Drilling down into quality of earnings and why it matters
Audit reports confirming that financial statements adhere to generally accepted accounting principles do not always reflect a business’s true earnings capacity
AS CORPORATE collapses continue to catch stakeholders off guard, analysts face growing pressure to dig deeper than traditional audits allow. The limitations of standard financial reporting – especially in identifying “going-concern” risks – have exposed systemic blind spots in evaluating a company’s true financial stability.
For those involved in mergers and acquisitions (M&As), private equity (PE) or strategic planning, Quality of Earnings (QofE) analysis has become an indispensable tool. It helps surface red flags, validate financial performance and provide a more reliable foundation for investment decisions. Here is my take on why this topic is important, as well as a rundown of the components of QofE analysis.
Why quality of earnings analysis is critical
Research from the Audit Reform Lab at the University of Sheffield found that auditors failed to identify material uncertainties related to going-concern risks in three-quarters of significant corporate failures in the UK from 2010 to 2022. The Big Four auditing firms – Ernst & Young (EY), PricewaterhouseCoopers (PwC), Deloitte & Touche, and KPMG — provided going-concern warnings in less than 40 per cent of situations; smaller firms had an even more disappointing warning rate of 17 per cent.
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