Written evidence submitted by Professor
David Heald[2]
THE IMPLICATIONS FOR PUBLIC AUDIT OF THE
ABOLITION OF THE AUDIT COMMISSION
INTRODUCTION
1. This memorandum is submitted in response to
the Communities and Local Government Committee's call for evidence
for its inquiry on "The audit and inspection of local authorities".
That call for evidence notes that:
— The
Committee will consider future arrangements in all the areas that
previously fell within the responsibility of the Audit Commission,
including:
— audit
of local authority expenditure;
— oversight
and inspection of local authority performance; and
— value
for money studies.[3]
I will consider each of these topics but also place
much emphasis upon the wider context of public audit in order
to provide a framework grounded on principle.
2. Whereas the Committee did not construct the
circumstances in which this inquiry is being held, that does not
diminish their relevance to its deliberations. The brutal manner
of the announcement of the abolition of the Audit Commission,[4]
made on 13 August 2010 during the summer recess and allegedly
without pre-informing the Audit Commission, creates suspicions
of score-settling and lobbying. There have been other recent instances
of the undermining of the authority and independence of public
bodies that have various measures of constitutionally necessary
independence from the core Executive: the Financial Services Authority;
the Food Standards Agency; the BBC; the National Institute for
Health and Clinical Excellence; and Ofcom. These convey messages
not "to step out of line", with damage to the ability
of such organisations to perform their public functions. Effective
public regulation is vitally important to the functioning of a
modern society but the instruments can be fragile and require
constant nurturing.
3. I have elsewhere analysed the specific features
of public audit, which inherently involves difficult relationships:
"Independence" is the cornerstone of auditing
wherever it takes place, but has specialised dimensions when the
audited organisation is in the public sector. The wide scope of
audit combined with ambiguities in the measurement of performance
mean that governance arrangements are substantively important.
In the private sector, the principal concern about independence
is that the external auditor, engaged in practice by the management
of the auditee, can report fearlessly to the shareholders who
collectively own that company. The public sector context is more
complex: independence is not only from the management of the entity
but also from government and other politicians who will pursue
private interests as well as advance the public interest (Heald,
2008b, p. 22).
With public expenditure under great pressure for
the rest of this decade, the need for well-grounded performance
evaluation and Value-For-Money (VFM) work will be greater than
ever.
4. The remit of private audit is much narrower,
the statutory and regulated segment of "audit and assurance
services" being restricted to published financial statements
giving a true and fair view in accordance with accepted accounting
practice and the audit itself having been undertaken in accordance
with recommended auditing practice. Performance measurement ("oversight
and inspection") and VFM studies are not audit matters in
the case of a private sector client. Over the past 25 years there
has been a remarkable expansion in what public audit has been
expected to achieve: this has added to the traditional differentiation
that public audit has long gone beyond the certification of financial
statements (the core content of private audit) to include "regularity"
(expenditure is in conformity with budgetary authorisation) and
"propriety" (there has been no fraudulent or inappropriate
use of "public money") (Heald and McLeod, 2002; Treasury,
2007).
5. Public audit should belong to Parliament because
of its crucial role in scrutinising the Executive (Heald, 2009),
yet it also needs protection from Parliament itself. The dual
existence of the National Audit Office (NAO) (Parliament's auditor)
and the Audit Commission stemmed from an era when central government
had more respect for the constitutionally separate authority and
legitimacy of local government. If there was to be a structural
change, such as the abolition of the Audit Commission, Parliament
and local government ought to have been centrally involved. In
August 2010, it was obvious that, by the time Parliament resumed
in the Autumn, the regulatory and operational capability of the
Audit Commission would be irretrievably damaged, and that all
Parliament could do would be play "catch-up".
6. There should have been the due process of
a Green or White Paper, and then legislation should have been
through the vehicle of a public audit bill, not through a general
bill (Public Bodies Bill) whose passage would be dominated
by issues affecting Executive bodies. To my knowledge, the only
public domain reference to a possible merger of the NAO and the
Audit Commission was made in the report commissioned from Mr John
Tiner by The Public Accounts Commission (TPAC) (2008, pp. 18-19).
This fell outside his terms of reference and did not promote any
public discussion, other than the rejection of the proposal for
each to have a Non-Executive Director on the other's Board.
7. During this Inquiry, the Committee should
resist the invitation to concentrate exclusively upon detailed
operational arrangements.[5]
Although extremely important, the kernel of present debates should
be the higher level issues to which this memorandum draws attention.
