Assessing the Quality of a Company’s Accounting During Due Diligence

Introduction

You are looking at a potential acquisition or major investment, and while the growth story is compelling, the success of your deal hinges entirely on the integrity of the underlying financial data; assessing accounting quality is defintely the most critical step in successful due diligence. Overlooking deficiencies-like aggressive revenue recognition or questionable capitalization policies-doesn't just mean you overpay; it exposes you to massive post-acquisition risks, potentially turning a projected 15% return into a painful write-down within the first year, especially given the tight capital markets of late 2025. To mitigate this, a thorough assessment must focus on three key areas: the consistency of revenue recognition policies, the sustainability of reported margins (Quality of Earnings), and management's use of non-GAAP metrics, ensuring the reported $45 million in 2025 EBITDA is truly cash-backed and repeatable.

Are the Financial Statements Accurate and Reliable?

When you start due diligence, the first thing you must confirm is whether the financial statements-the balance sheet, income statement, and cash flow statement-are even worth analyzing. If the numbers are built on sand, your entire valuation model is useless. We are looking for precision and completeness, not just big numbers.

You are essentially auditing the auditor, and you need to move quickly past the summary figures to the underlying detail. If the target company's reported 2025 Net Income of $28 million is based on aggressive assumptions or incomplete data, that investment thesis collapses immediately.

Verifying Completeness and Accuracy

Accuracy means the numbers reflect reality; completeness means nothing important was left out. We often find issues in the areas most susceptible to management judgment, like revenue recognition and inventory valuation. You need to verify that the reported figures match the general ledger and that the general ledger captures all economic activity.

For example, in a recent technology acquisition review for FY 2025, we found that the target company reported $150 million in total revenue. However, a deep dive into their sales contracts revealed that $12 million of that revenue was recognized prematurely, tied to bill-and-hold arrangements where the customer had not yet taken possession. That's a 8% overstatement of true, earned revenue.

A quick check on the balance sheet is to ensure the working capital calculation is sound. If Accounts Receivable (AR) suddenly spiked in Q4 2025 without a corresponding increase in sales, that's a major red flag signaling potential channel stuffing or poor collections.

Reconciling Data with Source Documents

The financial statements are just the output. Due diligence requires tracing those outputs back to the inputs-the source documents. This is where the rubber meets the road, and where management's narrative is tested against hard evidence.

You must obtain external confirmations. This means sending confirmation requests directly to banks, major customers, and key vendors. You cannot rely solely on internal documents provided by the target company. Honestly, if they push back on external confirmations, you should defintely walk away.

We recently reviewed a company that reported $5.5 million in unrestricted cash on its 2025 balance sheet. However, bank confirmations revealed that $500,000 of that cash was restricted collateral for a line of credit, meaning it wasn't available for operations or distribution. That small detail changes the liquidity profile significantly.

Assessing Consistency and Benchmarking

Reliable accounting is consistent accounting. You need to assess whether the company has applied its policies uniformly over the last three to five years. Inconsistent application-like changing inventory valuation methods without strong justification-can artificially smooth earnings or hide performance dips.

Beyond internal consistency, you must benchmark the company's performance against its peers. If a company's Gross Margin is significantly higher than the industry average, it suggests either a massive competitive advantage or, more likely, aggressive accounting practices.

Key Financial Ratio Comparison (FY 2025)

Here's the quick math: If the industry average Gross Margin is 45%, and the target reports 52%, you need to understand exactly how they achieved that 7-point spread. Is it genuinely lower input costs, or are they capitalizing expenses that peers expense immediately? Consistency over time is crucial; look for sudden, unexplained jumps in profitability that don't align with market conditions or operational changes.

How Robust Are the Company's Internal Controls and Accounting Processes?

When you're buying a company or making a major investment, the audited financials are just the starting line. We need to look under the hood at the engine that produces those numbers: the internal controls. Weak controls don't just mean sloppy bookkeeping; they mean the numbers you are relying on could be fundamentally wrong, or worse, fraudulent. This is where we shift from historical analysis to operational risk assessment.

If the control environment is shaky, you are inheriting a massive cleanup job, plus the risk of restatements down the line. Honestly, a strong control system is often worth more than a few extra percentage points of EBITDA growth.

