Tuesday, February 17, 2015

Understanding the Audit Opinion: "He's a good guy"

One of the challenges of understanding the value proposition of an external audit is to understand the link, or more accurately the lack of a link, between the work done and the actual output to the client: the actual audit opinion.


Essentially, the audit firm is vouching for the financial story that the client is communicating on an annual basis. It is akin to vouching someone in social circles and saying that he or she is a "good guy or gal". 

The interesting thing is that amount "evidence" you have to present to backup your claim can change greatly depending on the context. Consider the following scenarios.  
  • He's good guy to hang out with: This is the lowest risk situation due to the low impact: if the guy is actually not good it's just one night wasted. Evidence required: pretty much your word. 
  • He's good guy to hire: Risk here is (your) reputation risk, if he actually is a bad employee then your reputation is tarnished. The risk on the employer is actually quite low - they can fire the guy if he's not good. Evidence required: Although ultimately it is still your word, as the employer will rely on you to know that your friend's resume is true from experience to protect your reputation. 
  • He's good guy to loan money to: now it gets interesting! Here your friend is going to impart cash to your friend based on your testimony.  Evidence required: you will likely need to explain how he's paid you back, has a job or rich parents that can pay for him if he doesn't do so. 
  • He's good guy to do business with: Here your friend is not only going to impart cash to your friend based on your testimony, but share their work life with him and rely on him to actually do things.  Evidence required: you will likely need to explain how he's reliable, hardworking, previous work experience, how much money he will invest in the business and need to prove these things somehow. 
  • He's good guy to live with:  It's debatable whether more assurance is required in this context or the previous context. The thing with business is that you are tied in for the long run whereas most leases only go a year :). Evidence required: You need to have lived with them and provide first hand evidence about how clean there, easy to get along with and overall considerate.
I realize that this analogy is not perfect: purpose that the financial statements are issued are for the same decision and the risks of material misstatement or audit failure are the key drivers of work. However, it illustrates that the output - an opinion on an issue - remains consistent but the amount of work can vary greatly. 

No comments: