RST and why it is usefulA guide for entities
This guide introduces reverse stress testing as a tool that all entities can use to enhance their going concern assessments and improve risk assessment during the COVID-19 crisis and beyond.
Reverse stress testing is a requirement for some financial institutions, but is not currently used widely by other entities. Reverse stress testing can provide management with a different lens through which to view going concern and risk assessments, and to enhance their robustness. It also provides auditors with persuasive evidence to support their conclusions on going concern.
This guidance from the Financial Reporting and Audit and Assurance faculties explains what reverse stress testing is, and how it can be a useful tool for management of a wide range of entities.
Going concern is a key area of focus for the faculties as part of our work on audit reform. ICAEW’s five goals for audit reform were published in February 2020. The third goal, A more reliable core audit, calls for a renewed focus by auditors on fraud, going concern and internal controls to improve audit quality, and we are prioritising the development of resources in these areas to equip businesses and auditors to respond to the challenges faced during the pandemic.
What is stress testing?
Stress testing is a forward-looking analysis technique that many entities are carrying out to some degree, if not in name. An entity identifies an appropriate range of adverse scenarios of varying nature, severity and duration relevant to its business, and considers its exposure to those scenarios.
Stress tests involve a variety of techniques, including sensitivity analysis, and can be carried out on individual activities as well as at entity-wide level. Stress testing typically involves shifting the values of individual parameters that affect the financial position or performance of an entity and then determining the impact on the entity’s financial resources. This allows mitigating actions to be developed.
Stress testing can be used to:
- quantify to what extent reserves might be absorbed, or cash required, if an adverse event occurs;
- provide a check on the outputs and accuracy of risk models; and
- explore the sensitivities in business plans and how capital needs might change over time.
What is reverse stress testing (RST)?
A reverse stress test is a stress test that starts from the opposite end – with the identification of a pre-defined outcome. This might be the point at which an entity can be considered as failing, or the entity’s business model becomes unviable. Severe, but plausible, scenarios that might result in this outcome are then explored.
RST broadly involves exploring three questions in the following order:
- What would it take for the entity to fail?
- What individual event, or sequence of events, could lead to this outcome?
- What can be done now to avoid this?
The answer to the third question helps the entity to develop plans to address the specific weaknesses identified by the RST. RST is a systematic process of finding weaknesses in a business and deciding on the action that needs to be taken. Businesses may continue to generate revenue during the current crisis. RST may consider the level of revenue the entity will need to generate in order to maintain a positive ‘bottom line’ despite continuing fixed costs.
As the scenarios to be explored should be ‘severe’ and ‘plausible’, it is important to understand these terms.
Severity is the extent of the adverse impact on the entity when a risk crystallises. In RST it may relate to the severity of the assumptions, or the extent of deterioration of the scenario, from base case to an adverse scenario.
Plausibility of scenario is how likely it is that it will arise. This might be in light of the current macroeconomic environment, and the extent to which the scenario is supported by a coherent narrative, probability distributions and historical experience.
The extent of RST should be proportionate to the nature, size and complexity of the entity's business and its risks. Where the entity is part of a group it should consider conducting RST on an individual entity basis and a group basis.
The directors of the entity are responsible for the assessment of whether the entity is a going concern, and if it is, whether there is material uncertainty related to going concern. Therefore, for the purposes of users of this guide, the most relevant possible starting points (‘pre-defined outcomes’) are likely to situations in which:
- the entity runs out of cash, or otherwise experiences cashflow issues which mean that it is unable to settle liabilities as they fall due;
- operating cash outflows exceed cash inflows;
- there is a demand for immediate repayment of a loan or loans;
- loan covenants are breached due to asset valuations falling due to COVID-19, and the lender does not waive the covenants; or
- a sole or principal source of funding is lost.
These factors individually or collectively could lead to material uncertainties, or the entity no longer being considered a going concern, and may be suitable pre-defined outcomes for RST, depending on the circumstances of the entity. Equally, the RST pre-defined outcome may be widened in scope to where there is material uncertainty.
Why might entities find RST useful?
- One of the criteria for the UK government’s CBILS (Coronavirus Business Interruption Loan Scheme) is that “your business has a borrowing proposal which the lender would consider viable, if not for the coronavirus pandemic”. RST may assist in demonstrating that an entity’s borrowing proposal is viable.
- The lockdown may have led to temporary or more lasting effects on consumer behaviour, including patterns of home working and travel. An entity might therefore use RST as part of its business planning in the short term and for when restrictions start to be lifted. An entity can reverse stress test its business plan by carrying out stress tests that test its business plan to the point of failure. This may help understanding of the viability and sustainability of the entity’s business model and strategies, and identify circumstances where it might fail.
- RST adds value to an entity’s risk management process and provides management with a risk management tool that can be used in planning and decision-making.
- RST can overcome the limitations of an entity’s risk model, which can break down in periods of crisis. An entity’s risk register may include risks such as loss of key management personnel, loss of a key customer or supplier, or cyber security risks. Due to the COVID-19 pandemic, the probability and severity of these risks are likely to be higher, with staff unable to attend the workplace, the risk of several customers or suppliers ceasing to trade, and the incidence of cyber-attacks increasing.
- RST can reveal hidden vulnerabilities and scenarios not identified by traditional stress testing. Tail risks (low probability, high loss events) are dangerous - especially where the associated probabilities may have increased due to COVID-19. Identifying these extreme scenarios can reduce the chances of an entity failing.
- Traditional stress testing can be subject to bias by management in terms of the scenarios selected. RST can help reduce the possibility of a false sense of security arising from regular stress testing, where entities identify manageable impacts.
- RST can be used to provide early-warning signals of the occurrence of the scenario. If an entity identifies that it cannot survive four months without revenue during lockdown, management will know that if month three is reached without improvement, further actions will be required.
- Practically, in the financial reporting process, reverse stress-tested scenarios developed to support the going concern conclusion will require less frequent updating by the directors, because they represent an ongoing worst case scenario. Conversely, traditional stress testing or sensitivity analysis will require more frequent updating for reasons of constantly changing assumptions about COVID-19 uncertainties, especially if there is a delay before signing the financial statements.
Our thoughts are with everyone affected at this challenging time. We encourage all parties to stay up to date with the latest public health advice in their country.
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