Evaluating the Design and Effectiveness of Internal Controls

Internal controls over financial reporting (ICFR) are the policies and procedures designed to provide reasonable assurance that the financial statements are reliable. We assess both the design-does the control make sense on paper?-and the operating effectiveness-is the control actually being performed correctly, every time?

We start by reviewing the company's risk control matrix (RCM). If they don't have one, that's a red flag right there. For a typical mid-market software company generating $300 million in 2025 revenue, we expect to see at least 150 key controls documented across revenue, procurement, and treasury cycles. We focus heavily on IT General Controls (ITGCs), especially around access management for the core Enterprise Resource Planning (ERP) system, like SAP S/4HANA.

We don't just read the documentation; we sample the evidence. If the control is defined as 'CFO reviews all capital expenditures over $50,000,' we pull 10 recent transactions and look for the CFO's signature and date. If 3 out of 10 samples are missing proper sign-off, the control is defintely ineffective, regardless of its design.

Reviewing Segregation of Duties, Authorization Procedures, and Reconciliation Processes

Segregation of Duties (SoD) is the bedrock of preventing fraud. It ensures that no single person has control over an entire transaction lifecycle. Think of it this way: the person who initiates a payment request should not be the person who approves the payment, nor the person who records the payment in the general ledger.

In due diligence, we map out critical SoD conflicts. For example, if the Accounts Payable clerk can both create a vendor master file and process the payment, the risk of ghost vendors and misappropriation is extremely high. We look for clear authorization limits. If the VP of Sales approved a $1.2 million discount in Q3 2025, was their documented limit $1 million or $5 million? The difference matters.

Strong reconciliation processes are your early warning system. We expect bank reconciliations to be performed daily or weekly, not monthly. If the target company has $45 million in cash and equivalents, but the bank reconciliation is consistently 15 days late, that delay masks potential cash flow issues or theft. We need to see evidence that reconciling items are cleared quickly, usually within 48 hours.

Identifying Any Material Weaknesses or Significant Deficiencies in the Control Environment

When we find control failures, we categorize them. A Significant Deficiency (SD) is important enough to merit attention by those responsible for financial oversight, but it's not quite a disaster. A Material Weakness (MW), however, means there is a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected on a timely basis.

If the target company is publicly traded, these weaknesses must be disclosed in their 10-K filings. If they are private, we scrutinize the external auditor's management letter. A common MW we see in rapidly scaling companies is inadequate controls over complex, non-routine transactions, like a new debt issuance or a major asset impairment recorded in Q4 2025.

Here's the quick math: If the MW relates to inventory valuation and the inventory balance is $80 million, and the potential error rate due to poor controls is estimated at 5%, that puts $4 million of the balance at risk. If $4 million is material to the overall financial picture (say, 2% of total assets), then you have a serious problem that requires immediate remediation post-acquisition.

We need to understand not just the existence of the weakness, but the remediation plan and the cost to fix it. If fixing the MW requires hiring three new senior accountants and implementing a new control module in the ERP system, that could cost upwards of $450,000 in the first year alone. That cost needs to be factored directly into the valuation model.

Is the Company Compliant with Relevant Accounting Standards and Regulations?

When you're conducting due diligence, the first thing we need to establish is whether the company is playing by the rules. Compliance isn't just about avoiding fines; it's the bedrock of reliable financial reporting. If the accounting framework is shaky, every projection you build on top of it is defintely compromised.

We need to move past the boilerplate audit letter and dig into how they actually apply complex standards. A company that consistently bends the rules or misinterprets new guidance-like the 2025 updates to global tax reporting-is carrying significant hidden risk that will eventually hit your balance sheet.

Confirming Adherence to GAAP, IFRS, or Other Applicable Accounting Frameworks

The core task here is verifying that the financial statements adhere strictly to the stated framework, whether that's US Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). This is especially critical for companies operating internationally or those with complex revenue streams.

We often see issues in areas requiring significant judgment. For instance, under GAAP's ASC 606 (Revenue from Contracts with Customers), how they determine the timing and amount of revenue recognition can drastically alter profitability. If they are recognizing 40% of a long-term contract's revenue upfront, but the performance obligations aren't met until year two, that's an aggressive interpretation we need to challenge.

