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IN mergers and acquisitions (M&A), investors rely on audited financial statements (FS) to assess a company’s value. These reports, carefully prepared, appear to offer a firm footing, but they often leave parts of the story untold. That is where quality of earnings (QoE) through due diligence steps in — a deeper analysis that looks beyond the polished figures to expose the real sustainability of a company’s earnings. Sticking to audited FS alone is a roll of the dice — a risk; it is like buying a car based on its paint job without lifting the hood. In M&A, QoE presents insights needed to dodge expensive curveballs.

Standard financial reporting, shaped by accounting frameworks, prioritizes consistency over full transparency. This can mask risks about a company’s ability to keep going — known as going-concern challenges. A business might show healthy profits, but what if those came from a one-time boost, like a property sale, or depend on a single key client? Audited FS may not wave a red flag; they reflect history, not the road ahead. There were cases where a company looked solid on paper, only for investors to later discover their earnings rested on shaky ground. QoE addresses this by examining how sustainable those earnings truly are.

Where audits fall short

Recent audit failures make this clear. In 2023, Brazilian retailer Americanas (AMER3) stunned markets with a $4-billion “accounting issue” after its external auditor missed years of hidden supplier financing — a reverse factoring scheme that dressed up liabilities as cash flow. The company’s stock tanked 80 percent in days, edging toward bankruptcy. India’s Byju’s faced its own reckoning that year as well when its external auditor stepped down after a $1.1-billion loss exposed revenues overstated by multi-year subscriptions that never turned into cash. In just over a year after, in September 2024, the successor auditor resigned, mentioning delays in financial reporting and doubts about recovering $170 million from a Dubai-based entity — repeating the predecessor auditor’s concerns about transparency.

These incidents show a recurring issue: audits can conform with the standards yet overlook glaring problems. This stems from inherent limitations, like reliance on sampling, which may not catch all discrepancies, and the need for independent expertise that audits alone cannot always provide. QoE steps up as a critical tool, moving beyond net income to assess a company’s true earning strength. It asks the right questions: Can these profits last? Is the cash flow reliable? Will the business hold steadily under strain? In M&A, this insight separates a smart move and an expensive mistake.

The pillars of QoE

QoE focuses on three essential areas to bring that clarity: financial performance, cash and working capital. Each offers a window into what keeps a company strong or vulnerable.

QoE examines revenue and expenses to test their soundness. For instance, if 70 percent of revenue comes from one customer, losing it could spell trouble. Consistency counts, that is, earnings should stay stable, not leap from one-off gains like asset sales. Steady performance beats erratic highs. A wise step is to adjust earnings by removing oddities, for example, legal settlements to show the core results. There were QoE reports that uncover a retailer’s “banner year” as mostly tax credits, not sales, which is a detail that reshaped the investor’s strategy.

Cash is king, but only if it is real! Profits on paper are meaningless without cash inflows. QoE goes further from just checking bank statements. It links profits to cash flow to see if it is real and repeatable. It looks for tricks like delayed supplier payments or cash from loans masquerading as sales revenues. Key areas include growing unpaid invoices — those are not assets, “just hopes” — or cash tied up in murky or shady investments. Mapping cash from sales to collections ensures it reflects operations, not accounting games. The performance of a QoE can catch a manufacturer faking sales to a shell company, saving the investor from a multimillion-dollar blunder.

Working capital, meanwhile, is current assets minus current liabilities or the funds a business needs daily. QoE confirms whether it is enough and sustainable. It looks for excess inventory that will not move or unpaid bills piling up, pointing to cash flow stress. Further, checking trends matters; a downward slide could signal problems and comparing industry averages and testing against a sales drop, like a 20-percent decline, gauges resilience. The rule of thumb is to run a 90-day forecast to brace for the unexpected.

A stronger view

In M&A, due diligence is about making confident decisions, not just checking off steps. Audited FS gives a baseline, but QoE digs deeper by reviewing revenue sources, verifying cash quality, and measuring working capital health. Recent audit stumbles, from Americanas to Byju’s double auditor exit, prove trusting numbers in the audited FS alone is like accepting numbers blindly. This is where we move beyond the audit. Unlocking the truth with QoE equips investors to bargain smartly or walk away when it is wise.

Today’s business world moves fast where markets shift, supply chains falter, and new challenges emerge constantly. QoE helps decision-makers see through the clutter, turning uncertainty into opportunity. It is not just about doubting the audited figures; it is about proving their merit. With so much on the line, skipping QoE in due diligence is like sailing blind into a storm. Those who use it do not just close deals; they secure futures that stand the test of time.

Seb Serrano is a director for advisory services at P&A Grant Thornton. One of the leading audit, tax, advisory and outsourcing firms in the Philippines, P&A Grant Thornton is composed of 29 partners and 1,500 staff members. We’d like to hear from you! Connect with us on LinkedIn and like us on Facebook at P&A Grant Thornton and email your comments to [email protected]. For more information, visit our website at www.grantthornton.com.ph.