in the treatment of pass-through costs, raising concerns about accounting accuracy.
• Working Capital Strain: Accounts payable rose by 36%, with 67% overdue, much of it was towards related parties. This backlog in payables raises concerns about vendor relationships and short-term solvency. Additionally, retained earnings remained consistently negative, reflecting ongoing operational losses and limited capacity for self-funded growth or reinvestment.
• EBITDA Adjustments: Included a $500K downside adjustment for unsustainable related-party income and $71K for India-based costs absorbed externally. Additional non-quantifiable concerns included internal control gaps, key person risks, and outdated assets, all of which resulted in a lower valuation.
• Asset Concerns: 99% of fixed assets were fully depreciated, with minimal reinvestment, indicating future capex pressure, creating concerns of high capital investments in the immediate future.

Conclusion:  The QoE report proved to be a pivotal tool in guiding the client’s decision-making. It provided a clear and accurate picture of the target’s financial health, uncovering unsustainable revenue streams, accounting inconsistencies, rising costs, and overlooked operational risks. By addressing these critical areas, the report not only strengthened the client’s negotiating position but also ensured greater transparency, helped avoid costly surprises, and enabled a smoother, more informed path forward in the transaction process.