How to scrutinise public spending
A research project will provide policy makers with guidance on how to maintain the quality of public audit at a time of radical reform and public spending cuts.
The importance of good quality financial reporting and high levels of assurance over it cannot be overstated. Robust academic research like this, to inform future development, is exactly what is required.
Last month, after three decades as the ‘protector of the public purse’, the publicly-funded Audit Commission was abolished following accusations of inefficiency and poor accountability to local people.
Eric Pickles, the Secretary of State for Communities and Local Government, described the Audit Commission having ‘lost its way’.
‘Rather than being a watchdog that champions taxpayers' interests, it has become the creature of the Whitehall state’, he said.
The move, which signals big changes in a crucial part of the process by which public spending is put under the microscope, has sparked controversy and considerable public debate.
Concerns around cost and quality of audit
Dr Margaret Greenwood, lecturer at our School of Management, describes the reforms as ‘radical’ with big questions being raised for the quality and cost of public audit.
‘The abolition of the Audit Commission could potentially weaken the audit function at the time when financial pressures are strong,’ she warns.
‘Independent research is important to find out whether such concerns are justified and in identifying areas where action may need to be taken.’
From now on, £200 billion of annual public expenditure will be audited completely by private audit firms under the regulation of the Financial Reporting Council, the body which sets the the standards for the accounting firms in the UK.
In the future, local authorities and certain health bodies will be able to appoint their own auditors and negotiate their own fees, contrary to the original principles which led to the establishment of the Audit Commission.
‘Robust academic research needed’
With over 10 years of experience in NHS governance and research expertise in public sector accounting, Margaret is ideally placed to investigate the impact of the reform on both fees and quality.
Her new research project looks at the effect of the reform. The findings will inform both practitioners and policy makers on how to maintain - or enhance - the quality of the audit process in the newly privatised landscape.
Peter Wyman, the former President of the Institute of Chartered Accountants in England & Wales, said he was delighted to see the research project launched.
‘The importance of good quality financial reporting and high levels of assurance over it cannot be overstated and yet much of its development in recent years has been driven by a combination of expert opinion and political prejudice’, he commented.
‘Robust academic research like this, to inform future development, is exactly what is required."
The importance of audit
The main function of public audit is to provide assurance that public money is being well spent and that public services are financially viable and can continue to operate.
‘In a time of austerity when the financial pressures are even greater, the function of audit becomes even more important’, Margaret says.
‘At the moment, trust in public services and big corporations seems to be wavering. In the private sector we’ve had some scandals where there have been questions about the role of auditors.’
The Communities and Local Government Secretary has recently launched an investigation into the alleged misuse of public money by mayor Lutfur Rahman.
This case, brought to the public domain following a BBC Panorama report, acts as a good reminder of just how important the function of public audit is.
‘Without a good quality audit, the risk of not identifying where public money is being misspent would be greatly increased’, Margaret says.
Independence of auditors potentially under pressure
One of the fundamental principles which led to the establishment of the Audit Commission was that local authorities shouldn’t be allowed to appoint their own auditors. This preserves the vital independence of auditors which is one of the most important factors in audit quality.
‘With the Audit Commission gone, additional care must be paid to maintain the independence of auditors’, Margaret says. ‘This was one of the key issues raised at the Select Committee review in 2012.’
One of the most well-known examples of questionable auditor independence is the case of Bernie Madoff.
The former NASDAQ Chairman was convicted of a large-scale fraud in 2009. The business records of Madoff’s company were audited by small accounting firm run by a close family friend with investments in Madoff’s funds.
Managing financial performance
One strand in Margaret’s research portfolio focuses on investigating the potential for savings from making improvements in pre-audit financial reporting quality.
Working with Monitor, Foundation Trust regulator for health services in England, she has previously investigated to what extent the reported financial performance was ‘managed’ in order to meet regulatory targets.
‘There are two main ways in which managers can manage reported financial performance. One is through spending decisions, some of which come as part of normal budgeting, while others can potentially undermine their strategic capacity such as neglecting maintenance and repairs or staff training,’ Margaret explains.
‘For example, £39 million of public money was recently transferred to Foundation Trust to assist them with issues related to backlog maintenance.’
Exercising managerial judgement
The other way is to use accounting adjustments in the preparation of the annual financial statements.
‘For example, you might have to make a provision for a legal case in the next financial year. In order to be prudent and to accurately reflect the financial position of the organisation an organisation may wish to incorporate some provision for that expenditure in the future. But of course the size of that provision is subject to managerial judgement.
‘It’s that exercise of judgement can differ. If you wanted to report lower profits, you might take a more conservative view. If you wanted to increase your performance, you’d might estimate a lower figure or wait for next year when the position may become clearer.’
This is where the role of audit comes in.
When managerial judgement is exercised, interpretations can vary. Legally, the financial statements of any organisation or public body have to show a ‘true and fair view’.
The accounts are then scrutinised by auditors and if they are not satisfied that a true and fair view is shown, the audit report is qualified, and the issue is thus brought to the attention of the public and major stakeholders.
Centre of expertise
Backed by an influential group of stakeholders, Margaret’s research aims to generate a number of recommendations which will inform how the new legislation around public audit will be implemented.
She also hopes her work will influence the monitoring bodies who give guidance to auditors and will feed through to accountants in the NHS and local government - which in combination deliver the vast majority of local public services and both of which are under considerable pressure in public spending terms.
In the context of current reforms, there is a lot of research ground to cover within public sector accounting. Margaret is hoping to use the new research project to kickstart cross-institutional collaborative research on the topic with fellow academics with similar interests.
Margaret’s research is a unique addition to the research portfolio of our School of Management which was ranked 8th in the UK in the independently-assessed Research Excellence Framework. 89% of their submitted case studies were deemed to have an outstanding or very considerable impact.