Significant reforms in publicsector audit – staying relevantin times of change and challenge

Des PearsonSouth Melbourne, Australia

Abstract

Purpose – This paper aims to talk about the changes to auditing practice in the context of broaderchanges in the public sector.

Design/methodology/approach – A personal reflection on the issue using prior experiences as aformer auditor-general of two Australian states.

Findings – The role for government audit will always mirror the change in the public sector.Whether audit fulfils this role depends on having the right legislation and the right approach. Whileaudit legislation lags behind recent shifts in public sector approaches, government auditors arecontinuing to explore new ways to give parliament, as well as the sector, authoritative opinions andcommentary that is relevant and valuable.

Practical implications – Increased understanding of the changing role of the Auditor-General’sOffice that affects the efficiency and effectives of public sector entities will help practitioners inimproving strategic directions of their operations. This will also help academic researchers indeveloping ideas for future research.

Originality/value – Reflections presented here are based on the author’s practical experiences overthe past 40 years as a program manager and as a government auditor.

Keywords Government audit, Public sector audit, Audit practice

Paper type Viewpoint

1. IntroductionAlthough originally developed for an audience of accountants with diverse roles in awide variety of organisations, this paper reflects the views of an auditor on theprofession that has been my pleasure to serve in for more than half my career. For thoseof you who have, or are planning, a career in auditing, I hope this paper offers someuseful insight to the challenge facing us in the public sector. For those working inmanagement and consulting, perhaps my perspective will offer something fresh in yourunderstanding of your own work and in your relationship to your auditors. Forresearchers, I hope this will help generate some ideas for future research.

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1832-5912.htm

JEL classification – M42, M48This paper is based on the author’s Neil Walker memorial lecture at CPA Australia Congress,

Wednesday 17 October 2012. The author wishes to acknowledge the assistance ofJacquie Stepanoff and Lucy Horan in preparing the original version of the speech. The authoralso thanks CPA Australia for inviting him to give this memorial lecture which has a specialsignificance for him as a Past National President of CPA Australia, and also as someone who hadthe honour to have known Neil Walker, and having served alongside him on the then NationalCouncil that he worked so tirelessly for. As such, the author would like to pay his respects toNeil’s family and honouring his memory.

Received 17 June 2013Revised 24 July 2013Accepted 28 July 2013

Journal of Accounting &Organizational ChangeVol. 10 No. 1, 2014pp. 150-161q Emerald Group Publishing Limited1832-5912DOI 10.1108/JAOC-06-2013-0054

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Further, my focus is also, necessarily, on the public sector – I worked as a “publicservant” in a career spanning more than 40 years! I expect, however, that some of thesereflections will strike a chord also with those with private sector experience – it wouldbe surprising if some of the challenges and opportunities outlined in this paper werenot shared.

Now, caveats aside, I will begin with some background on my own role.

2. My role as an auditor-generalAuditing is essentially a process of “checking up” on persons entrusted with aresponsibility – and having an independent auditor is one of the best ways of gettingan objective, unbiased opinion on something (Gendron et al., 2000; ICAA, 2013; Taylorand Glazen, 1996; Moroney et al., 2014).

Parliament has long valued the role that auditors can play in “checking up” ongovernment. The Westminster system of government establishes an independentauditor-general, who checks up on the activities of the executive arm of governmentand reports the results directly to parliament (McGee, 2002; Jacobs and Jones, 2009;Sinclair, 1995).

With the size and complexity of today’s public sector, this is no small task.Modern public sector audit practices are complex, sizeable operations, run via amixture of skilled staff and contactors, providing assurance on hundredsof millions of dollars of transactions and billions of dollars of assets (Moroney et al.,2014).

In Victoria, the Auditor-General’s Office (VAGO) produces annual audit opinions onthe financial statements of over 560 government entities. An opinion is also expressedon the non-financial performance statements of around 170 of these entities across thelocal government, water and TAFE sections. Each year around 30 performance auditsare also conducted, delving more deeply into specific government agencies, programsand activities.

This picture, however, has not always looked the same – the practices, approach,mandate and legislation of the auditor-general have changed across the 160-yearhistory of the position.

