A warning for public sector mutuals
The Government’s programme for mutualising public services is at its first important crossroads. While ministers remain enthusiastic, staff seem unimpressed. The initial scheme of mutualisation – though staff will only partly own the resulting ‘mutual’ – is MyCivilServicePension. Employees are planning strike action to resist the proposal.
Now we have a report from the National Audit Office casting doubt on the value for money of the first ‘right to request’ mutualisation arrangements and suggesting that public sector managers have not entered into contracts with the staff mutuals on a sufficiently hard-headed basis. One of the points made is that while it is assumed that mutuality will deliver efficiency improvements through greater staff commitment, no such financial or productivity gain requirements are built into the contracts.
The first application of the principle of staff ‘spin-outs’ has been in NHS social enterprises, where £900m of contracts have been awarded to groups of employees to run their own services. So far only 20 health social enterprises are operational through the staff spin-outs, so, says the NAO, it is too early, with too few case studies, to say definitively whether they represent good value for money and whether they have achieved efficiency improvements. But, it adds, there ought to be clearer and contracted expectations on the social enterprises.
Amyas Morse, head of the National Audit Office, concludes: “The Department [of Health] needs to reassess its approach, when contracting with social enterprises, of not requiring efficiencies over and above what would have been achieved if the services had remained within the Department.” The NAO study suggests that without defining the benefits expected to be achieved by spin-outs, these benefits are less likely to be produced.
The established social enterprises provide health and social services that were previously provided by primary care trusts (PCTs – bodies that are to be abolished under the current Government’s health reforms). So the social enterprise spin-offs do not offer the acute and chronic secondary care services that are provided at hospitals. However, at least one business that calls itself a ‘social enterprise’ – Circle Healthcare – does run hospitals and has recently won a contract to takeover a failing NHS trust.
But to my mind, the key point made by the NAO report applies pretty well to all public service privatisations. Despite the service being outsourced, in practice the risks and the service and financial liabilities will continue to reside with the NHS. Both services and business viability will therefore have to be closely overseen by the public body after the contracting-out has taken place.
This point was dramatically illustrated by the near collapse of a social care business that is most definitely not a social enterprise – Southern Cross. As readers will know from the massive publicity attached to the travails of the business, it no longer operates on a viable or sustainable basis and it has had to arrange a short-term rent reduction in order to continue trading. But, should the company (which is a PLC) actually go bust, it will be up to social services authorities to ensure either continuity of service provision, or, in worse case, take responsibility for moving patients and residents to other care homes.
The Southern Cross crisis provides a lesson for the outsourcing of all essential public services, which the NAO has stressed with regard to the ‘right to request’ programme. “At least for a time, social enterprises will be highly dependent on work and cash flow from their respective PCTs,” says the NAO. “They will also be operating in an increasingly competitive market owing to changes in health legislation currently going through Parliament. PCTs or their successors will need to have a clear idea of how they will react if enterprises run into financial difficulty or fail.”
And, it must be conceded, social enterprises and other staff mutuals are more likely to be vulnerable to market forces than are PLCs, because they will not benefit from large investment backing, unless they are supported by venture capitalists in ways that purists – such as me – would argue mean that they cannot truly be called ‘mutuals’. The comment from the NAO is: “The sustainability of social enterprises is, currently, heavily dependent upon funding and cash flow from the NHS.”
Despite these reservations, there are indications that social enterprises and mutuals can be a model for public service improvement, says the NAO. “There are…. a number of examples where increased staff engagement and awareness of local needs from social enterprises formed earlier have delivered cost and service improvements,” comments the report. “For example, Sandwell Community Caring Trust has made substantial savings by reducing staff sickness absences from an average of 22 days per year in 1997 to 0.34 days in 2008.” This is exactly the type of productivity improvement that would be expected from a mutualised public service.
However, it is difficult to calculate whether the productivity improvements have been achieved on a cost effective basis. “As regards the costs of the [Sandwell] programme, there is no central record and it is difficult to get accurate estimates from PCTs as most are still part way through the spinning out process,” explains the NAO. “A small number of trusts told us that their costs varied from between £120,000 to £500,000, but we have no assurance that these costs are typical. In addition to the costs of PCTs, the Social Enterprise Investment Fund provided over £7 million in grants and they were supported by the Department’s central unit.”
