Step two involves certifying that non-residual bond interest payments are correct. Bond interest payments can be tested in a spreadsheet by dividing them by their respective bond balances, converting them to annual coupon rates and comparing them against the coupon rate time series. Bond coupon rates should be verified as part of this process.

The third step is testing the accuracy of bond principal payments. If collateral cash flows are correct, the amounts of monthly bond principal payments are a function of each bond's principal balance and complex bond payment logic that parses collateral cash flows into bond principal payments and payments to the residual class. It is easiest to leave the validation of bond payment logic to last and first check that each bond's principal balance is correct. This method confirms that the amount of principal paid to each bond over its life does not exceed its principal balance.

At this point the monthly collateral cash flow, non-residual bond interest payments and the cumulative amounts of principal distributed to non-residual bonds have been verified. Step four requires checking that the residual cash flows projected equal the monthly collateral cash flow less the sum of non-residual bond interest and principal payments. If this is correct, the most likely source of residual cash flow forecasting errors that remains is the misallocation of principal amongst the various bond classes, or the misallocation of excess cash flow between principal payments to the non-residual class bonds and payments to the residual class.

Testing for these cash flow "allocation" errors requires an in depth understanding of the complex bond payment logic contained in the bond offering documents. In general, there is no substitute for a detailed understanding and testing of the bond payment logic and the conditional factors governing the amounts and timing of residual cash flows, such as the over collateralization requirements, delinquency and loss triggers. However, insight into the accuracy with which collateral cash flow is split between bond principal payments and payments to the residual class can be gained by (1) analyzing the sequence of principal payments projected for the non-residual classes of bonds, (2) verifying that over collateralization accumulates toward its targets correctly, and (3) analyzing the pattern of payments to the residual holder.

Summary
Testing the accuracy of residual cash flows is time consuming because residual cash flow projections result from the interaction of numerous variables representing collateral and bond indicative data, fair value assumptions and bond payment logic. An organized approach to validating residual cash flows can help eliminate the most likely sources of error and minimize the time required to do so. A testing approach that focuses on verifying residual cash flow by deduction is one example of such an approach.