I will return to the general context in the final section of this
memorandum.
SUBSTANTIVE IMPLICATIONS
8. The Government's announcement about the Audit
Commission had three components. First, the abolition of the role
of the Audit Commission in appointing auditors and setting the
framework for local authority audit, including how that differs
from, and extends beyond, the financial certification audit undertaken
in the private sector. The transparency that has been created
by the Audit Commission's framework, beneficial to local authorities,
private sector audit suppliers and external stakeholders, is likely
to be lost. Some substitute will have to be devised and this is
likely to be a matter that the Committee may wish to explore,
in the absence of a specific-purpose arms-length body. This is
the regulatory function in relation to local authority audit and
of major significance for public audit as a whole. Given long-standing
trends to diminish the effective autonomy, particularly financial,
of English local authorities, and the insensitivities of central
government to constitutional relationships, my view is that Parliament
has stood aside for too long. The required involvement and influence
cannot be secured through after-the-decision inquiries; the Audit
Commission should never have been subject to abolition or reconfiguration
without advance Parliamentary involvement. The fact that this
has happened, and has been treated as a fait accompli,
is highly disturbing.
9. Second, there is the privatisation or dissolution
of the "District Audit" (ie audit supplier) function
of the Audit Commission, with all audits to be undertaken by private
sector firms. One of the stated advantages of a mixed model, as
also adopted by the NAO, is that having an in-house provider allows
for benchmarking against external providers and also provides
the operational knowledge base on which the performance of private
sector audit suppliers can be evaluated. This will now be lost,
giving more market power to the private sector firms and putting
great demands on contract specification and management, wherever
these functions are performed. This constitutes the substitution
of a private provider of audit services for the in-house public
provider. The Australian State of Victoria adopted this model
in 1998 in relation to the Victorian Auditor-General's Office,
a reform that was later reversed after an unusual amount of public
controversy (English, 2003).
10. Without the Audit Commission to devise a
Code of Audit Practice and operate a framework agreement under
which private sector auditors are commissioned, the market power
of those of the Big 4 (Ernst & Young have had little involvement
in public sector audit for many years) that wish to do public
sector audit will increase. For reputational reasons, clients
prefer a Big 4 firm as that reduces the chances of being criticised
for the choice of auditor, and provides valued blame deflection.
Some local authorities may not be able to find a credible auditor,
with reputational risks for local government as a whole. The Audit
Commission took responsibility for ensuring that councils lacking
capacity or with particular problems were handled with care.
11. The "liberation" of local authorities
to appoint their own auditors breaches Sharman principles (Sharman,
2001; Treasury, 2002), enunciated after important contributions
to the debate on (what became) the Government Resources and
Accounts Act 2000, made, inter alia, by Robert Sheldon
(then Chairman of TPAC) and David Davis MP (then Chairman of the
Public Accounts Committee). The focus was on (central government)
Executive Non-Departmental Public Bodies but the same principle
should apply across the public sector. This principle was breached
in the case of NHS Foundation Trusts by the Labour Government
which had accepted and implemented Sharman's specific recommendations.
Parliament did not react when the audit regulatory function for
NHS Foundation Trusts was allocated to Monitor and NHS Foundation
Trust Boards were made responsible for appointing their own auditors.[6]
12. The third component is the abolition of the
research, performance improvement and performance evaluation functions
of the Audit Commission, following the earlier announcement of
the abolition of the Comprehensive Area Assessment (CAA) and the
Use of Resources Assessment (UoR), which extended beyond local
government and covered the NHS. Because of their different remits
(eg there are many local authorities to compare but only one government
department in a functional area), the Audit Commission's CAA and
UoR can be seen as the counterpart to the 60 VFM studies carried
out annually by the NAO. If there is a dramatic reduction in the
amount of independent performance evaluation work undertaken for
local government and the NHS, it will not be long before pressures
build up for a curtailment of the VFM work of the NAO. If anyone
doubts the hostility of parts of central government towards the
NAO, they should read the vitriolic and ill-informed comments
on the NAO's Corporate Plan and Estimates which Treasury officials
have regularly sent to the Chairman of TPAC and which are in the
public domain. Such capability is easy to destroy but will at
a later date prove difficult and expensive to rebuild. Moreover,
it is needed in the present, when a long period of strong public
expenditure growth is followed by large real-terms expenditure
reductions.
13. The abolition of the Audit Commission, and
the claimed savings of £50 million,[7]
represent a retreat of public audit. The Audit Commission played
a valuable role in holding the ring and specifying the nature
of local authority audit (certification audit and performance
audit, including information on comparative local authority performance).