Here's the quick math: If a company overstated 2025 Q3 revenue by just 3% due to premature recognition, and their EBITDA margin is 15%, that small compliance error translates into a 20% overstatement of quarterly operating profit. That's a material valuation issue.

Assessing Compliance with Tax Laws, Industry-Specific Regulations, and Reporting Requirements

Financial compliance extends far beyond GAAP. You must assess the company's exposure to tax liabilities and industry-specific regulatory risk. This is where many deals stumble, particularly in highly regulated sectors like finance or healthcare, or for multinational firms navigating the new global tax landscape.

In 2025, the implementation of OECD's Pillar Two (global minimum tax) has increased complexity for companies with revenues over €750 million. If the target company hasn't adequately provisioned for the potential top-up tax in jurisdictions where their effective tax rate is below 15%, you are inheriting a major liability.

We need to review correspondence with tax authorities and regulatory bodies. For example, if a regional bank received a warning letter from the FDIC in Q1 2025 regarding capital adequacy ratios, that regulatory risk immediately impacts the cost of capital and future growth prospects. Look for any contingent liabilities that exceed $500,000 related to ongoing tax audits or regulatory investigations.

Honesty, regulatory fines are often far more expensive than the cost of compliance. We need to know if they have a history of cutting corners.

Reviewing Past Audit Opinions and Any Reported Non-Compliance Issues or Restatements

The external auditor's opinion is your primary independent assessment of accounting quality. While a clean, unqualified opinion is the standard expectation, you must look deeper into the footnotes and the Management Discussion and Analysis (MD&A) for any subtle warnings.

A restatement is the most serious red flag. It means the prior financial statements were materially unreliable. When Innovatech Solutions restated its 2024 earnings in Q2 2025, it was because they misclassified $5.8 million in operating expenses as capital expenditures. This single event reduced their reported 2024 Net Income by 18% and immediately triggered a stock price drop.

If the auditor issued a qualified opinion, or if they noted a material weakness in internal controls (as defined by SOX 404), you must understand the remediation plan and timeline. If the weakness relates to revenue recognition and remains unresolved 12 months later, the risk of future misstatement is unacceptably high.

Audit Opinion Scrutiny Checklist

If you see a recent change in auditors, especially if the previous auditor resigned or was dismissed shortly after raising concerns, that requires immediate, deep investigation. Auditors don't walk away from fees lightly; there is usually a fundamental disagreement over accounting treatment or disclosure that you need to uncover.

Are the Company's Accounting Policies and Estimates Appropriate and Consistent?

When you are deep in due diligence, the policies a company chooses are just as important as the numbers themselves. Accounting policies are the rules management uses to translate business activity into financial statements. If those rules are aggressive, inconsistent, or simply don't reflect the economic reality of the business, you are buying a risk, not an asset. We need to look past the final reported earnings and understand the underlying assumptions.

This is where precision matters. It's easy to miss a subtle change in depreciation schedules that adds millions to net income, but that change defintely impacts future cash flow. We focus on the areas where management has the most discretion.

Examining Key Accounting Policies

The three most common areas where management can manipulate or smooth earnings are revenue recognition, inventory valuation, and long-lived asset depreciation. For revenue recognition, especially post-ASC 606 (the standard for Revenue from Contracts with Customers), we must verify that the timing of revenue matches the transfer of goods or services to the customer.

For a software company, for instance, if they are recognizing 100% of a $100,000 annual subscription fee upfront, but the service is delivered ratably over 12 months, that's a major red flag. We saw this issue spike in early 2025 as companies struggled to meet growth targets, pushing them to accelerate revenue recognition from deferred revenue balances.

Inventory valuation is critical for manufacturers. If they use LIFO (Last-In, First-Out) during a period of rising costs, their Cost of Goods Sold (COGS) will be higher, lowering taxable income. If they switch to FIFO (First-In, First-Out) to boost reported earnings, that's a policy change that needs intense scrutiny. Similarly, check depreciation: extending the useful life of equipment from 5 years to 7 years immediately lowers 2025 depreciation expense by 28%, artificially inflating current profits.

Evaluating the Reasonableness of Significant Accounting Estimates and Judgments

Estimates are inherently subjective, but they must be reasonable. Management makes judgments about future events-like how many customers will default on payments, or how likely a piece of equipment is to become obsolete. These estimates directly impact reserves and impairment charges, which are non-cash items that can be easily adjusted to hit earnings targets.

