How entities and auditors use reverse stress testing

How entities can  use the results of an RST exercise

Entities may include scenarios identified through the reverse stress testing to complement the range of stress test scenarios they undertake. For comparison purposes, to assess the overall severity, RST will allow identification of severe but still plausible scenarios. This will inform the entity’s risk management.

The design and results of an entity's reverse stress test should be reviewed by the entity's senior management and those charged with governance

If the RST exercise has led to the development of new mitigation actions, management should ensure these are reflected in its revenue and cashflow forecasting.

As part of management’s assessment of going concern, reverse stress testing might be used in combination with stress-tested scenarios. The directors should consider whether RST scenarios are adequately included in the entity’s going concern disclosures, including quantified disclosures.

Many entities will be used to disclosing a range of sensitivities when it comes to estimates, and likewise, a range of scenarios impacting going concern may promote transparency and be helpful to users of the financial statements. Where requirements dictate, this will also help to ensure disclosures are ‘fair and balanced’.

An entity’s going concern disclosures may include the following:

• ...[cash at bank and in hand/loan facilities] [is/are] available to cover [x] months of revenue at the reduced level of [x]% of [the equivalent period in the prior year]...

Why is RST useful in management’s going-concern assessment and as audit evidence for the auditor?

Auditors are required to review the entity’s going-concern disclosures which may include these stress-tested scenarios, and assess the robustness of the information and assumptions used in the scenarios.

The pre-defined outcome used in RST can be determined as the entity no longer being a going concern. Therefore, the results of RST can help support management’s assessment of whether the entity is a going concern, and whether there are material uncertainties related to going concern.

ISA 570 requires the auditor to obtain sufficient appropriate audit evidence on whether a material uncertainty related to going concern exists; and the appropriateness of management's use of the going concern basis of accounting in the preparation of the financial statements.

ISA 570 defines material uncertainty as being when events or conditions exist that may cast a significant doubt on the entity’s ability to continue as a going concern. The steps in carrying out RST of determining the plausibility and likelihood of scenarios is therefore highly relevant. If scenarios are identified that individually or collectively could lead to the pre-defined condition, and are not remote, a material uncertainty might exist.

If they are probable, then the entity may not be a going concern. Therefore, conversely if management can demonstrate that these RST tested scenarios are remote, the auditor  will have more compelling audit evidence to support the auditor’s own assessment that no material uncertainties relating to going concern have been identified.

The auditor will be expected to challenge robustly the assumptions used by management around the severity and plausibility of the scenarios tested. The auditor should also look beyond management’s assessment, and consider whether there are material uncertainties which management has not identified. Profession scepticism should be engaged to consider scenarios that management has not identified, but which could nevertheless lead to the failure of the entity.