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A model audit is the colloquial term for the tasks performed when conducting
due diligence Due diligence is the investigation or exercise of care that a reasonable business or person is normally expected to take before entering into an agreement or contract with another party or an act with a certain standard of care. It can be a ...
on a
financial model Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio ...
, in order to eliminate
spreadsheet A spreadsheet is a computer application for computation, organization, analysis and storage of data in tabular form. Spreadsheets were developed as computerized analogs of paper accounting worksheets. The program operates on data entered in ...
error. Model audits are sometimes referred to as model reviews, primarily to avoid confusion with
financial audit A financial audit is conducted to provide an opinion whether " financial statements" (the information is verified to the extent of reasonable assurance granted) are stated in accordance with specified criteria. Normally, the criteria are interna ...
. A study in 1998 concluded that even
MBA A Master of Business Administration (MBA; also Master's in Business Administration) is a postgraduate degree focused on business administration. The core courses in an MBA program cover various areas of business administration such as accounti ...
students with over 250 hours of spreadsheet development experience had a 24% chance of introducing spreadsheet error. Model audits are typically requested by banking organizations, in order to reassure lenders and
investors An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...
alike that the calculations and assumptions within the model are correct, and that the results produced by the model can be relied upon. When a comprehensive review of the model is required, the scope of review is often extended to include
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
and accounting, sensitivity testing and the checking of data contained within the model back to the original financing and legal documentation.


Purpose

The purpose of a model audit is to provide assurance that the results can be relied upon. For this reason, the party conducting the review will provide a level of reliance on the form of an amount of liability. This may range from a multiple of the fee (2×, 3×, 4× fee, etc.) to a fixed amount, often up to US$20 million. In the event an error or omission is found in the model due to the model auditor's negligence, the organization relying on the report may choose to sue the model auditor in order to recover any loss. The objective of the model audit should be to the reduce financial risk that is being taken on by under the transaction to which the financial model relates. As such, it is more important to ensure that the model audit has the proper scope, and is undertaken using a robust methodology, to identify material errors than to negotiate a liability cap if material errors are not identified. The model audit is not, or at least not as a primary purpose, an insurance policy, it is for reducing the financial risk that is being taken on.


Typical scope

For a full-scope model audit, the following elements would usually be included: * A review of the model's logic; * A review of the model's consistency with financial and contractual documentation; * A review of the model's consistency with relevant accounting and tax requirements; * A sensitivity review.


Application

Model audit has predominately been related to project finance and infrastructure finance, including Public Private Partnership ("PPP") transactions (including PFI in the UK and P3 in the USA). Model audits are applicable to any financial model that is used to support the taking on of any financial risk, e.g. valuation models, operational models, refinancing models, portfolio model, M&A models etc.


How it is conducted

Most financial models are produced using spreadsheet software. The model will routinely contain sheets for input data, formulas (the 'workings') which drive the model, and outputs, which are usually in the form of
financial statements Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
(
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
,
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...
,
cash flow statement In financial accounting, a cash flow statement, also known as ''statement of cash flows'', is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to op ...
, etc.). Model auditors may undertake a detailed 'bottom-up' review (cell-by-cell checks) of each unique formula, and/or combine a 'top-down' analysis such as the performance of calculations based upon the project's documentation There is some debate as to whether a "cell-by-cell" or performance approach is most appropriate. A model auditor may emphasize one or the other or use a combination of both approaches.


Competitive dialogue for PPPs

Procurement of public-private projects is often undertaken under a competitive dialogue regime. This requires bidders to commit earlier in the process, and the implication of not identifying errors in a financial model at any early stage could be that a bidder is unable to rectify the error. As a result, financial models are being checked earlier in the bid process, not just at financial close – these are known as pre-preferred bidder reviews. In some cases, these will have almost the same scope as a financial close model audit (but with documentation review limited as this will still be being drafted), but in other cases, the pre-preferred bidder review will be limited to an agreed scope of procedures with the objective of maximizing risk mitigation whilst minimizing the fee. The benefits of a pre-preferred bidder review is that it should lead to a reduced model audit fee at financial close. The introduction of this process to North America has been controversial. The
City of Brampton Brampton ( or ) is a city in the Canadian province of Ontario. Brampton is a city in the Greater Toronto Area (GTA) and is a lower-tier municipality within Peel Region. The city has a population of 656,480 as of the 2021 Census, making it the ...
, for instance, has faced lawsuits and controversy about use of the process.


Cost and duration

A model audit may take between 1 and 5 weeks, but this does not include the time taken by the model author to rectify the errors identified by the model auditor. The fee is largely dependent upon the scope of review, the number and complexity of the unique formulae in the model, the volume and complexity of the documentation and the number of versions of the model/documentation to be reviewed. The cost will also depend on the seniority of staff undertaking the work. Planning of the model audit, as for a statutory audit, is vital to mitigating risk, and thus this needs to be undertaken by senior staff. In planning, the elements of the model audit should be allocated to staff with the appropriate level of experience, technical expertise (e.g. tax or accounting) and seniority. The senior staff needs to look at the big picture of the model to ensure that it makes sense as a whole.


References

{{reflist Corporate finance Financial models