In recent decades there have been significant reforms to public sector accountingand administration (Guthrie and Parker, 1998; Hood, 1995; Hughes, 1992; Lapsley,2008). Mirroring this, public sector auditing itself has changed, to stay relevant andsustain the provision of assurance to parliament.

We have seen several phases of change, and I have no doubt more changes willcome, in parallel with the public sector itself.

In this paper, I will look backwards – and then forwards – at these changes withinthe public sector and within audit practice, and consider how auditors remain relevantin changing times. First, I will canvas how audit practice in Victoria has changed inresponse to some significant public sector reforms of recent years. Then, I will identifysome current trends in public sector management and governance that pose realchallenges for the audit practice and that our profession must grapple with, in order toremain relevant.

Although the last 50 years have seen many changes to the way the public sectoroperates, in this paper I draw attention to two developments with particular impact onauditing practice in Australia.

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One of the most significant reforms to public sector accountability andadministration has been the transition to accrual accounting (Funnell and Cooper,1998; Guthrie and Parker, 1998). It has been almost 20 years since the public sectoradopted accrual accounting. Much has been said about this shift at various professionaland academic events, and I will not labour the point, but I do want to start byacknowledging the enormity of the shift, the transformations it wrought in auditors’role, and the challenges perhaps that still lie ahead in our professional response.

Many of us in the public sector may recall the days of cash budgeting andaccounting in the government sector:

. Full costs of programs and activities were not recorded.

. Timing of transactions and inconsistent treatments provided misleading results,and were easily manipulated.

. There was no over arching, systematic record of the government’s non-cashassets and non-borrowing liabilities, such as superannuation.

The introduction of accrual accounting required a much broader range of financialinformation to be considered when preparing financial reports, and offered afuture-focussed resource for decision makers and financial managers.

To paraphrase one of my colleagues, the Australian Auditor-General Ian McPheeput it this way when he spoke at a CPA Australia event in 2006:

By analysing prospective transactions, accountants in public sector agencies are now able tocontribute to a more informed understanding of the transactions. This may includeunderstanding the level of risk being taken by the government, or the future economic benefitsthat will flow as a result. In this light, accrual budgeting and accounting isn’t just aboutrecording the debits and credits – it is a discipline which aids public sector management tobetter understand and govern their programme and organisation (McPhee, 2006).

It is not surprising, then, that the adoption of accrual accounting led to a significantrise in both the complexity and the significance of financial reporting. These financialreports were complex to prepare, as they had to take into account future contingenciesand liabilities.

As public sector decision makers (and external stakeholders) began to understandthe insight on performance and risk that accrual-based financial reports could offerthem, the pressure to deliver high quality and timely reports began to increase and thesignificance placed by management and stakeholder on these reports grew.

So how did our audit practice change in response to these profound changes inpublic sector accounting and financial management?

First, as the financial reports became more important to management, so too did therole of the auditor, in offering assurance that the financial reports were reliable. This wasa long way from the early days of cash accounting, when the Victorian Auditor-Generalprovided assurance by year-round audits of public sector transactions.

Second, audits became more complex, with a large amount of information to beconsidered when preparing an opinion on the reliability of the reports. Suddenly, theaudit task had doubled.

Responding to this rising complexity, new auditing standards were introduced toenable a more risk-based approach whilst also safe-guarding the quality of the auditopinion. New auditing standards required auditors to go through specific steps,

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tests and procedures, to collect and analyse sufficient evidence for the amounts anddisclosures in the financial report. Based on this evidence, the auditor could thenexpress an opinion with confidence.

Whilst this shift occurred right across the audit profession, there were specialimplications for the Victorian Auditor-General. In delivering this new, risk-based approachto financial audit, the Auditors-General across the 1980s utilised a provision introduced tothe Audit Act in 1958 that allowed them to determine the “extent of check”: this legislationallowed the Victorian Auditor-General to use the risk-based approach to audit that wasenabled by accrual accounting, and is still the basis of our audit approach today.

