Professional financial model auditing: The importance of ethical principles

According to Infralogic data, over $1 trillion in transactions for energy and infrastructure projects have been subject to model audits in the past decade. Of this, 75% by value were completed by accounting firms. This shows that, when it matters most, accounting firms are typically the preferred choice for model auditing. Indeed, for major transactions, there is often a requirement that the model auditor be “an accountancy firm of sufficient standing.”

But why is model auditing the domain of accounting firms? While several factors contribute to their prominence, many of which we will cover later in this series, the most important reason is their strict adherence to ethical principles, which form the foundation of trust and reliability in professional financial model auditing.

Ethical principles

Forvis Mazars is regulated by The Institute of Chartered Accountants in England and Wales (ICAEW). The ICAEW outlines fundamental ethical principles that guide us in delivering services with integrity, objectivity, and professionalism (Code of ethics | ICAEW). The principles can be summarised as follows:

1. Integrity: We must be straightforward and honest in all professional relationships. Integrity fosters trust, ensuring that clients and stakeholders can rely on our findings without doubt.

• Objectivity: We should not allow bias, conflicts of interest, or undue influence to override professional judgments.

• Professional Competence and Due Care: Maintaining professional knowledge and skill is essential. We must act diligently, applying technical and professional standards to provide high-quality services.

• Confidentiality: Respecting the confidentiality of information acquired during professional relationships is crucial. We must not disclose information without proper authority unless there is a legal or professional duty to do so.

• Professional Behaviour: We should comply with relevant laws and regulations, avoiding actions that discredit the profession.

Professional scepticism

Underpinning this ethical approach, the ICAEW highlights the importance of a mindset of “professional scepticism”. Professional scepticism is defined as an attitude that includes a questioning mind and being alert to conditions that may indicate a possible misstatement due to fraud or error.

Why ethics and professional scepticism matter in model audit

The application of ethical standards and a mindset of professional scepticism have far-reaching consequences. Two aspects key factors are particularly relevant in today’s model audit market:

1. Maintaining independence: Ethical standards require us to remain independent in both mind and appearance. Independence is crucial for providing unbiased assessments of financial models. If model auditors become too collaborative or involved in the model-building process, their objectivity may be compromised. Maintaining clear boundaries ensures that opinions remain impartial.
   
2. Ensuring reliability and trust: A range of stakeholders rely on model audit opinions to make informed decisions. By exercising professional scepticism, model auditors ensure that models are thoroughly reviewed, reducing the risk of errors or intentional misstatements.

The risks of over-collaboration

Some alternative approaches to model auditing offer close collaboration between the model auditor and the model builder. While collaboration can be beneficial in many contexts, in financial model auditing, it can lead to significant risks, including:

• Blurred lines of responsibility: Excessive collaboration can shift the responsibility for the model’s accuracy from the builder to the model auditor, undermining accountability.

• Compromised objectivity: When model auditors are involved in modifying the model, their ability to provide an independent assessment is diminished.

• Compromised data security: IT collaboration platforms need to be carefully managed. Performing “live” model audits in the cloud, across various unidentified locations, raises concerns about data security (which we will explore in more detail later in this series).

• Ethical dilemmas: Close collaboration with one party, such as the model builder or equity sponsor, might pressure model auditors to overlook certain issues or adjust findings to align with their preferences. This could conflict with the needs of other stakeholders, such as banks or government procurers, who may expect to rely on the model auditor’s independent opinion.

Best practices for professional model auditors

To ensure a professional approach to model auditing, the following best practices are recommended:

• Maintain clear boundaries: Define the roles and responsibilities of the model builder and the model auditor. The model audit team should assess and verify the model, not participate in building it.

• Adhere to a professional ethical code: Follow established ethical guidelines and standards set by professional bodies such as the ICAEW.

• Foster transparent communication: While maintaining independence, model auditors should communicate findings clearly and constructively, facilitating understanding without compromising objectivity. Communication should take place through agreed-upon, data-secure methods.

• Continuous training and awareness: Model auditors should engage in ongoing professional development to stay updated on ethical standards and techniques for exercising professional scepticism.

Takeaways

Upholding ethical standards through a mindset of professional scepticism is essential in financial model auditing. It ensures that model audits remain independent, thorough, and reliable. While collaboration has its place in business, the integrity of financial model audits depends on clear boundaries and a firm commitment to ethical principles. By prioritising these principles, model auditors not only enhance the quality of their work but also contribute to broader trust and stability in financial markets.

The next article in this series explains preferred approaches to model auditing and the importance of embedding these approaches within a wider quality management framework.