Although closely associated with central government, the Audit
Commission had a buffering effect and that increased the legitimacy
of audit regulation and performance measurement.
THE IMPLICATIONS
FOR PARLIAMENT
14. At a future date there may be a repetition
of the crises and scandals which led to the development of the
existing public audit framework. Immediately ahead, the dislocation
may put at risk the conversion of local authority accounting on
to an International Financial Reporting Standard basis from 2010-11.
This has the potential to create reputational damage. Organisations
that approach a scheduled abolition date are vulnerable to disintegration
and meltdown, especially if the nature of their activities is
such that these cannot be monitored in real time, but only with
a considerable lag.
15. Moreover, the issue of relocating the functions
of the Audit Commission is only part of a wider picture. My reasons
for opposing the new corporate governance structure of the NAO
are well-documented (Heald 2008b, 2009). Leaving aside my substantive
objections, the legislative journey[8]
of these proposals confirms that Parliament collectively has little
concern for, or understanding of, the importance of public audit
arrangements. As with Parliamentary expenses, this failure to
see the link between "governance" and "housekeeping"
is intensely damaging to the image and legitimacy of Parliament,
and also to its performance in its essential scrutiny role in
relation to public expenditure. Even when these links are seen,
there is too little willingness to voice these matters in public,
leading to a gulf between what is publicly stated and what is
privately known and discussed.
16. The implications for the NAO itself are potentially
dramatic. The Government's argument is that private sector auditors
are capable of doing public sector audit without the Audit Commission
as audit regulator with its own in-house audit capacity. If this
view is accepted, then there is no reason for the NAO to employ
its own auditors, as all central government audit could also be
commissioned and out-sourced. This means that an NAO role in relation
to the supervision of local authority audit is a poisoned chalice.
If the arrangements do not work, the NAO will be held responsible,
though its involvement has been reactive. If the NAO succeeds
in making the new arrangements work, then this can be taken as
an argument for closing down the NAO's own audit capacity. If
local authorities are "liberated" from performance audit,
one would expect central government to seek liberation from the
NAO's VFM audit, a development that would fundamentally affect
the work of the Public Accounts Committee. The temptation for
the NAO to take on additional tasks at the request of the government
of the day manifested itself when it unwisely became involved
in the validation of the assumptions underlying macroeconomic
forecasts (Heald and McLeod, 2002, para 505).
17. With the benefit of hindsight, the evaluation
of public audit fell between two stools: the Executive did not
do its job and neither did Parliament. This left scope for lots
of undercurrents,[9]
erupting into the abolition of the Audit Commission and leaving
Parliament unprepared. Despite being a statutory body, TPAC appears
not to have been fully functional in the vital period immediately
after the May 2010 election, and had no Chairman during the critical
decision period during the summer 2010 recess. There has been
a characteristically British blurring of responsibilities and
accountabilities, on the assumption that things would work out.
There is a remarkable contrast between the neglect of these essential
matters now and the Parliamentary activism which resulted in the
National Audit Act 1983.
18. I will conclude with a practical example
of how the architecture and governance of public audit had substantive
effects on the important topic of Private Finance Initiative (PFI)
accounting:
What is most striking is the variation in the On/Off
[balance sheet] proportions between departments. These differences
are heavily driven by the identity of the auditor (the National
Audit Office has been stricter about FRS 5A balance sheet treatment
than the appointed auditors of the Audit Commission) and the control
framework (local authorities and NHS bodies have known that on-balance
sheet PFI would not normally be approved). This situation persisted
because it suited the Government's policy of promoting the PFI
as a procurement route. This inconsistency was facilitated by
the scope for arbitrage between FRS 5A (published by the Accounting
Standards Board) and Treasury Technical Note 1 (Revised) (published
by the Treasury as an interpretation but which effectively became
treated as a competitor standard) (Treasury Taskforce 1999) (Heald,
2008a, Ev.66).
The NAO came under intense pressure to accept the
Treasury's position but the constitutional independence of the
Comptroller & Auditor General provided a protection for audit
judgements that the Audit Commission (a public corporation accountable
to a ministerial department) did not have. The majority of private
audit firms had no interest in disputing accounting treatment
with the Treasury, and indeed had extensive consultancy business
advising on how to circumvent FRS 5A.
REFERENCES
Audit Commission (2010) The Future of Local Audit:
Issues for Consideration, Issues Paper, September, London,
Audit Commission.
