Red Flags to Watch for During a Quality of Earnings (QoE) Review

A Quality of Earnings (QoE) review is a critical part of financial due diligence in mergers and acquisitions (M&A). It provides a deep dive into a company’s financial health, helping buyers and investors assess the sustainability and reliability of reported earnings. But beyond validating performance, a QoE review can uncover red flags—warning signs that may signal hidden risks, inflated valuations, or future instability.

Identifying these issues early can prevent costly mistakes and ensure smarter investment decisions. Below are the most common red flags to watch for during a QoE review, especially in the context of Australian accounting standards and business practices.

1. Revenue Recognition Issues

Improper revenue recognition is one of the most frequent concerns in QoE reviews. Under Australian Accounting Standards (AASB 15), revenue must be recognised when control of goods or services is transferred—not when cash is received or contracts are signed.

🔍 Red flags include:

• Premature recording of revenue

• Aggressive recognition policies

• Channel stuffing (pushing excess inventory to distributors)

These practices can artificially inflate earnings and misrepresent the company’s true financial performance, leading to overvaluation and increased risk for buyers.

2. One-Time or Non-Recurring Expenses

Earnings should reflect the company’s ongoing operations, not temporary gains or losses. Some businesses may exclude one-time expenses or include non-recurring income to make profitability appear stronger.

⚠️ Watch for:

• Legal settlements

• Restructuring costs

• Asset write-downs

While occasional one-offs are normal, a pattern of frequent adjustments may indicate recurring issues. If these are excluded from normalised earnings, buyers may be misled about the company’s true profitability.

3. Fluctuations in Gross Margins

Stable gross margins suggest a consistent business model. Unexplained fluctuations, however, can point to deeper problems.

📉 Potential causes:

• Cost mismanagement

• Changes in product mix

• Misclassification of expenses

For example, a sudden margin improvement without operational changes may signal manipulation. Conversely, declining margins could reflect rising costs or competitive pressure—both of which impact future performance and valuation.

4. Irregularities in Cash Flow

Strong profits mean little without healthy cash flow. A persistent gap between reported earnings and operating cash flow is a major red flag.

💡 Indicators include:

• High accounts receivable

• Delayed customer payments

• Declining operating cash flow despite rising EBITDA

These issues may suggest aggressive revenue recognition or poor collections, which can undermine the business’s ability to fund operations and growth.

5. Unusual EBITDA Adjustments

EBITDA adjustments help normalise earnings, but excessive or questionable add-backs can distort reality.

🔎 Problematic adjustments include:

• Discretionary expenses (e.g. management bonuses)

• Exclusion of legitimate operating costs

• Overly optimistic synergy projections

If a company consistently adjusts EBITDA upwards, it may be masking real costs. Buyers should scrutinise each adjustment to ensure it reflects genuine non-recurring or discretionary items.

6. Dependence on Key Customers or Suppliers

Customer and supplier concentration increases risk. A business that relies heavily on a few relationships is vulnerable to disruption.

📊 Examples:

• 60% of revenue from two clients

• Sole supplier for critical materials

Loss of a major customer or supplier can significantly impact earnings and operations. A QoE review should assess the diversity and resilience of these relationships.

7. Overstated Inventory Values

Inventory can be manipulated to inflate earnings. Businesses may fail to write down obsolete or slow-moving stock, overstating asset values.

🧾 Red flags include:

• Excess inventory relative to sales

• Low turnover rates

• Inadequate obsolescence reserves

These issues may indicate poor demand forecasting or inefficient inventory management, both of which affect profitability and working capital.

8. Unusual Debt Levels or Off-Balance Sheet Liabilities

Hidden liabilities can pose serious risks. A QoE review should go beyond the balance sheet to uncover off-balance sheet obligations.

⚠️ Examples:

• Lease commitments

• Contingent liabilities

• Pending legal claims

Excessive debt or undisclosed obligations can strain cash flow and reduce financial flexibility, especially if the business has borrowed heavily to fund growth.

9. Weak Internal Controls and Governance

Strong internal controls are essential for accurate financial reporting. Weak governance increases the risk of fraud, misstatements, and operational inefficiencies.

🔍 Warning signs:

• Lack of segregation of duties

• Frequent accounting restatements

• Related-party transactions without transparency

If financials rely heavily on one or two individuals without oversight, buyers should question the reliability of the data and the integrity of the management team.

Final Thoughts

A thorough Quality of Earnings review goes beyond surface-level financials. It uncovers hidden risks that can impact valuation, deal structure, and post-acquisition performance.

By identifying red flags such as revenue recognition issues, cash flow irregularities, or questionable EBITDA adjustments, buyers can make more informed decisions and avoid costly surprises.

Given the nuances of Australian accounting standards, it’s essential to tailor due diligence to local market conditions. Engaging experienced corporate finance professionals ensures that all critical aspects are properly evaluated—mitigating risk and improving transaction outcomes.

Need expert support for your next transaction?
Contact Mountain Peak Advisory to ensure your QoE review delivers clarity, confidence, and value.