Independent Model Review (Financial Model Audit)

Model auditing is an independent formal review process typically performed before a financial model is handed over from the team or company responsible for building the model to the end user.

The importance of an independent model review is often overlooked, in this article take a look at the crucial part that a model audit plays in the life of a financial model.

Independent model review
Model auditing is an independent formal review process typically performed before a financial model is handed over from the team or company responsible for building the model to the end user. The importance of an independent model review is often overlooked, in this article take a look at the crucial part that a model audit plays in the life of a financial model.

Timing of model audit
After it has been performed a model audit will guarantee that the calculations inherent in the model are correct from a mechanical point of view. For the best result an audits should not be performed at the last minute as a crucial modeling error is likely to result in a re-evaluation of the whole transaction. In the worst case the whole transaction could fall over completely after having spent both time and money putting together a financing package based on inaccurate underlying cashflows.

Risk allocation and audit opinion
Given the risks associated with financial models you will often see a model audit as a condition precedent in a debt facility term sheet. The model audit enhances project credibility as well as reduces risk since an audited financial model will be commercially insured by the party performing the review.. It is important that traditionally the Audit Opinion only covers the mechanical aspects of the financial model and not the underlying assumptions which would be the responsibility of either the sponsor or other third party information providers.

Model audit process
The model audit process usually starts with a presentation by the team responsible for building the model to the reviewing party. The presentation highlights any critical aspects of the model so that the audit process can be as smooth as possible Specialised but readily available software is used to test for complexity and inconsistency but the cell by cell review will ultimately be performed by trained people rather than software which is a risk in itself but one that can be mitigated by selecting the appropriate firm to perform the work.

Error categories
Once the initial review is complete an issue report will be produced to highlight any concern the auditors might have which are usually broken down into 4 categories:

• Potential Error
• Query
• Undocumented Assumption
• Design Issue

The model build team is then typically required to address all items and make the relevant adjustments to the model. The auditors then review these changes and send further issues and queries to the company until there are no outstanding items and a final report can be prepared based on the final version of the model.

Cost of a model review
The cost of a model audit will mostly depend on the complexity and number of unique formulae in the model and can often cost the sponsor as much as the original model build. The more complex the model, the more hours will need to be spent on reviewing. Tight deadlines will also add to the cost as more senior staff may be needed to deliver on time. The downside to this is of course a higher price and it is therefore more cost effective to leave ample time for the model audit process.

Ways to decrease costs are:

• Leave plenty of time for the model audit process
• Have a very clear and agreed Scope of work before approaching the Model audit firm.
• Separate and have a clear distinction between calculations assumptions
• Build the model using best practice protocols and maybe have a ‘model health check’.

1. Limit unique formulae to one per row
2. Break long formulae into one or more rows
3. Keep a clear and consistent calculation layout with third parties in mind
4. Repeat similar calculation frameworks such as those for depreciation of various asset classes

• Give the model review team a thorough briefing on the transaction and context of the model
• Provide supporting documents to the model such as extracts of term sheets and contracts. Do not provide whole documents unless all of it is modeled. Remember it takes time to read through long docs which will translate into higher costs.
• Keep in close contact with the model auditors and answer all questions clearly.

The key point is to deliver the model in such a way that the time required to review the model is minimised.

Navigator Project Finance prides itself in building and delivering models which have calculations structured and presented in such a way that audit costs can be kept at a minimum. We do this by employing experienced and intelligent staff who closely follow our best practice modelling standards. Navigator also provides financial modelling training to a large part of the model review sector which ensures that the people ultimately reviewing our work are familiar with our model construction and scenario management approach.

The decision as to which model auditor to employ should be based on the purpose of the audit and the budget available. Think about their credentials in the sector, the experience of the staff and whether or not model build is also part of their services. Also keep in mind the level of liability insurance they are willing to undertake.

Some reputed firms which provide model audits are:

• Corality
• PricewaterhouseCoopers
• Ernst & Young
• PKF
• Mercer Consulting

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