1. What is financial model validation?
A financial model validation is a process of reviewing the accuracy and appropriateness of the financial projections (“Model(s)”) prepared based on certain assumptions, using a tool such as Microsoft Excel. The validation process raises questions on the data, the assumptions used, formulae, macros, and the parameters considered while building the Model. It is an iterative process to ensure that the Model meets its intended purpose.
2. Why is Model audit undertaken?
The increasing use of detailed and often complex Models by promoters or corporates seeking funds or by equity houses or lenders investing in a deal could result arithmetical inaccuracies, errors in employing assumptions or mistakes in inserting formulae in a worksheet. This could potentially lead to an erroneous Model, resulting in unreliable and inaccurate financial projections and output, which could jeopardize a potential transaction and/ or lead to erroneous decisions. Consequently, model validation is considered as an important value-added exercise and has received increased attention in recent years.
3. I am not convinced that I need to get my model audited, are there any real-life examples of model errors that resulted in financial loss for a company?
As Models are constructed by individuals using spreadsheet software such as Microsoft Excel, they are always susceptible to human error, such as keying in the wrong numbers, using the wrong formulae, linking the wrong cells, or copying the wrong amounts. Certainly, there are instances where companies suffered financial loss due to model errors.
Some of the examples include:
TransAlta lost $24 million as an employee misaligned the rows in an Excel spreadsheet (https://www.theglobeandmail.com/report-on-business/human-error-costs-transalta-24-million-on-contract-bids/article18285651/).
JP Morgan took a $6 billion trading loss due to Excel copy-and-paste error. (https://www.businessinsider.com/excel-partly-to-blame-for-trading-loss-2013-2)
4. Why should I engage a third-party to review the model?
Banks, financial institutions, and shareholders place significant reliance on Models to assist them with their decision-making. To ensure that the Model is accurate and that the results generated can be relied upon, Model review/ audit is advisable and often demanded. In many cases errors in the Model can be overlooked, difficult to detect and rectify as the Model author is too integrally involved to notice the errors in an unbiased fashion or from the view of a fresh set of eyes. Further, to make the process transparent and independent, the end-users prefer a third party who is completely independent of the Model author to undertake the Model audit
5. What does a typical model validation entail?
Model validation involves a cell-by-cell review of the Model, with a view to detect formulae errors, integrity of formulae, copy and paste mistakes, fed in figures, accurate linking of the assumptions data to the calculations and other such oversight. A Model validation exercise also examines the data, contradictions in assumptions used, accurate translation of financial agreements into numbers and adherence to agreed performance parameters whilst building the Model for the intended business use
6. Does conducting Model audit guarantee that the proposed deal/ transaction will be completed successfully?
No, Model audit would not express any opinion or conformation on the outcome of the transaction. The purpose of the Model audit is limited to providing assurance that the assumptions and calculation in the spreadsheet are consistent with the agreements/ contracts governing it and that there are no material errors, and the Model is flexible enough to cater to different sensitivities. This provides the end users confidence to rely on the Model’s results, and the affirmation a banker/ investor requires to sign-off a transaction.
7. What is the process involved in a typical Model audit/ validation assignment?
- In most cases, the stakeholder provides a detailed scope of work for the Model auditor. A typical process would be as follows:
- On receipt of a copy of the Model, to review it to understand the mathematical as well as the computational framework employed to process the assumptions.
- Depending on the mandate, either undertake a high-level review of the Model or detailed cell-by-cell review with a view to check for logical integrity, internal consistency, and arithmetical accuracy.
- Highlight any circularities, errors in formulae, cell reference redundancy, hard-coding within formulae, hard-coding within cells, external file links, hidden data or codes and any other errors or omissions.
- Review the supporting documents (such as term sheets, lease agreements, EPC contracts, etc,) provided to check if the stated assumptions and calculations in the Model are consistent with and agree with the supporting information contained in the relevant documents.
- Assessment of the accounting treatments and assumptions applied in the Model are consistent with the accounting standards relevant to the business.
- Review tax assumptions applied in the Model are in line with the applicable tax laws
- Highlight any unusual trend and/or obvious discrepancies/omissions in the assumptions and results.
- Review the resultant ratios including debt specific ratios such as debt service coverage and financial covenants (if applicable)
- Check if the Model calculates sensitivities appropriately
- Highlight findings and suggest corrective measures to the Model author.
- Once the Model author undertakes the changes, issue Model audit report
8. Will PKF validate/ confirm the assumptions used in the financial Model?
It is not in the Model auditor’s scope of work to comment or examine the appropriateness, completeness and accuracy of the stated assumptions used in the Model. However, we may highlight any obvious errors, deviation from trends and major shifts in assumptions over the stated period of the Model. As some of the infrastructure projects for which such Models are prepared are very technical and complex, we are not equipped to comment on the technical aspects of the business and hence restrict our scope to cover the mathematical, tax and accounting review of the Model.
9. Will PKF rectify the mistakes/ short falls in the Model?
As part of our scope, we do not correct or rectify any such errors, or ascertain the impact of the error or deviation on the Model as this would impact our independence. Only once all corrections are made by the Model author or an explanation is given will we issue a report.
10. What will the Model audit report state?
The report refers to work that we have undertaken, highlight points that we would like to draw attention to and any special emphasis matters. Attached to the report will be a copy of the final Model and the underlying assumptions, duly stamped and sealed for identification purposes. The report also includes supporting documents reviewed and the specific clauses that were relied upon in the Model. In cases, certain suggested changes have not been undertaken by the Model author, the report will state the same. The report includes an opinion and a duty of care addressed to the client.
11. Will PKF UAE personnel available to bankers/ financial institutions if they have any queries on the Model?
Indeed, it can. PKF UAE will attend meetings for the financial closure. However, the Model author is the person primarily responsible for the Model.
12. What is an indicative time frame for completing a Model audit?
This is dependent on many factors, such as complexity of the Model, number of years and duration (monthly/ quarterly/ yearly), project documents to be reviewed, number of sensitivities/ scenarios, macros, etc. An audit of a standard financial model which is simple can be completed in 2-3 weeks with a maximum of 2 iterations. However, the elapsed time is also dependent on the promptness of the Model author to respond to our observations and rectify the errors. After understanding the project and the activities required to be undertaken, we will provide an indication of actual time required in our proposal.
13. What is an indicative cost of conducting a Model audit?
It is difficult to provide a standard fee for a Model audit as it depends on the complexity and depth of the Model, which will thereby have an impact on the hours spent. Contact us and we will be pleased to submit a fair and considered proposal after understanding your precise requirements. However, as a ballpark estimate, fees can vary between AED 30,000 to AED 110,000.
14. Is PKF UAE able to provide references from clients for whom it may have conducted a Model audit?
References received from earlier clients can be viewed on our website. Nothing will please us more. We will share the contact details or two or more clients to ascertain the quality, timeliness, and the professionalism of our services.