Although there are concerns about the structure of public service mutualisations, the programme will continue – not least because several contracts have only recently been awarded. Seven ‘Pathfinder’ social enterprises were spun out before 2008, another 20 have since been spun-out under the right to request programme and a further 30 are due to be spun-out by September 2011.
The NAO has made a series of recommendations on how to maximize savings and efficiencies from the ‘right to request’, not merely about specifying through contracts what gains are to be delivered. Public bodies should also have contingency plans regarding what should happen if the service provider ceases trading, or hits financial difficulties that cause it to reduce service standards. However, this contingency planning should obviously apply to any service externalization. But the NAO warns that a public body must ensure that such planning does not breach European Union state aid rules.
Those state aid rules also mean that social enterprises will have to retender for contracts periodically – and some are likely to be unsuccessful. There is, therefore, a serious concern that the right to request will simply the creation of short-term mutuals, that will then be replaced by PLC and private equity suppliers (now being referred to as ‘Trojan horse privatisations’). This is a major concern of trade unions and one reason for their lack of co-operation with proposals for mutualising public services.
Crucially, says the NAO, there are ways of supporting social enterprises that do not breach state aid rules. In particular, these involve providing practical support in advance of the contracting-out. “The Cabinet Office should ensure frameworks are in place so that new and emerging mutuals and public sector commissioners have access to appropriate information and support,” suggests the NAO. “This should include access to information and advice on adopting good financial practices such as: having clear objectives; ensuring that the means for evaluating success are established at the outset; and ensuring that cost or service improvements are secured.”
It is worth remembering that if we were today designing public service delivery, most of our readers would probably want to establish structures that were forms of mutuals, through which service users and providers operated in partnership to provide flexible and responsive high quality services. Part of the problem is how get from here to there – another is an issue of trust. The memories of Thatcherism are too raw to trust a Conservative-led government with public service reform.
Standards challenge for co-ops
Accountancy is regarded as a boring profession for boring people. This is very unfair. Indeed what was said about bankers, after the banking crash, is equally apposite to accountants. What the world needs now is rather more very boring bankers – and accountants.
As with bankers, accountants are society’s new ‘financial engineers’. (This reminds me of Stalin’s aspiration for artists to be ‘engineers of the soul’: the two concepts are equally dangerous.) It might seem at first glance that accountants are mere book-keepers, the people who compare the income with expenditure and then conclude whether the business has made a profit or a loss.
The reality is very different. Deciding whether a business is profitable or loss-making can come down to many matters of judgement. For example, do you treat the value of your assets as how much you paid for them, how much the market might pay for them today, or the average of recent transactions for similar assets in the recent past? And do you still use the same tests, even if you intend to hold onto the assets for the next 20 years and would not, in any circumstances, sell them?
These exact questions lie at the heart of how the financial system does, or should, operate today. Traditionally, accountants have reported asset values as the price they were bought. Profits were only recorded when assets were sold. But this meant that companies were often vastly more profitable than they appeared. And it opened the way to companies manipulating their accounts – for example, when executives’ pay was linked to company profits – by making overnight sales and re-purchases of assets in order to report higher asset values.
To overcome this, modern accounting principles – as applied in the International Financial Reporting Standards being adopted now in most of the world – take a different approach. With IFRS, ‘fair value’ is used for most assets. Fair value means the current market value of an asset.
But one problem with fair, or market, value is that as an asset class falls in value then companies must report that fall in their accounts. Even when a business is trading profitably, its accounts may show it entering heavy loss making territory, simply because the assets that it has no intention of selling have lost value. And asset value falls can become mutually reinforcing – a process that has been blamed as playing a key role in the recent financial crash.
There is, in the minds of many, no right or wrong answer about how to record profits, or asset values. But there is widespread acceptance that the whole world should take a common approach to how accounts are presented. Not least this reflects a globalised economy, where investors will want to understand whether funds will earn higher rewards if put to work in, say, China, the United States or the United Kingdom. Consequently, we have the International Accounting Standards project, which results in the IFRSs.