Unexpectedly, however, the “extent of check” provision of the Audit Act was alsothe basis of another significant change to public sector audit practice, one which arosein response to the sweeping changes of the “new public management” era of the 1990s(Barrett, 1996; English, 2003).

I can see through a quick search of the internet that public sector accountingconferences have often featured mention of the radical reforms to public sectormanagement that took place in Australia and other developed countries across the1980s, 1990s and 2000s. The transition to accrual accounting that occurred at the sametime was a part of this much wider movement to improve the efficiency, effectivenessand accountability of the public sector (Funnell and Cooper, 1998).

Often termed “new public management” (Hood, 1995), this paradigm shift included:. The introduction of purchaser-provider relationships between central agencies

and portfolio entities, or even within business units, to create “competitiveefficiencies”.

. Explicit focus on outputs and outcomes through the introduction of output-basedbudgeting for departments and portfolio bodies.

. A new focus on the “client” and customer service in public service delivery(Barrett, 2004; Hoque and Adams, 2011).

The purchaser-provider model of new public management meant that there was now asignificant separation between the people entrusted to govern, and those entrusted toimplement government activities (Fischbacher and Francis, 1998; Moll and Hoque,2008). Under new public management, performance measurement was seen as the wayto bridge this gap (Hoque, 2008; Hoque and Adams, 2011).

Further, the growing emphasis on the “customer” was paralleled by a communitywith increasingly high expectations of their government – high expectation ofperformance, and high expectations of transparency. Financial reports – even accrualreports – were no longer enough to meet the public and parliament’s appetite forinformation on the performance of their government.

Springing up to meet this appetite for transparency and performance measurementhave been a number of public sector performance reporting and measurementmechanisms, including budget outcome reporting, annual reports, freedom ofinformation, and an increasing number of reviews and reports.

It is the rise of performance auditing (Barzelay, 1996; Dittenhofer, 2001), however,that is most significant for many commentators and academics, and is most relevant tothis paper.

I mentioned earlier the provision in the previous Audit Act for the auditor-general toset his or her own “extent of check”. In the 1980s, a forward-thinking auditor-general

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began to do what we now see as early performance audits, undertaking special auditsfocused on particular issues and risks within public sector financial activity.

Eventually this led to the introduction in 1990 of amendments to the Audit Act –followed in 1994 by an entire new Audit Act, one that now explicitly gave theauditor-general the mandate to audit the “efficiency, effectiveness and economy” ofpublic sector activities.

Now for the first time, parliaments could ask their auditor to tell them not just“how much?” but “how well?” How well was government doing its job? How well wasmoney spent? How well was the public interest protected in major investments and indealings with the private sector?

This was an important evolution of the role of parliament’s auditor, and it kept theauditor-general’s mandate up to date with the changing public sector and therequirements of the parliament for independent assurance. Output-based managementnow had some degree of independent scrutiny, as performance audits could delve intoand answer questions on the extent to which agencies were achieving their objectives,and how well they were doing this.

So, to summarise this “look backwards”.The adoption of accrual accounting and the suite of reforms under new public

management gave rise to the kinds of modern audit reports that parliament now uses – thedistillation of targeted audits of systemic issues for the efficiency, effectiveness andeconomy of public sector activities, and the provision of risk-based financial audit opinionson the reliability and accuracy of agencies’ comprehensive, accrual-based financial reports.

This brief reflection on the joint history of public sector and audit reform brings usto today and, perhaps, to tomorrow.

3. Significant current trends and change in public sector auditI will now address three significant current trends that are changing the way that thepublic sector operates just as accrual accounting and output-based management did inthe past 20 years.

These trends have their own risks and challenges for audit practice, which theauditor-general should be monitoring and can help address. In order to do this, however,the auditor-general’s mandate must continue to keep pace with these trends. I will nowset out how I think audit is going to need to change to remain relevant and continue tofulfil the role of providing assurance to parliament.

