Note: Originally published in Bloomberg Tax. 

When a major company fails, investors may be left staring at financial statements wondering how they never saw it coming.

Blame may be cast at auditors in these cases, but that could be a misunderstanding of a critical nuance: Auditors uphold accounting principles but aren’t responsible for predicting insolvency. For example, the failure of a company due to a major macroeconomic shock would lie beyond auditor purview.

Instead, the responsibility for watching for insolvency typically falls on analysts, creditors, and other stakeholders who assess external factors alongside financial statements.

Auditors’ Responsibility

Public Company Accounting Oversight Board guidance identifies auditor obligations when confronting uncertainties during audits.

When faced with significant doubts, auditors examine management strategies and their feasibility. But auditors depend on information provided by management, and external variables such as market volatility and management efficacy may be outside the audit’s scope.

As they assess the likelihood of strategy success, auditors usually will have a thorough discussion with management which in turn is expected to explain their assumptions, considering their industry and company-specific expertise. However, these plans may falter due to poor execution, management’s lack of credibility, or unforeseen market dynamics.

As such, auditors operate within the confines of the information at their disposal. They may find themselves blindsided or misled when pertinent information is withheld from them.

Auditors are responsible for discerning if there is substantial doubt about an entity’s ability to continue as a going concern. This determination hinges on conditions existing at or preceding the auditor’s report date. But this approach is somewhat limiting for predicting bankruptcy, as an initial determination may not address early warning signs on future performance.

Answering Questions Raised

The auditor-client dialogue can highlight areas of concern on financial statements and management’s strategy for remediation, but the dialogue may raise more questions than it answers. Answering those questions often isn’t the responsibility of auditors or tax professionals.

Although auditors may use footnotes to outline concerns or provide additional details of what certain line items include, these footnotes may raise further questions for the investment community.

However, auditors can assist by having experts scrutinize the viability of management’s projections, evaluating competence of the management team, and reviewing the adequacy of the company’s internal controls. Inadequate internal controls may heighten the risk of insolvency.

Lenders and Creditors

Lenders often wield significant tools to assess the viability of potential borrowers. They can impose stringent requirements or covenants for loans and credit predicated on thorough analyses and risk assessments.

While auditors play a crucial role in ensuring financial transparency, lenders also must exercise due diligence in scrutinizing loan applicants and monitoring their ongoing financial performance and adherence to covenants.

If borrowers are at risk of breaching covenants, agent banks discuss cure options with borrowers and notify other banks within the syndicate.

Red Flags

Recognizing the warning signs of financial distress helps safeguard investments and interests. By understanding and heeding these warning signs, stakeholders can proactively assess the financial health of organizations and take preemptive measures to mitigate risks and protect investments.

Macroeconomic shocks. Foreign and domestic economic events can drastically impact large or small companies. For example, fluctuations in oil and gas prices can exert pressure on margins, potentially leading to negative margins for businesses reliant on these commodities.

Secular declines. Industries may experience a gradual decline in support as consumer preferences shift. For example, as consumers adopted new technologies and demanded real time news consumption, print newspaper subscriptions declined in place of a lower margin product, online subscriptions.

Regulatory or legislative changes. Significant impacts can occur in industries such as oil and gas, life sciences, and healthcare because of regulatory or legislative changes. For instance, amendments to Medicare reimbursements rates in assisted homes required additional nursing staff in order to receive the same rate reimbursement, increasing the assisted homes’ expenses and placing strain on the business.

Rating agency credit downgrades. These ratings are determined by a blend of qualitative and quantitative factors, assessing both current and projected performance, alongside comparisons to peers and macroeconomic conditions. A downgrade in ratings can signal potential future instability, as was the case in Bed Bath & Beyond’s ratings downgrades.

Decrease in cash flow. Nominal or negative cash flow may require a company to tap into reserves to fulfill weekly obligations or capital expenditure requirements. Without a return to positive cash flow, reserves eventually will be depleted.

High leverage. Increased leverage resulting from additional debt or declining performance can make managing debt more challenging, potentially requiring bankruptcy protection for companies with excessively high leverage ratios.

Fraud or mismanagement. Instances of fraud such as Enron aim to deceive auditors. Once uncovered, they typically reveal additional underlying issues that may lead to bankruptcy, as further exemplified by cases such as FTX or Theranos.

Litigation. Legal battles, such as the Johnson & Johnson talc cases, can escalate, with unfavorable decisions potentially pushing a company toward bankruptcy.

Underperformance compared to peers. Significant underperformance relative to peers may indicate poor management decisions or unfavorable long-term contracts, adversely affecting the business.

Increase in media coverage of the industry. Shifts in technology, management, or regulations highlighted in the media can adversely affect business operations, its perception in the investing community, and its regulatory focus, as was the case with Gamestop.

Preventing and predicting financial distress requires a collective effort, with auditors, lenders, and stakeholders each playing a distinct yet interconnected role. Understanding these roles and paying attention to signs of distress can help stakeholders identify risk of insolvency before it is too late.