Model Audit
Encyclopedia
A model audit is the colloquial term for the tasks performed when conducting due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...

 on a financial model, in order to eliminate spreadsheet
Spreadsheet
A spreadsheet is a computer application that simulates a paper accounting worksheet. It displays multiple cells usually in a two-dimensional matrix or grid consisting of rows and columns. Each cell contains alphanumeric text, numeric values or formulas...

 error. (Also known as Model Review in some areas). A study in 1998 concluded that even MBA students with over 250 hours of spreadsheet development experience had a 24% chance of introducing spreadsheet error. Model audits are typically requested by banking organisations, in order to reassure lenders and investors 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
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 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
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...

. This may range from a multiple of the fee
Fee
A fee is the price one pays as remuneration for services. Fees usually allow for overhead, wages, costs, and markup.Traditionally, professionals in Great Britain received a fee in contradistinction to a payment, salary, or wage, and would often use guineas rather than pounds as units of account...

 (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 organisation 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 local GAAP and tax;
  • A sensitivity review.

Application

Model audit has predominately been related to Public Private Partnership ("PPP") transactions (including PFI in the UK and P3 in the USA), but is increasingly applicable to wider project finance and infrastructure finance transactions.

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 is it conducted?

Most financial models are produced using Microsoft Excel
Microsoft Excel
Microsoft Excel is a proprietary commercial spreadsheet application written and distributed by Microsoft for Microsoft Windows and Mac OS X. It features calculation, graphing tools, pivot tables, and a macro programming language called Visual Basic for Applications...

. The model will routinely contain a number of pages of input data, a sheet of formulas (the 'workings') which drive the model, and the output pages, which are usually in the form of standard financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...

 (balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

, income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...

, cash flow statement
Cash flow statement
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, 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 operating, investing, and financing...

, 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 reperformance of calculations based upon the project's documentation ("shadow modelling"), analytical review of trends in key outputs, sensitivity analysis and commercial sense checking.

Debate on alternative approaches

As noted in the citations, Andy Hucknall of PKF (UK) LLP (and many others) argues that the combination of a 'bottom up' all-cells review with 'top-down' analytical review gives the greatest assurance, whereas the alternative 'top down'-only approaches, such as shadow modelling, may provide a limited level of assurance that may be appropriate in some circumstances. An approach including an 'all cells' review will always provide more assurance as issues related to options not currently active in the Model, such as scenarios or alternative inputs, will not be identified where a reperformance only approach is used as such issues will only be identified by carefully reviewed a model's logic. That said, an 'all cells' review without 'top down' analytical review would lose context, so it is important to use both techniques.

An alternative argument, put forward by Jerome Brice of Mazars LLP, is that shadow modelling provides sufficient assurance.

Providers of model audit services

Given that the concept of formal model audits is thought to have started with early UK PFIs, many of the long-standing model audit firms are based in London. Many of the newer entrants to the market are based in Australia.

Some of best known model audit firms are:
  • PKF (UK) LLP(London)
  • Operis plc (London)
  • Ernst & Young (London)
  • PwC (London, Sydney and Melbourne)
  • Mazars LLP (London)
  • Corality (Sydney)
  • KPMG (Melbourne)
  • Deloitte (Sydney)


Many of the above firms, such as PwC, PKF, E&Y, Mazars and KPMG, are major accounting firms. This enables them to provide the tax and accounting reviews (usually required in a model audit) in-house or through their internationals networks, avoiding the need for separate subcontractors. It is also likely that they will be providing other services to the transaction such as tax advice or financial, commercial and operational due diligence, and the model audit is provided as part of the package.

Software for model audit

Spreadsheet tools and software are useful to the model auditor for assessing the model, providing a work plan and for identifying potential errors, but can not replace a properly planned, scoped and undertaken model audit. Commonly used tools include OAK, SpreadsheetProfessional, SpreadsheetAdvantage and Arixcel Explorer, but there are many others.

Changed environment of the credit crunch

Banks are now more risk averse. Given that they do not pay for the model audit (the sponsors do), but they rely upon the model audit report, they are able to dictate the scope of the model audit. Given that the banks will now insist on a properly scoped model audit, the model audit will finally be seen as a critical financial risk management task, rather than simply have someone to sue if things go wrong.

Competitive dialogue

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 maximising risk mitigation whilst minimising 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, 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, and if done properly, the number of unique formulae and their complexity.

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.
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