Financial modelling is a vital tool for key business decisions and is used to project the actual or estimated performance of a company, project, business, or any other financial investment. Financial models, typically prepared using MS Excel or equivalent, are based on assumptions regarding future events that drive earnings, expenses, profitability and the resultant balance sheet, cash flow and other parameters, both financial and otherwise. With increasing complexities and scenarios being applied to make the financial models more robust, flexible and adaptive, errors creeping into a model has become a major concern. According to a study by Ray Panko, a leading authority on spreadsheet practices, around 90% of spreadsheets contain formulae and logical errors. These errors can be difficult to detect and rectify and in many cases the model authors are too closely involved to notice the errors in an unbiased fashion or from a fresh perspective. Errors in a financial model can cost a business dear, as was the case in the following illustrative examples.

  • In 2003, TransAlta lost USD24 million due to MS-Excel copy-and-paste error
  • In 2005, Kodak suffered USD11 million severance error due to MS-Excel typo
  • In 2008, Barclays Capital spent millions on worthless contracts due to MS-Excel reformatting errors

Detailed and often complicated financial models are prone to arithmetical inaccuracies, errors in translating assumptions or mistakes in inserting formulae in a worksheet, which could potentially lead to inaccurate, or worse, wrong financial projections and expected results, jeopardizing a potential transaction. Thus, validating a model has become a prerequisite for many businesses.

Independent model validation is be an important value-add activity to overcome these challenges and help the reader of the model with a reliable, tested and accurate financial model. Model validation follows a defined and iterative process that validates and verifies the usability and adaptability of the financial model for the intended business purpose. Model validation involves a detailed review of the accuracy of financial data, as well as logical flow and integrity of the formulas used in the model. A validation exercise raises questions on the data, contradictions in assumptions used, accurate translation of financial agreements into numbers and adherence to agreed performance parameters whilst building the financial model for the intended business use. It also includes a cell-by-cell review to ensure that there are no formulae, arithmetical and clerical errors.

Critical review of a financial model requires a varying range of skills in addition to advanced MS Excel skills, such as knowledge of International Financial Reporting Standards (IFRS), local laws and regulations, understanding the terms and conditions of financing, ability to interpret agreements and their implication on the model. Model auditor(s) (it is often difficult to find all the requisite skills in one person and more than one person may be engaged in a model audit) is expected to comment on the soundness, flexibility and reliability of the model in addition to adherence to IFRS and local laws and regulations.

Model audit also involves a review of the best practices in financial modelling such as – inputs shown in a separate sheet, colour coding of inputs and formula cells, presence of a model guide with a brief explanation of how the model works, to name a few.

Model validation is typically requested by banks/ financial institutions, project promoters, corporates seeking funds, equity houses, etc.  to reassure the end-user that the calculations and assumptions within the model are correct and that the results produced by the model can be relied upon. To ensure transparency and independency, lenders/ banks prefer a third party who is completely independent of the model author and the borrower.

PKF UAE has a team of highly experienced professionals with many years of expertise, offering a wide range of advisory services across sectors. PKF has assisted clients by undertaking detailed model validations on various transactions across sectors such as real estate/ infrastructure, higher education, contracting, manufacturing, power plant, mining and sewerage amongst others. We would be happy to discuss any of your requirements. Please feel free to get in touch with us on difc@pkfuae.com or at www.pkfuae.com.