The Financial Model Audit

What is the Financial Model Audit?

Why is auditing of financial models so important, and who does it?  There are in fact world-renowned model auditors who will audit everything in your financial model, from the technical assumptions to the accounting methodologies and formula logic.  They will even ensure that scenarios in the model are run correctly!  Why is this so important?

Model Building is an Art, Not a Science

Every financial model, especially those that provide forecasts, are incorrect.  I often say this at work, to the bemusement and shock of my colleagues.  The fact is though if my models were correct, I shouldn’t be building financial models, but instead be trading, gambling or playing the lottery!  A forecast is merely a view on the future if our current assumptions all hold out to be 100% true.  I personally don’t see how this is possible, especially when dealing with modelling companies or wind farms.  That said, it is important that our models are logically correct and also accurately apply the assumptions we are using.

Famous Model Errors

There are more than a few famous Excel errors, but two that stand out in recent history include the following.

During the London 2012 Olympics, an Excel error led to one event being oversold.  Visitors who purchased tickets to a synchronised swimming event actually ended up getting upgraded tickets, with some even attending the 100m final, one of the hottest events at the Olympics.  You can read more about the error here.

Known as the ‘Excel Error Hear Around the World’, Rogoff and Reinhart’s paper overstated economic growth and for high-debt countries due to a very basic Excel error that could have been easily avoided.  More about that famous error here.

A Model Audit isn’t just about Model Logic

So, before financial close on a deal, we send our financial models to be audited.  The auditors tell us lots of things about our models, namely:

  1. Are there any formula or logic errors?
  2. Are the assumptions being used correctly?
  3. Is the accounting in line with accounting standards?
  4. Does the legal and technical documentation and the financial model tie up?
  5. Sometimes specific elements such as tax are audits as well.

This is exceptionally important for a financial model who has spent weeks or months on end developing a financial model.  You get so deep into the details that it is often difficult to spot your own errors.  Indeed, sometimes errors are exceptionally difficult to identify, requiring model audit software to reveal them.

How do we go about auditing financial models?

There are a number of model auditors out there, but for the beginner modeller who wants to identify issues on their own, there are a number of model auditing software packages available as well.  I would recommend you experiment with these software packages to assess where your likely mistakes are.  Model audits make us better modellers and make our financial models more robust.

As always, good luck and happy modelling!

Matthew

Matthew Financial Modeller
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