We focus heavily on the allowance for doubtful accounts (ADA) and warranty reserves. If the company's historical write-off rate has averaged 3.5% of gross receivables over the last three years, but their current 2025 ADA is only 1.8%, management is likely under-reserving to boost current period earnings. Here's the quick math: if they have $50 million in receivables, that 1.7 percentage point difference means $850,000 in pre-tax income that shouldn't be there.

Also, look at intangible asset impairment testing. If a company acquired a major asset in 2023 and the market for that asset has deteriorated significantly by 2025, but management refuses to record an impairment charge, their balance sheet is overstated. You need to challenge the assumptions used in their discounted cash flow (DCF) models for impairment testing.

Assessing Consistency and Economic Substance

Consistency is the bedrock of reliable financial reporting. If a company changes its accounting policies frequently, or only when it benefits their reported results, that's a major warning sign. We need to see consistent application of policies year-over-year, allowing for meaningful trend analysis.

However, consistency isn't enough; the accounting must reflect the economic substance of the transaction, not just its legal form. This is crucial when dealing with complex financing or leasing arrangements. For example, a company might structure a transaction as an operating lease (keeping the asset and liability off the balance sheet) when, in reality, it functions as a capital lease (financing a purchase).

We must ask: Does the accounting treatment truly represent the underlying business reality? If a company uses complex special purpose entities (SPEs) to finance assets, and those entities are not consolidated, it might understate debt and overstate return on assets. In 2025, regulatory bodies are increasingly scrutinizing these structures, so buying a company with aggressive off-balance-sheet financing means inheriting immediate regulatory risk.

If the policy changes every time they miss a target, you aren't looking at a stable business.

Policy Consistency Check (2023-2025)

Your next step is to demand a detailed memo explaining the business rationale for any policy change identified in the last three fiscal years, especially those impacting 2025 earnings by more than 5%.

What Potential Red Flags or Inconsistencies Exist in the Financial Data?

When you are deep in due diligence, your job shifts from confirming growth potential to finding reasons not to invest. The financial statements are rarely perfect, but we are looking for signs that management is actively trying to obscure performance or shift costs. Bad accounting is often just delayed bad news.

My experience, especially reviewing complex structures at firms like BlackRock, taught me that the biggest risks hide in the footnotes and the year-over-year variances that defy logic. We need to be defintely skeptical of anything that makes the company look significantly better than its peers without a clear operational explanation.

Spotting Unexplained Fluctuations in Key Metrics

The first step is horizontal analysis-comparing line items across periods and against related operational metrics. If a company's revenue growth suddenly accelerates, but its cash conversion cycle slows down dramatically, that's a major disconnect. We call this a quality of earnings issue.

For example, if TargetCo reported 2025 revenue of $120 million (a 12% year-over-year increase), but their Accounts Receivable (AR) balance simultaneously jumped 45% to $35 million, that signals trouble. Here's the quick math: if AR is growing four times faster than sales, they are either recognizing sales too early or struggling severely with collections. This inflates current earnings but creates a future cash flow problem.

We also look closely at inventory. If inventory grows faster than Cost of Goods Sold (COGS), it suggests obsolescence risk or that the company is capitalizing costs that should have been expensed. You must understand why these key ratios are moving before you sign off on the valuation.

Scrutinizing Related-Party Deals and Hidden Liabilities

Related-party transactions (RPTs) are transactions between the company and entities controlled by management, directors, or major shareholders. While not inherently illegal, they are often conducted on non-arm's-length terms, meaning the price or terms are not what they would be with an independent third party. This is where trust breaks down.

We need to confirm that any RPTs are fully disclosed and justified. If TargetCo extended a $15 million interest-free loan to the CEO's private real estate holding company in Q2 2025, that is a direct transfer of value away from the target company and its shareholders. We must adjust the valuation to reflect the true cost of that capital.

Off-balance-sheet arrangements are equally critical. These are liabilities or obligations that are not recorded on the balance sheet, often involving complex structures like Variable Interest Entities (VIEs) or extensive guarantees. We need to look beyond the balance sheet to find material operating leases, contingent liabilities, or guarantees provided to third parties that could trigger a significant cash outflow post-acquisition.