3.1 Arm’s length service deliveryThe first trend is arm’s length service delivery. Increasingly, the public sector isturning to private sector service delivery to improve efficiency and get better resultsfor its investment. This decentralisation of service delivery arrived in the new publicmanagement reforms of the 1980s and 1990s. In Victoria, and I imagine acrossAustralia and probably most of the Western world, we have seen more and moreservices to the public delivered through:

. straightforward fee-for-service contracting;

. commercial partnerships with the private sector, through alliances and PPPs;

. service delivery through the community sector, through grants and contracts; and

. public entities created at “arms-length” to government, with a high degree ofautonomy.

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If done well, this can mean financial savings, more innovative approaches, and betterquality services.

This trend, however, has placed significant government activity – and public funds –outside the scope of the auditor-general. The Victorian Audit Act defines the ability toaudit based on the legal status of the entity, rather than the source of funds provided.This provides a serious obstacle on how far VAGO can go in auditing the use of publicfunds.

Although the Act makes some provision for audit access to the activities ofnot-for-profit entities receiving public funds as grants and benefits, currently, there isvery limited audit access to information held by private sector or community partiesperforming public services on behalf of government, such as:

. prison management;

. public transport;

. developing and maintaining major public infrastructure – both physical andtechnological;

. providing health advice and health care; and

. community housing.

Often, even this limited access is dependent on provisions in the contracts that thegovernment designs. These provisions are not compulsory, too narrow, and are rarelyenforceable by VAGO, because the auditor-general is not a party to the agreements.For this reason, and now for some years, amendments to the Act have been sought toenable VAGO to “follow the dollar”.

At a minimum, I believe that any Auditor-General’s Office should have the ability toundertake financial and performance audits of any matter relating to “public money”(money given by the state to another person/body). This should include grants andcommercial contracts for services with all types of entities, both not-for-profits andfor-profits.

The provision should not be based on the type or legal structure of an entity thatmay or may not be audited as this restricts the auditor-general’s power. This should bematched by broad access powers for the auditor-general, including the ability to accesspremises, backed up by coercive powers to compel a person to provide evidence.Accountability standards should not differ because of the means of delivery.

3.2 Shared and networked delivery of servicesThe second trend that I will focus on is the trend towards shared and networkeddelivery of services, including “joined up” government. “Joined up government” hasbeen described by the Victorian State Services Authority (2007) as “Workingcollaboratively across departments, portfolios or levels of government to addresscomplex issues which cross-individual agency boundaries”.

Traditionally, government departments have been responsible for sector portfoliosand the delivery of programs and services tied to those portfolios. This facilitatesstrong accountability in traditional delivery models and is particularly effective forclearly defined policy issues.

Sometimes, however, policy issues are complex and interrelated and cannot beaddressed through the services and programs of a single department. Increasingly,

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governments are responding to these complex issues by turning to joined up approaches,where government agencies coordinate to address complex, high-priority issues.

Aged care, hospitals, flood and bushfire recovery, transport infrastructure,community services, education and disability services, are all delivered jointly,through new kinds of interlinking legislation operating across and betweenjurisdictions, and through formal agreements between the commonwealth and the state.

Following this new kind of joined up delivery has been a heightened public appetitefor joined up accountability.

To date, public sector audit has stopped “at state lines” – legislation has preventedstate and national audit offices from reaching across boundaries to “follow the money”and review activity funded by one jurisdiction and being delivered in another jurisdiction.

It is evident, however, this is no longer good enough: media, community andparliamentarians have increasingly called for more seamless end-to-end accountabilityto track the funds flowing from the commonwealth to the states. These newexpectations are also triggering some significant shifts in accountability and auditarrangements.

In 2011, the Australian Auditor-General was provided with legislative powers toundertake audits of states and territories that have received federal funding – skippingover the boundary to follow the money into the states. This has created a new and morecomplex landscape for the audit mandate in Victoria.

Meanwhile, the VAGO has begun to see commonwealth/state funding agreementswith innovative new “joined up accountability” features, requiring state programs tobe subject to audit by both state and commonwealth audit offices.

These agreements require a “coordinated audit approach” between the VAGO andAustralian National Audit Office. One Agreement required that both audit officescollaborate on an agreed audit plan, carried out between them, with information sharedbetween offices.

