Why Financial Audits Alone Don’t Cut It in Private Equity Due Diligence

When private equity (PE) firms evaluate acquisition targets, they often treat audited financials as reliable truth. That assumption can be costly. Audits are necessary because they confirm that historical statements comply with GAAP or IFRS within acceptable materiality limits. Yet they are not sufficient for proper PE underwriting. The real insight begins when those statements are translated into sustainable earnings, tested for cash conversion, and linked to deal protections and valuations.

This post explores how audits differ from PE due diligence, how Quality of Earnings (QoE) analysis extends their value, and why aligning audit results with different types of financial models and investment banking decks is critical for deal success.

What an Audit Covers Compared to What PE Buyers Require

Audit: Assurance on Historical Accuracy

An audit’s purpose is to provide an opinion on whether financial statements fairly represent the company’s position under applicable accounting standards. Auditors test transactions, balances, and sometimes internal controls. Their focus is compliance rather than business sustainability.

Auditors apply materiality thresholds that define what is “significant.” Anything below those thresholds may be ignored. However, in valuation terms, a small misstatement can have a disproportionate effect on enterprise value or working capital pegs.

Audits also look at full-year results, not monthly trends. This limits their usefulness for understanding seasonality, customer churn, or real cash dynamics. For public companies, SOX 404 adds internal control testing, but most private targets lack that coverage.

In short, an audit checks compliance boxes, but it does not answer the investor’s central question: Can this business sustain its earnings and convert them into cash?

PE Diligence: Forward-looking and Valuation Focused

A study by MLRPC noted that audited financials often fail to reveal deal-relevant issues that buyers later discover during due diligence. EY also highlighted that leading private equity firms are shifting toward insight-led diligence rather than relying on audit outputs alone.

How QoE Strengthens and Extends the Audit

A Quality of Earnings review builds on audit information but interprets it through a commercial and operational lens.

1. Adjusted EBITDA and Sustainable Earnings

QoE teams remove non-recurring and discretionary items, adjust for accounting timing effects, and recast financials to show “true” run-rate performance. This becomes the anchor for valuation and leverage sizing.

2. Working Capital Diagnostics

Instead of relying on an audited balance sheet, QoE analysis builds monthly roll-forwards and aging schedules. It identifies policy differences, seasonality, and structural shifts that define an accurate working capital peg.

3. Cash Conversion and Leakage

Audits verify balances; QoE investigates flow. It examines how earnings translate to operating cash, uncovering issues in capitalization policies, cutoffs, vendor terms, or inventory valuation.

4. Debt and Debt-like Mapping

Obligations buried in current liabilities, such as customer advances or deferred revenue, can behave like debt. QoE teams reclassify them to ensure dollar-for-dollar price adjustments in the SPA.

5. Linking to SPA Mechanics

QoE findings inform SPA definitions, accounting hierarchies, and completion account schedules. The goal is to ensure diligence insights are reflected in contract terms, preventing disputes after closing.

Embedding Audits Into SPA Mechanics

A strong SPA integrates audit data with economic logic.

Accounting hierarchy: A typical SPA ranks accounting precedence in the following order: SPA-specific policies, then audited reference accounts, and finally GAAP or IFRS. This approach limits ambiguity when historical practice differs from accounting standards.

Working capital peg: The peg should reflect normalized averages rather than a single audited date. Collars and defined inclusions or exclusions help avoid post-close arguments.

Locked box vs completion accounts:

• Locked box structures use audited statements as the “locked” base with protections against value leakage.
• Completion accounts rely on audited reference accounts but require a true-up post-close.

The choice depends on earnings volatility and the reliability of the accounting framework.

Ambiguous definitions of “net debt,” “cash,” or “working capital” often trigger disputes. Grant Thornton found that roughly half of all M&A transactions face such conflicts, usually because of imprecise wording in SPAs.

What Audit Findings Reveal About Internal Controls

Even limited audits can provide useful signals about control maturity.

• Qualified opinions or emphasis-of-matter notes suggest risks in accounting judgments or going-concern assumptions.
• SOX 404 assessments in public or IPO-ready targets give insight into system discipline and process reliability.
• Private company audits provide limited control testing, so PE buyers should perform additional walkthroughs and IT general control reviews.
• Control gaps identified in audits should be incorporated into a day-1 or 100-day remediation plan post-acquisition.

Weak controls typically lead to reporting delays, integration issues, and potential covenant breaches after closing.

IFRS vs US GAAP: Translation Risks in PE Deals

Cross-border transactions demand careful reconciliation between frameworks.

• Provisions and recognition thresholds: IFRS recognizes provisions more broadly and may require discounting, while US GAAP records only the minimum probable amount.
• Impairments: IFRS allows reversals (excluding goodwill), which can alter future depreciation profiles.
• Inventory accounting: IFRS bans LIFO, whereas US GAAP permits it.
• Other comprehensive income: IFRS treats certain valuation changes differently, affecting equity and ratios.

Auditors operate within one framework, but diligence teams must normalize results for comparability and covenant compliance. Differences highlighted in audit footnotes should directly inform QoE adjustments and SPA terms.

Revenue Recognition: The Most Sensitive Audit Area

Revenue accounting often hides the biggest valuation risks.

Growth-linked incentives can create pressure to book revenue prematurely or bundle contracts creatively. Auditors assess compliance with ASC 606 or IFRS 15, but PE diligence must dig deeper.

Bundled arrangements, variable consideration, and incomplete documentation frequently distort margins and forecasts. Even automation systems can hide manual overrides that auditors miss. Diligence teams should reperform contract tests, trace billing data, and review policies for fraud indicators.

A Structured Workflow That Combines Audit and PE Diligence

To integrate audits effectively, PE firms can follow a practical sequence:

1. Map audit materials to diligence workstreams, focusing on judgmental areas like provisions, leases, and impairments.
2. Launch QoE with monthly data to normalize EBITDA and reconcile to audited results.
3. Perform contract and revenue testing by customer and product category.
4. Develop a working capital playbook that includes seasonality analysis, policy differences, and recommended peg methodology.
5. Identify debt-like items such as customer deposits or unrecorded liabilities.
6. Build cohesive financial models and corresponding investment banking decks reflecting diligence findings.
7. Draft SPA exhibits and accounting hierarchies early to ensure that deal language matches operational realities.
8. Plan control remediation for access, change management, and reporting.
9. Negotiate precise SPA protections based on audit and QoE results.
10. Monitor post-close integration through first-year financial statements and cash reconciliations.

This sequence turns audits from static documents into active tools for risk management and valuation defense.

Key Takeaways

• A clean audit opinion does not equal a reliable valuation base.
• Audits confirm compliance; QoE reveals economic truth.
• Always translate audit findings into actionable SPA definitions and exhibits.
• Treat working capital pegs as dynamic, not as a snapshot.
• Review revenue recognition policies rigorously, especially where growth incentives exist.
• Pay attention to control weaknesses in audit opinions.
• Normalize GAAP and IFRS differences for consistency.
• Combine audit evidence, diligence analytics, and contractual protections into one integrated process.

A good audit is a foundation. A strong diligence process builds on that foundation and safeguards value through structured analysis and clear contractual language.