How to do RST
The following are steps that entities follow in carrying out RST:
- Identify the pre-defined outcome to be tested
Traditionally in RST this might be the point at which the entity fails. For practical use in going concern assessments, this is likely to be when an entity runs out of cash, is requested to repay a loan, or where loan covenants that have not been waived are breached.
- Identify a range of adverse circumstances which would cause this outcome
The severity of each scenario should be considered.
- Quantify the financial deficit which would cause the pre-defined outcome should the identified adverse circumstances occur
Financial resources required will depend on the severity of the scenario.
- Assess the likelihood that such events could occur
Assess the likelihood of events included in the scenarios leading to the pre-defined outcome. RST commonly refers to plausibility. Stress events observed in similar environments outside the entity should also be considered.
- Mitigate the risk
Where the above steps reveal a going concern risk that is unacceptably high in terms of the entity's risk appetite, the entity should adopt effective processes, systems or other measures to prevent or mitigate that risk. This should take into account the time that the entity would have to react to the events and to implement measures mitigating the risk, including considering changes to the business model.
A wide range of scenarios should be considered. They are likely to include non-financial scenarios, that when reverse stress-tested lead to the adverse outcome. For example:
- Covid-19 has put an entity’s regular supplier out of business, so the entity has been forced to source alternative suppliers. The product provided by the new suppliers is of a lower quality, which has led to reputational damage for the entity. This has a knock-on effect of higher than usual levels of refunds and warranty claims.
- Higher instances of phishing and other cyber attacks have led to a publishing entity’s intellectual property being made available as open-access.
As an example, using these principles, we explore how a coffee shop might apply the reverse stress testing steps outlined earlier. A coffee shop is a business that is likely to be affected in a number of different ways by the COVID-19 pandemic, but many of these considerations will be equally applicable to other types of business.
- Identify the pre-defined outcome
In this example this might be the failure of the coffee shop, or running out of cash.
- Identify a range of scenarios which would cause this outcome
A coffee shop might identify that there is risk of business failure because COVID-19 isolation guidelines prevent customers from coming into the premises and sitting at tables, and the RST can help establish how long it is before financial resources are insufficient to allow the business to continue.
The consequence is that customers will not be able to buy coffee, or other food and drink, and the lack of access to tables will stop customers staying longer and making further purchases. Other incidental sales of merchandise such as mugs, re-usable cups, or bags of ground coffee might also suffer.
There may also be other lasting effects of COVID-19 on consumer behaviour. More home-working may lessen demand for coffee shops in commercial areas. Reduced demand for rail travel might impact the entity if it has an existing contract to supply coffees and pastries to train operators.
- Quantify the financial deficit
The assessment of financial resources might identify that not receiving revenue until the end of June 2020 would lead to the entity becoming no longer viable, given rental, staff and debt-servicing costs. If the coffee shop is run on a franchise basis it may have additional risks, such as threats to the license if sales fall to the extent the franchisee costs are no longer manageable, or if the brand’s reputation is impacted due to the reduced service.
- Assess the likelihood
The likelihood of this scenario leading to the coffee shop no longer being viable will be subject to available information from the government over how long restrictions will be in place, and judgment by management. It might also depend on the success of new revenue-generating activities, which might include deliveries, a coffee take-away service, or the sale of ‘meal deal’ boxes of coffee and sandwiches.
- Mitigate the risks
Mitigations put in place to extend the outcome beyond June might include furloughing and pay cuts of staff, negotiating with landlords for rent holidays or reduced rent.
How can the point at which the business model fails be identified?
The Financial Services Authority’s 2011 ‘Reverse stress-testing surgeries FAQs’ notes that entities may start to develop scenarios that lead to the business model failing by considering the cause, consequence or impact (financial or otherwise) of one or more events that lead to the failure of the entity.
Entities should note that ’failure’ can occur well before the point at which the capital or liquidity of the entity is exhausted. For example, it may be the point at which:
- market participants see that the entity is over-exposed to a particularly risky sector – in the COVID-19 pandemic this might be the travel sector (cause);
- the market loses confidence in the entity, resulting in the refusal of market counterparties to deal with the entity, or under such onerous conditions that it is economically unviable for the entity to carry on its business activities. This might include a situation where, under COVID-19 conditions, suppliers of goods or services are requesting payment in advance (consequence); or
- the entity is unable to transact any new business and its revenue streams dry up, or shareholders are unwilling to provide new capital (impact). The impact might also be that a loan covenant is breached.
Entities might consider any one of these as the ‘pre-defined outcome’ from which to develop the scenarios.
Entities should also consider that the pre-defined outcome of reverse stress testing can be produced by circumstances other than the circumstance analysed in the stress test.
Which COVID-19 scenarios might management consider in carrying out RST?
Below are a range of scenarios that might occur during the COVID-19 pandemic in terms of operational, structural and financial scenarios
These factors might be considered by management and used to fine tune the revenue and cash flow forecasts. A RST approach will then allow management to determine the level of decline in revenue which would lead to the predetermined outcome, ie. running out of cash. Management can develop mitigations by assessing how much lower this level would be compared with its downside forecast, and base case scenario.
The above factors may induce further reputational consequences. Actions that the entity may take to mitigate losses might have their own reputational impact, including paying suppliers more slowly or seeking faster recovery of debtors.
What time horizon might be considered?
The period of uncertainty caused by the COVID19 pandemic, is unknown. Following this period of restrictions, there is expected to be a period of incremental lifting of restrictions, followed by an unknown period of recovery.
There may then also be lasting impacts on consumer behaviour following recovery. Entities should be assessing their ability to continue as a going concern for a period at least as long as that required by the applicable financial reporting framework for the purposes of preparing their financial statements, and therefore management’s model will need to consider these different time horizons.
An entity may consider conducting reverse stress tests more frequently if there are substantial changes in the market or in macroeconomic conditions. For example, if the UK government starts to ease restrictions on movement.
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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