At this stage, however, it is unlikely that VAGO can actually fulfil the roleenvisaged in these new agreements. The Victorian Audit Act specifies strict secrecyprovisions which strictly limit the ability to share audit information, even with otherAuditors-General. Without amendment to the legislation, it is doubtful the informationnecessary to truly undertake coordinated audits can be shared, regardless of theprovisions in these new agreements.

Indeed, VAGO is currently (2012) trying to resolve a real-life example of this: thelegislation of a newly created commonwealth-state health body suggests the potentialfor a combined audit from all states and the commonwealth. It looks likely that theVictorian secrecy provisions mean that VAGO cannot comply, and that audit officesand the new body will need to find another solution.

So [. . .] while there is a national movement towards joined up service delivery, andtowards joined up accountability, the limitations to Victoria’s audit mandate hold backthe state from full participation in the new arrangements. Again, this is somethinghoped to be addressed in amendments to the Act.

3.3 Increasing pressure on the decision-making of the public sectorThe third trend is the increasing pressure on the decision-making of the public sector.A number of recent events have meant that decisions are harder and leaders have totake greater personal accountability for informing themselves.

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The first of these events is the global economic downturn. Although the Victorianeconomy has been reasonably resilient, Victorian Government revenue will be underpressure for at least the next two to five years. Constraints on the government’stwo main forms of income – commonwealth grants and income from taxes andcharges – mean that government is going to have to either: watch its financial positiondeteriorate, raise taxes, or reduce its expenditure. We are seeing the last one in action,though ultimately we may see a mix, depending on unfolding developments.

Managers across the public sector are having to do the same with less, or even morewith less – cutting programs and activities. The pressure is on to make appropriatechoices on what stays and what goes.

Concurrently, there is a trend both local and global towards greater pressure onleadership in fulfilling governance and legal responsibilities. A recent federal court caseconcerning the near collapse of the Centro group found that directors had failed to takeall reasonable steps required of them when signing off financial statements containinginaccurate treatment of around $3.3 billion. The judge’s final statement emphasised that,in fulfilling their legal obligations, all directors must carefully read and understandfinancial statements before they form the opinions which are to be expressed in therequired declaration, including whether the financial statements were consistent withtheir knowledge of the company’s financial position. While the case dealt withCorporations Act duties, the principles are applicable in the public sector where directorsmust comply with values including integrity, accountability and leadership.

It is pleasing to hear from VAGO’s financial auditors that, following this case, theyhave seen a marked positive shift in diligence by audit committees.

So decision-makers and accountable officers are facing challenges in how to maketheir decisions, and how best to inform themselves about these decisions.

3.4 The role of auditorsThere is a role for auditors here, as skilled advisors who can give decision-makersvaluable information.

But how well are we fulfilling this role? There is recent work by the InternationalAuditing and Assurance Standards Board in relation to user perceptions of the standardauditor’s report. In 2006, the Board commissioned research into these user perceptionsand identified a number of issues with the current format of the auditor’s report on thefinancial statements of an entity. An “expectation gap” exists between what users expectfrom an auditor and their audit report, and what is actually available to them.

This gap means users do not find the information they want from an audit report toassist them in making informed investment and fiduciary decisions. So there was aneed to address this gap and improve users’ ability to make more informed decisionson the basis of financial statements and audits.

In response, the Board has proposed changes, most notably the addition of “AuditorCommentary” to the auditor’s report, to highlight matters that could be important tousers’ understanding of the financial statements or the audit (International Auditingand Assurance Standards Board, 2012).

From my perspective, the types of matters that an Auditor’s commentary couldinclude are:

. areas of significant management judgment – for example in relation to anentity’s accounting practices;

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. significant or unusual transactions; and

. matters of audit significance, such as difficult or contentious matters notedduring the audit.

At this stage, the changes are still being debated and we are yet to see what theultimate result will be. But it does show the importance of auditors staying relevant,and it does reinforce the needs of our clients and stakeholders for objective advice,delivered in an accessible way.

In fact [. . .] I challenge all professionals not to wait and let the standard-setters leadour professional response to this development, but to take the lead ourselves.