The adoption of IFRSs is of enormous significance to the co-operative movement. Housing co-operatives, for instance, are very exercised by the proposals contained in Financial Reporting Standards for Medium-size Entities, or FRSME (accountants’ lives are dominated by sets of initials and acronyms). Under FRSME, housing co-ops would have to report the value of assets and other investments at current market values. At present they report these at the lower of cost, or net realisable value.
“Co-operatives hold investments on a conservative basis and they do not form a significant part of operation or nature of the business,” explained the Irish Co-operative Organisation Society Ltd to the UK’s Accounting Standards Board (whose standards are also used in Ireland). “Also on a prudence basis, co-operatives don’t recognise investment gains until realised [ie the assets are sold]. The FRSME ‘Fair Value’ treatment of investments will now make co-operatives and other entities appear [as] if they have realised gains on which to distribute to Members and Shareholders, when this is not the case.”
And so it is made clear how the academic-type approach to accounting standards will have its impact on the reality of running a business – in this case housing co-ops. There is a second issue in the proposed changes to FRSME that affects both larger housing co-ops and other types of housing associations.
For these larger housing providers, the value of the assets they held could actually fall under the adoption of FRSME. This is because they would have to report recent falls in property values and they would have to remove some development costs in the reported value of their property portfolios. By potentially reducing the value of the portfolios, many housing providers could breach their banking covenants. (Financial covenants agree how a borrower conducts business: including the ‘gearing’, or ratio of assets to liabilities. As asset values fall, so a covenant might be breached.) And banks in recent years have had a distressing tendency to call in loans where covenants are breached – sending businesses that are sometimes trading profitably into administration and closure.
Housing co-operatives and associations are also very unhappy at the likely cost of moving to IFRS, which could lead to them being forced, between them, to spend tens of millions of pounds in buying new IT systems. Credit unions are similarly unhappy. They feel that they are being pushed to adopt the same standards, and be treated in the same way, as banks that hold billions of pounds of assets and liabilities on their balance sheets.
“We are concerned that what the ASB is proposing is disproportionate and is likely to see significant cost increases for our members without any equivalent benefit for anyone involved in credit unions – not the members, regulator nor credit unions themselves,” says ABCUL Chief Executive, Mark Lyonette. He adds: “If the ASB does not reconsider, we could end up in the sorry situation where credit unions are put out of business because of the costs they face in producing their end of year accounts. We do not think this is the basis for sound accounting policy.”
Nor is this by any means a full list of the problems that IFRSs are causing the co-operative movement. Co-operatives UK has been very vocal for the last year or so about another unfortunate impact from proposed changes to accounting standards. Under a proposed IFRS, co-ops will be required to treat members’ dividends as refunds. This would significantly reduce their reported revenues.
Ed Mayo, Secretary General of Co-operatives UK, says: “This new standard may end up cutting profits as the rules want to treat the dividend as if it were no different to a sales promotion, rather than something fundamental to co-operative businesses since the pioneers - sharing the profit.”
Co-ops UK has raised the matter with the International Accounting Standards Board – the body leading on IFRS globally – but complains it has had difficulty in getting the IASB to understand how damaging the issue is to co-ops. The response of the IASB has been that while it is sympathetic, it is determined to adopt ‘principles-based’ standards and hints that it would be wrong for it to allow opt-outs for particular sectors because it affects them in specific ways.
Co-operatives UK is now working with members through its Co-operative Performance Committee to contest the proposed changes to accounting standards. It warns that a sector-wide campaign may be needed if the standard is not amended and that such a campaign should be international, given that IFRS will have their effects on co-ops around the world.
Consultation on IFRSs continues and there will be more meetings involving Co-ops UK in November. Meanwhile, the ASB’s consultation of FRSME in the UK and Ireland is now completed – though the ASB has made clear it understands the particularly difficult impact its proposed changes will have for the not-for-profit sector. As far as both sets of proposed changes are concerned, no final decision has yet been taken.
Ed Mayo puts these discussions into their correct perspective. “This is about accounting standards, but it’s bigger than that: it is part of the work Co-operatives UK, with its members, does everyday to create a legislative environment that provides co-operatives with a level playing field.”
