What is a Model Audit?

A model audit is a test run on a financial model to make sure it does not contain any mistakes in the way it is set up. The term model audit does not refer to an audit in its better known sense of an assessment of a company's accounts. Instead, it refers to the model used to forecast cashflow and other financial predictions.

A financial model is designed to map out the relationship between different financial factors over a future period. The aim is to make it easier to see how a change to one factor would affect other elements and outcomes of the process. This is usually done via computer spreadsheet software.

A simple example of a financial model is a household budget spreadsheet. This can show how, for example, an increase in rent would affect the household's finances. It would not just take into account the overall increase in expenditure, but also interest and bank penalty charges if that increase causes a serious cashflow problem.

Most financial models used in business and accounting work along similar lines, albeit with a much wider range of interconnected factors. The idea is to give decision makers a way of seeing the potential effects of making different choices. While the most common form of financial models involve some form of cashflow forecast, they can also be used for other types of calculation, such as calculating a fair price for an options contract.

A model audit is a process carried out to test that a financial model is set up accurately. A successful model audit will mean potential investors in a projects can be confident that the predictions made using the financial model are reliable. Such audits are particularly common in public-private partnership schemes.

There are two main things a model audit can look for, depending on the wishes of the people commissioning the audit. One is to simply examine the mathematical side of the model to make sure the calculations will be reliable. In practice, this often means examining every component of a spreadsheet to look for mistakes in setting it up that mean it won't produce accurate results. The second possible element of a model audit is to check the model takes account of the right factors. This can be a more subjective issue, as a financial model is effectively trying to cover an infinite range of possible factors.