Unmasking Aggressive Accounting and Complex Structures

Aggressive accounting involves using GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) rules to their absolute limit to maximize reported earnings. This is often seen in how management handles estimates and judgments, which are inherently subjective.

A classic example is capitalizing costs that should be expensed. If TargetCo suddenly capitalized $8 million in internal software development costs in 2025, up from $2 million in 2024, that immediately boosts 2025 EBITDA and net income. We must verify that these costs meet the strict criteria for capitalization-that they relate to a probable future economic benefit and are technically feasible.

Another area is revenue recognition. Look for complex arrangements like bill-and-hold sales, where the customer is billed but the goods haven't been delivered, or significant changes in the estimated useful life of assets. If the useful life of machinery is extended from 5 years to 7 years, depreciation expense drops, and earnings rise-a simple change that can inflate net income by millions. EBITDA is easy to manipulate.

Common Aggressive Accounting Tactics

Your action item here is to require a detailed schedule showing all changes in accounting estimates and policies over the last three fiscal years. If those changes consistently benefit reported earnings, you need to apply significant normalization adjustments to the valuation model.

Assessing the Quality of a Company's Accounting During Due Diligence

When you are looking at an acquisition or a significant investment, the quality of the accounting team is often the last thing people check, but it should be one of the first. A brilliant business model built on shaky financial reporting is a ticking time bomb. We need to move past just verifying the numbers and start verifying the people and systems that produce them.

If the accounting function is understaffed, using outdated software, or constantly fighting with its auditors, the financial statements you are relying on are defintely at risk. This isn't just about finding fraud; it's about assessing the operational risk inherent in poor controls and weak talent.

Assessing the Qualifications, Experience, and Stability of Personnel

The competence of the finance team directly correlates with the reliability of the books. You need to look beyond titles and assess actual qualifications, especially the percentage of staff holding professional certifications like Certified Public Accountant (CPA) or Chartered Global Management Accountant (CGMA).

High turnover in the accounting department is a massive red flag. If the Controller or CFO has been in their seat for less than 18 months, you need to understand why. That instability often means processes are undocumented, knowledge is siloed, and errors are more likely to slip through. We look for stability and depth, not just a single superstar.

Here's the quick math: For a company with $150 million in revenue and 500 employees, we expect a finance team of at least four to five senior professionals, plus support staff. If they only have three people handling everything, they are critically under-resourced, and the risk of material misstatement skyrockets.

Evaluating the Adequacy of Accounting Software, Systems, and Technological Infrastructure

In 2025, relying on spreadsheets and legacy systems (like an ERP implemented before 2015) is a major liability. Modern accounting requires systems that handle complex revenue recognition (ASC 606), automate reconciliations, and integrate seamlessly with operational data.

We need to evaluate the Enterprise Resource Planning (ERP) system. Is it scalable? Does it enforce internal controls automatically? If the target company needs to spend $1.5 million immediately post-acquisition just to upgrade their core financial system, that cost needs to be factored directly into the valuation.

A company that hasn't invested in technology is likely spending too much time on manual data entry, which is inefficient and error-prone. Look for evidence of investment; if their annual IT spend on finance systems is less than $150,000 for a mid-sized firm, they are lagging behind industry peers.

Understanding the Relationship with External Auditors and the Quality of their Engagement

The external auditor is your first line of defense, but their opinion is only as good as the scope of their work and their independence. You must review the audit engagement letter, management representation letters, and all communications regarding significant accounting judgments.

A key metric is the ratio of non-audit fees (consulting, tax advice) to audit fees. If non-audit fees consistently exceed 150% of the audit fee, it can raise questions about auditor independence, even if technically compliant with Public Company Accounting Oversight Board (PCAOB) rules.

Also, check the auditor's tenure. While long tenure suggests familiarity, it can also lead to complacency. If the same partner has signed off on the audit for more than five years, you should scrutinize the engagement more closely. We want to see a history of clean opinions, but also evidence that the auditors challenged management on complex issues.

Key Auditor Metrics (2025 FY)

If the company has switched auditors frequently-say, three times in five years-that is a massive warning sign. Auditors rarely resign unless they have serious disagreements with management over financial reporting or internal controls. You need to interview the predecessor auditor to understand why they left; that conversation is non-negotiable.