Competing for public audits

What does the OFT’s announcement that the audit market should be investigated by the Competition Commission mean for the audit of public organisations? When Eric Pickles announced in August 2010 that the Audit Commission would be abolished he stated that public organisations should be free to choose their auditors. One possibility is that the Audit Commission's own audit arm (formerly known as District Audit) could be floated off in some form to compete with the existing audit firms. I believe that Pickles's department has hired some management consultants to advise on how that might happen.

The abolition of the Audit Commission is, in its way, a classic piece of Conservative market deregulation. My personal view is that, generally speaking, market regulations were imposed by governments for good reason and deregulation makes things worse for most people, whilst allowing a few to make a lot of money. There are too many cases of deregulation resulting in a bad deal for consumers (eg price rises) if not worse (Enron-type frauds and scandals). Once local authorities and NHS trusts are in a position to choose their own auditor I am sure that the larger ones—the county councils, London boroughs, metropolitan boroughs, major acute hospitals—will receive suits from the 'Big Four' as well as some of the smaller firms. The process will be a beauty parade. The codes of practice that set out what comprises the audit of a major organisations means all the firms will provide the same service so the client organisation will pick the one they fancy. In the first year or two they might also get a good discount on the fee.

What the practice of the FTSE 350 companies shows is that once an audit firm is hired they very rarely are replaced. I suspect that's because there's little incentive. All the firms do more or less the same thing and charge more or less the same fee so why would a client organisation spend the time and trouble to have a new beauty parade every five or seven years? And if a new firm were selected as a result there would then be an element of disruption as the new auditors found out all they needed to know about the client's business and accounting system and so on. It's rather like changing your bank. Even if you could get a cheaper deal from a different bank, it would have to be a very significant improvement on your current deal for it to be worth the trouble of moving all your direct debits and all the rest of it.

Whilst the larger public organisations can look forward to being enticed by the Big Four audit firms I doubt that the smaller district councils, the ones whose budgets are still £10–20million and so are substantial organisations in their own right, will. They might see much the same effect, though, from the small and medium-sized audit firms who would be happy to have a regular income from organisations that will pay their bills and never go bust.

If the Audit Commission's audit division is floated off as a stand-alone organisation (New District Audit, perhaps?)then I expect it would compete for all shapes and sizes of audit. Its unique selling point would be its specialism in public sector audits and I expect that it would win some of the business. Prior to the Audit Commission's creation, local councils could choose between being audited by the District Audit or by a 'professional auditor'. (Back then hospitals were not part of trusts and the whole of the NHS was audited by the Exchequer and Audit Department, which was renamed the National Audit Office in 1983).  When local government was reorganised in 1974 202 boroughs had moved over to the professional audit, while 119 use the District Audit (Coombs and Edwards, 2004: 82). (There were 21 others who used the antiquated system of electing local people as auditors, a practice which I don’t think the secretary of state, or anyone else, is proposing to reinstate.) So back then the private sector held about 2/3 of the local government audit market. During its tenure the Audit Commission has favoured its own auditors with about 70% of the market. Would a stand-alone ‘New District Audit’ be able to hang on to 70% of the market. I doubt it. At least, I doubt it in terms of fees. There are about a thousand principal councils and NHS bodies currently audited by the Audit Commission (and many thousands more parish councils). The New District Audit might be able to win 70% of them as clients but the professional firms will focus on the bigger, more valuable clients and I can well imagine that they might secure 70% of the fees. And once they are in they’ll be very difficult to replace.

Reference: Coombs and Edwards, (2004) The audit of municipal corporations—a quest for professional dominance. Managerial Auditing Journal, 19(1), 68-83.