What is a Model Audit?
In simple terms, a model audit is a review of a financial model, generally completed by an independent third party to help minimise the risk of error.
Model audits are typically (but not exclusively) undertaken in relation to financial models which have been developed to support large transactions, where a financial modelling error could have major consequences on investor returns.
The term model audit can be used as a general term for any review of a financial model.
However, within the industry, an ‘audit’ is generally taken to mean a review for formal funder due diligence, as opposed to a ‘review’ which can be a lighter touch exercise with reduced reliance placed on the model auditor.
The ‘full fat’ audit
Senior lenders often insist on a financial model audit in the project finance world.
From a bank’s perspective, if they are lending 100’s of millions of dollars into a deal based upon the outputs of a financial model, they want to be pretty sure it is right.
They also want to have someone to blame (read sue) if it is not.
Enter the formal funder due diligence ‘full fat’ audit. This is a key part of funder due diligence on a deal and they will not sign off the deal until the audit has been satisfactorily completed.
This requires the model auditor to undertake a very rigorous, time-consuming (and expensive) review of the financial model. A letter is then signed backed by millions in liability cover assuring that the model is correct.
Unlike the formal funder due diligence audit, many clients just need a degree of comfort that their model is functioning correctly. They want a second pair of eyes from an experienced firm to take a look at their model and point out if there are any problems.
There will not generally be an expectation that the firm completing the review will formally sign off the model. Their liability is usually capped much lower than for formal funder due diligence.
What does a model audit entail?
At the heart of a model audit is a check on the arithmetic accuracy and integrity of the model. This checks that the calculations within the model function as expected and that the calculation logic makes sense.
Most audit firms use a range of software tools to highlight common sources of error, such as embedded constants, inconsistent calculation, hidden cells, etc.
In addition to software checks, there are 2 main approaches auditors take when assessing a model’s arithmetic accuracy and integrity.
- Cell by Cell – a manual exercise where the auditor works through every unique formula to check that it is functioning correctly.
- Shadow Build – the auditor uses template models to recreate the model’s logic under test and then reconciles the outputs to identify variances/errors.
Most audit firms choose one approach over the other based on their ideology, the skillset of their team, or the type of models they are reviewing.
An argument for Shadow Build is that it will give a high-level picture of the overall correctness of a model, so even if small errors are lurking, you can still be confident that the overall output is materially correct.
One advantage of cell by cell over shadow build is that it does not rely on template models and can be used more flexibly across a wider variety of novel models.
Document Checks and Tax and Accounting
In addition to checking the arithmetic accuracy of the model, the model auditor is often asked to confirm that the model correctly reflects the terms of contractual documentation and that it correctly reflects tax and accounting legislation.
Do I need an audit?
If you are working on a major project finance deal, the likelihood is that your lenders will tell you that you do! If so, please get in touch!
Otherwise, it boils down to a judgement call based on the cost and time to get an audit done versus the risk to you or your company of a serious modelling error coming to light.
If you would like to discuss model audit in more detail, please contact our senior model audit team here.