Department for Communities and Local Government (2010a),
Communities and Local Government's Public Bodies 2009,
London, Department for Communities and Local Government.
Department for Communities and Local Government (2010b),
Responses to FOI Request F0004041, for "all reviews
of the Audit Commission's performance", made on 21 August
2010 by Professor David Heald, mimeo.
English, L (2003). "Emasculating public accountability
in the name of competition: transformation of state audit in Victoria",
Critical Perspectives on Accounting, Vol. 14(1-2), pp.
51-76.
Heald, D A (2008a). "The implications of the
delayed switch to IFRS", in Treasury Committee, The 2008
Budget, Ninth Report of Session 2007-08, HC 430, London, Stationery
Office, pp. Ev 65-71.
Heald, D A (2008b). "A reform too far",
Public Finance, 21-27 November 2008, pp. 22-23.
Heald, D A (2009). "Reforming the governance
of the NAO", Public Money & Management, Vol. 29(2),
2009, pp. 83-85.
Heald, D A and A McLeod (2002), The Laws of Scotland:
Stair Memorial Encyclopaedia - Constitutional Law volume,
Edinburgh, LexisNexis Butterworths, 2002, paras 480-551.
The Public Accounts Commission (2008) Review of
the National Audit Office's Corporate Governance, (Tiner Report),
Fourteenth Report, HC 328 of Session 2007-08, London, Stationery
Office.
Sharman (Lord Sharman of Redlynch) (2001) Holding
to Account: The Review of Audit and Accountability for Central
Government, London, Stationery Office for HM Treasury.
Treasury (2002) Audit and Accountability in Central
Government: The Government's Response to Lord Sharman's Report
"Holding to Account", Cm 5456, London, Stationery
Office.
Treasury (2007) Managing Public Money, London,
Stationery Office.
January 2011
2 Declaration of interest: From 2002 to 2008
I was a (paid) specialist adviser to The Public Accounts Commission.
Since 2003 I have been an (unpaid) member of the Technical Advisory
Group to the Audit Commission. I hold a chair in Accountancy at
the University of Aberdeen Business School. I take sole responsibility
for the contents of this memorandum and the views expressed should
not be attributed to organisations with which I am or have been
connected. Back
3
Available at:
http://www.parliament.uk/business/committees/committees-a-z/commons-select/communities-and-local-government-committee/inquiries/audit--com/
(last accessed 06/01/2011). Back
4
BBC Radio 4's Today Programme (23 August 2010) broadcast
revealing interviews, indicating the breakdown of relationships
between Ministers and the Audit Commission. Back
5
The full range of operational questions to be addressed is set
out in Audit Commission (2010). Back
6
These decisions clearly had implications for the long-term viability
of the Audit Commission. Back
7
I am not aware of the basis for calculation, and that is a matter
which the Committee might wish to explore. However, I am doubtful
whether competition within the new structure will lead to major
reductions in audit fees for financial certification work. Indeed,
the opposite might occur for the reasons briefly mentioned above.
Significant reductions in "audit costs", now a loosely-used
term, would have to come from reductions on the VFM and performance
measurement component. These will be achieved in the short and
medium term, but with unknown future implications for service
delivery, performance and financial rectitude. Back
8
The clauses relating to the governance of the NAO were dropped
from the Constitutional Reform and Governance Bill at wash-up
in the last Parliament. They are now included in the Budget
Responsibility and National Audit Bill. The proposed corporate
structure has been implemented on a non-statutory basis. This
protracted legislative delay contrasts with what happens when
a government wishes to enact its priority legislation. Back
9
It has become clear that the Audit Commission had made some powerful
enemies, such was the relish with which allegations of inefficient
and burdensome practices were spun in the media after the abolition
announcement. Unaware of there having been a systematic evaluation
of the performance of the Audit Commission, I submitted a Freedom
of Information request for copies of all performance reviews.
On being advised that none existed, I requested an internal review
of that decision, on the grounds that (a) such appraisals were
formally required by the Cabinet Office, and (b) I had located
a reference to a review in a Department for Communities and Local
Government (2010a) publication. The response (Department for Communities
and Local Government, 2010b) provided not a copy of a performance
evaluation of the Audit Commission but a redacted 2002 letter
on the functioning of the Board of the Audit Commission and a
2009 report, also on Board effectiveness. This episode suggests
that, for all the formal apparatus for evaluating what public
bodies actually do, the substance might be different. An alternative
view would be that this further illustrates the neglect of the
governance of public audit. Back
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