The unexpected arrival of the COVID-19 pandemic shows how important reverse stress testing can be in managing business vulnerabilities.
As well as being able to flag early warning signs of going concern issues, reverse stress testing can also help directors with enhancing risk assessment. Reverse stress testing can help identify high risk, low probability events which may have become more prominent during the pandemic. As a result, it can help to develop mitigating actions.
As a technique, it can also be used to help identify weaknesses in an entity's business model and strategies and highlight to management where these may need attention.
ICAEW's Audit and Assurance Faculty, together with the Financial Reporting Faculty, has created a guide that aims to explain the concepts behind reverse stress testing to directors and management of entities that are not currently required to carry it out by regulation.
An accompanying webcast, delivered by Neil Lawrinson of Mazars UK and Alex Russell of ICAEW, loosely follows the format of the guide, adding considerations on how reverse stress testing as a technique can help directors to meet their obligations with respect to going concern, and to meet s172 responsibilities.
What is reverse stress testing?
Certain banks, building societies and investment firms are required to undertake reverse stress testing. A lot of the focus of guidance in the past is around regulatory requirements. However, it can be used effectively by other businesses. Management and directors can use reverse stress testing to look at their going concern assessment from a different angle, to test the robustness of the business model. It can identify gaps in a business's risk assessment that might have otherwise ignored, particularly pre-COVID-19.
Traditional stress tests involve shifting the values of various parameters that would affect the financial position or performance of the organisation and determining the possible impacts. Reverse stress tests identify pre-defined outcomes, such as a business failing, or its business model becoming unviable, then explores plausible scenarios that could result in that outcome.
In general terms, reverse stress tests need to answer three questions: what would it take for the entity to fail? What event or combination of events might lead to this outcome? What can we do now to avoid this happening?
The webcast compares the approach of reverse stress testing to traditional stress testing and identifies the main steps that entities may wish to consider in carrying it out. The steps are then applied to a real-world example of a coffee shop, to demonstrate how it works, and how it can help management to develop mitigating actions. The webcast also considers how to pick a starting point, including COVID-19 specific scenarios, and then how directors should use it in their assessment of going concern and in making quantified disclosures. The webcast also considers how it can add to audit evidence.
The webcast includes a brief Q&A on some further practical aspects, including some thoughts on how the adoption of reverse stress testing by a greater number of entities now and after the COVID-19 pandemic, might tie in with Sir Donald Brydon's recommendations on resilience, and indicators of distress.