I believe we need take seriously the challenge to make our audit advice accessible,and to give value to our clients by better leveraging the rich information we haveaccess to throughout the audit process, without compromising our objectivity orindependence.

In this vein, VAGO has recently made changes to the approach to parliamentaryreporting to better connect with management and bring issues of significance to lightin a way that users can understand.

Recent audit reports on the annual financial report (AFR) of the state now includecommentary on significant projects and developments which are not required to beincluded in the state’s AFR, despite high public interest.

For example, whilst financial statements of agencies and the AFR are prepared inaccordance with accounting standards, these standards do not require all costsassociated with a project to be drawn together. Therefore, for PPPs, the total cost to thestate is generally more than the contract cost disclosed by the portfolio agencies and inthe AFR. This had come to light from our audits such as that of the Desalination Plantand the Peninsula Link. In the report to parliament on the 2010-2011 AFR, the totalcosts of those projects was compiled and reported, to the appreciation of our parliamentand many other report users (VAGO, 2011a).

VAGO also made changes to the way the results of annual financial audits by sectorwere reported to parliament. In 2006-2007, a traffic light system was introduced toillustrate the financial sustainability risk of local councils. This made audit work moreaccessible to readers and thereby emphasised the responsibility of local councils tomanage their financial sustainability risk.

Since introduction of the traffic light system, there has been an overall improvementin the financial sustainability risk of local councils, with the number of councilsreceiving a “low risk” rating increasing from 73 to 93 per cent (VAGO, 2011b).

Finally, new ways to communicate audit findings, and means of continuing to providevalue from audit insights long after the report has been tabled have been explored.

Four years ago, the disparate findings from the around 600 financial and performanceaudits VAGO undertakes each year were drawn together so they could be shared as aquick “hit list” of key operational risks and common management and governanceweaknesses. These high level “key audit themes” have been an unexpected success –audit and risk committees, leadership teams, professional bodies and central agencieshave used these common findings to inform their organisations’ risk, internal audit andbusiness improvement planning.

Nonetheless, all these new products, approaches and strategies can be futile if theauditor does not have effective relationships with audited agencies. The potential for

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the auditor to be a skilled advisor, to share key information with decision-makersbased on the audit process and findings, hangs on the ability to work togetherprofessionally and effectively.

The overriding obligation to report independently, “without fear, favour oraffection” to the parliament, however, must continue to be the pre-eminentconsideration.

I am very proud of the work VAGO has done in improving relationships withauditees. There has been a significant drop in delays and obstructions during and at the“11th hour” of the audit process. VAGO, the parliament and taxpayer are now reaping thebenefits and this has been achieved without compromising independence or integrity.

4. ConclusionSo, a wide ground has been traversed:

. First the changes to the public sector in the last few decades and how auditpractices have shifted in response to remain relevant as the world around uschanged have been canvassed.

. In particular the rising role of auditors has been detailed, as the public expectsmore of their government and public sector activity becomes more complex.

. Three current trends have been signalled and the challenges they bring for futureaudit practice have been identified, emphasizing where Victorian legislationneeds to change to allow audit to keep pace with the changing world of moderngovernment.

As a closing comment:. The role for audit will always mirror the public sector. Whether audit fulfils this

role depends on having the right legislation and the right approach.. While audit legislation lags behind recent shifts in public sector approaches,

auditors are continuing to explore new ways to give parliament, as well as thesector, advice that is relevant and valuable.

. I conclude with the challenge for individual professionals and organisations toactively look for ways to innovate in response to these trends and pressures and findnew ways to stay relevant and authoritative in these changing times. Academicresearch can explore my ideas further in real-life settings across the globe.

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About the authorDes Pearson recently retired as Auditor General of Victoria and now operates as a Consultantand Advisor. In his more than 40 years public service, he worked across five jurisdictionsincluding over 30 years at senior and chief executive levels. He has primarily worked ingovernance, financial and performance reporting and accountability roles, including more than21 years as an Auditor General. His earlier experience included financial management, programmanagement, corporate support and regulatory roles. He has served as National President ofCPA Australia and is a National Fellow of the Institute of Public Administration Australia.Des Pearson can be contacted at: despearson@bigpond.com

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