Financial model validation involves the review of financial models (complex spreadsheets) which forecast the financial risks and income opportunities that are likely to emerge over the lifetime of a business undertaking. Model validation is primarily applicable to large infrastructure projects, owing to their complexity, size and life span.
The financial forecast that spans on an average, a 20 to 30-year period, commencing at the construction stage to ongoing operations, attempts to demonstrate to financiers, investors and promoters that the project will generate adequate revenue and cash flows to meet long-term debt repayment obligations. To shareholders, it indicates whether the returns are worth the risk.
The essence of financial model validation
A model author (“Author”) typically prepares a financial model (“Model”) using a spreadsheet which includes financial projections of a large infrastructure project spread, typically, over a 20 to 30-year period. FAST Standard (www.fast-standard.org) and its provisions for model preparation are usually adopted by an Author to ensure that basic design rules of model preparation are adopted. A well- prepared Model is primarily driven by an assumptions sheet, where all inputs that are used in the Model are set out and from which all results are derived using set of formulae, macros and other spreadsheet tools. A good Model will feature minimal hard coded figures and will be flexible to sensitivities. All inputs flow from the assumptions sheet so that input errors in multiple sheets are minimised. Various data and result check points are inserted in the projections to ensure that results are cross-checked and validated.
In addition to technical inputs of a large project, a Model will also feature its commercial aspects, typically including pricing, financing terms and conditions, conditions precedent, forward and backward-looking ratios, profitability levels, production targets, milestone achievements, etc.
Given the fact that all the above must be incorporated in one single file involving many work sheets, a Model can be quite technical and complicated, generally requiring advanced knowledge of spreadsheets, macros and other tools.
Validating such a Model requires a diverse range of skills at multiple levels including awareness of financial reporting standards, local laws and regulations and commonly used legal terminology. A Model Auditor (“Auditor”) is expected to comment on the soundness, flexibility and reliability of the Model.
The Auditor is also required to comment on the adherence to international financial reporting standards and local laws and regulations. In addition, he/she must ensure that the detailed and, at times, overwhelming commercial terms and conditions put in place by bankers and financial institutions are faithfully, completely and accurately incorporated into the Model. Given the diverse skill sets required for validating a Model, it may be difficult for a single individual to be an expert in all of the required skills. Consequently, model validation is undertaken by at least three to four individuals who are professionals in spreadsheet operation, use and controls, legal and commercial experts in terms of financing and banking and finally on international reporting standards. All these individuals will need to work together as a team to issue an opinion on the integrity, quality and reliability of the Model.
PKF’s model validation service
PKF has been undertaking model validation assignments for banks, financial institutions and large corporate clients for many years in the UAE, for projects both in the UAE and in the wider GCC area and, consequently, have the necessary experience to meet the requirements of clients.
PKF can undertake Model validation assignments due to the skill sets available within the firm to deliver results professionally and in a timely manner.
Contact PKF UAE for your model validation requirements.
(This article is compiled by Hoshedar J. Cooper, Partner based in Dubai.)