Model audit

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A model audit is the colloquial term for the tasks performed when conducting due diligence on a financial model, in order to eliminate spreadsheet error. Model audits are sometimes referred to as model reviews, primarily to avoid confusion with financial audit. 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. [1] Model audits are typically requested by banking organizations, 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 and accounting, sensitivity testing and the checking of data contained within the model back to the original financing and legal documentation.

Contents

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[ citation needed ]. 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[ clarification needed ] 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.[ citation needed ] 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.[ citation needed ]

Typical scope

For a full-scope model audit, the following elements would usually be included:

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 (balance sheet, income statement, cash flow statement, 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, for instance, has faced lawsuits [2] and controversy [3] [4] about use of the process.

Cost and duration

A model audit may take between 1 and 5 weeks[ citation needed ], 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[ citation needed ]. Planning of the model audit, as for a statutory audit, is vital to mitigating risk,[ citation needed ] 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.[ citation needed ]

Related Research Articles

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<span class="mw-page-title-main">Audit</span> Independent examination of an organization

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<span class="mw-page-title-main">Financial audit</span> Type of audit

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<span class="mw-page-title-main">Auditor's report</span> Type of written document

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<span class="mw-page-title-main">External auditor</span> Person who audits an entitys financial statements and is independent of that entity

An external auditor performs an audit, in accordance with specific laws or rules, of the financial statements of a company, government entity, other legal entity, or organization, and is independent of the entity being audited. Users of these entities' financial information, such as investors, government agencies, and the general public, rely on the external auditor to present an unbiased and independent audit report.

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A software audit review, or software audit, is a type of software review in which one or more auditors who are not members of the software development organization conduct "An independent examination of a software product, software process, or set of software processes to assess compliance with specifications, standards, contractual agreements, or other criteria".

<span class="mw-page-title-main">Internal audit</span> Independent, objective assurance and consulting activity

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<span class="mw-page-title-main">Materiality (auditing)</span> Concept in auditing and accounting

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<span class="mw-page-title-main">Reconciliation (accounting)</span>

In accounting, reconciliation is the process of ensuring that two sets of records are in agreement. It is a general practice for businesses to create their balance sheet at the end of the financial year as it denotes the state of finances for that period. Reconciliation is used to ensure that the money leaving an account matches the actual money spent. This is done by making sure the balances match at the end of a particular accounting period.

<span class="mw-page-title-main">Continuous auditing</span>

Continuous auditing is an automatic method used to perform auditing activities, such as control and risk assessments, on a more frequent basis. Technology plays a key role in continuous audit activities by helping to automate the identification of exceptions or anomalies, analyze patterns within the digits of key numeric fields, review trends, and test controls, among other activities.

<span class="mw-page-title-main">Entity-level control</span>

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<span class="mw-page-title-main">Control self-assessment</span> Technique to assess process effectiveness

Control self-assessment is a technique developed in 1987 that is used by a range of organisations including corporations, charities and government departments, to assess the effectiveness of their risk management and control processes.

Audit technology is the use of computer technology to improve an audit. Audit technology is used by accounting firms to improve the efficiency of the external audit procedures they perform.

Artificial intelligence is used by many different businesses and organizations. It is widely used in the financial sector, especially by accounting firms, to help detect fraud.

References

  1. ↑ Panko, Raymond (1997–2005). "Errors During Spreadsheet Development Experiments". Study. Shidler College of Business, Hawaii. Archived from the original on 21 September 2008. Retrieved 17 July 2008.
  2. ↑ Grewal, San (13 July 2011). "He built city hall. Now he's suing it". The Brampton Guardian. Toronto ON. Retrieved 14 July 2011.
  3. ↑ Douglas, Pam (25 March 2010). "City plans under wraps". The Brampton Guardian. Brampton ON. Retrieved 14 July 2011.
  4. ↑ Douglas, Pam (29 March 2011). "Conflict allegations raised at city". The Brampton Guardian. Brampton ON. Retrieved 14 July 2011.
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