Governance Structures and Contracting Out Municipal Auditing in Finland and Norway

GOVERNANCE STRUCTURES AND CONTRACTINGOUT MUNICIPAL AUDITING IN FINLAND AND

NORWAY

AGE JOHNSEN, PENTTI MEKLIN, LASSE OULASVIRTA AND JARMO VAKKURI*

INTRODUCTION

The purpose of this paper is to analyse governance structures of municipal

audit in Finland and Norway. By governance structures (Williamson, 1985)

we in this study mean how the municipalities organise the provision of the

mandatory audit. Municipalities can organise the mandatory audit by pro-

ducing the audit internally within the hierarchy (unified governance), by

producing it in co-operation with or in mixed ownership with other organisations

(relational contracting), or finally, by contracting the audit from suppliers in the

market (market contracting). Williamson (1985) called for special attention to the

underdeveloped state of the theory of bureaucracy, and he argued that the study of

bureaucratic failure was very primitive compared to the study of market failure.

Furthermore, Williamson argued that public finance was an area where transac-

tion cost economics held out considerable promise but that problems of incentives

and governance are extremely difficult in particular political contexts. Conse-

quently, he called for tolerance for greater variance in public sector efficiency

assessments compared to private sector efficiency assessments. In this paper, we

analyse governance structures and explore the effects of contracting out municipal

auditing. We have addressed the political costs in addition to production and

transaction costs, which traditionally are the two main efficiency measures in

transaction costs analysis (TCA).

The background for our study is the ongoing public sector reforms in

many countries, including Finland and Norway. Some public sector services

now permit competition, and there has been an increased emphasis on

output and performance measurement, including performance auditing

(Pollitt and Bouckaert, 2000). Finland harmonised its municipal accounting

*The first author is from Oslo University College, Norway and the University of Edinburgh, UK.The second, third and fourth authors are from the University of Tampere, Finland. This study waspart of the project ‘Contracting out municipal audit’ at Agder Research, Kristiansand, financed bythe Norwegian Research Council programme ‘Public Sector in Transition’; and the ‘Localauthority economic management’ project in the ‘Finnish Local Government 2004’ programmefinanced by the Association of Finnish Local and Regional Authorities.

Address for correspondence: Age Johnsen, Faculty of Business, Public Administration and SocialWork, Oslo University College, P.O. Box 4 St. Olavs plass, NO-0130 Oslo, Norway.e-mail: [email protected]

Financial Accountability & Management, 20(4), November 2004, 0267-4424

#Blackwell Publishing Ltd. 2004, 9600 Garsington Road, Oxford OX4 2DQ , UK

and 350 Main Street, Malden, MA 02148, USA. 445

system with accrual accounting and deregulated the municipal audit market

in 1997 (Monsen and Nasi, 1996). In 1992, the Norwegian Parliament

decided to keep a distinct (idiosyncratic) municipal accounting system

(Bergevarn et al., 1995) and a regulated municipal audit market, and this

decision was upheld in the revision of the municipal accounting system in 2000.

Unlike the other Nordic countries, Norway did not allow municipalities to

contract out municipal audit during the period of study (1996–2000). How-

ever, there was an increasing political demand for change during that period

of time. In 2002, the Norwegian centre-right coalition government proposed

a change in the existing legislation in order to allow municipalities to voluntarily

contract out municipal auditing. The Norwegian Parliament approved the new

legislation in 2003, and municipalities will be able to voluntarily contract out

municipal audits from 1 July, 2004. The Labour Party, the Centre Party and

the Socialist Left Party voted against this proposal. The re-organisation of

Norwegian municipal auditors, the increased emphasis upon performance

auditing, and the greater investment in audit competence, are events that

occurred during the late 1990s (Johnsen et al., 2001). All of these events can be

understood as being actions that were in accordance with the growing political

demands for change and for an alignment with auditing practices in the other

Nordic countries.

The increased competition that will soon be allowed, due to deregulation

and contracting out, is interesting to study from a TCA perspective. Muni-

cipal audit is characterised by the agency problem of asymmetric informa-

tion (Watts and Zimmerman, 1983). In addition, auditing is strongly

regulated by the norms of the accounting profession (Hatherly and Brown,

1996). Consequently, there may be problems related to human asset speci-

ficity (specialised competence), which could facilitate opportunism. These

potential problems may be measured in terms of effects on productivity, i.e.

the cost of audit services to the municipalities under non-competitive versus

competitive conditions and in terms of transaction costs for different govern-

ance structures. In this paper, we have analysed the costs (audit fees and

transaction costs) and governance structures of municipal audit services in

Norway, where there has been little or no competition in the municipal audit

market, and the governance structures and costs of similar services in

Finland, which deregulated the municipal audit market in 1997. Our three

research questions are: What governance structures are used in municipal

auditing? How does governance structure, including contracting out, affect

audit fees? How does governance structure affect transaction costs?

There are several reasons why it is important to study governance struc-

tures and contracting out municipal auditing. First, there is the need for

studies of governance structures and contracting out municipal audit in

European contexts. Contracting out has been an important element in

public sector reforms during the 1980s and 1990s, and there is extensive

documentation of the effects of contracting out many municipal services

# Blackwell Publishing Ltd 2004

446 JOHNSEN, MEKLIN, OULASVIRTA AND VAKKURI

(Boyne, 1998). Still, to our knowledge, there are no empirical studies of

contracting out municipal audit in Europe.

Second, there is a need for more knowledge about ‘hybrid forms’ in

transaction cost analysis (TCA). By hybrid forms we mean those governance

structures that organisations use instead of unified governance (hierarchy) or

market contracting (Powell, 1990). These are commonly referred to as rela-

tional contracting, networks and alliances. However, although all three of

these governance structures are important, unified governance and market

contracting have received most attention in empirical TCA studies. In 1985,

Oliver Williamson wrote:

Bilateral structures [one of the relational governance structures between unified govern-ance and market contracting] have only recently received the attention they deserve,and their operation is least well understood (Williamson, 1985, p. 76).?

Unfortunately, the neglect of hybrid forms in TCA has persisted. According

to Williamson (2000), the new institutional economics (transaction cost

analysis) has hitherto dealt incompletely with mixed ownership, e.g. govern-

ance structures between ‘in-house’ municipal audit and market contracting:

The attributes of mixed ownership modes (alliances, joint ventures, franchising, and thelike) as well as the mechanisms for supporting credible contracting between autonomousfirms are incompletely worked out (Williamson, 2000, pp. 610–11).

Few have addressed hybrid forms and their potential impact upon differ-

ent services, including audit. For instance, in a relatively recent study on the

boundaries of the firm and why firms outsource internal auditing (Widener

and Selto, 1999), only unified governance and market contracting of profes-

sional accounting firms were studied. However, Widener and Selto (1999)

relied on an early formulation of Williamson’s transaction cost theory in

their study (Williamson, 1975). While Williamson in his earlier formulations

of TCA regarded transactions of the ‘middle kind’ (hybrid forms), as being

very difficult to organise and unstable, he was later persuaded to regard such

transactions as being much more common. Furthermore, he also argued that

many of the most interesting problems of organisation involve both asset

specificity and, one of the core issues of interest within agency theory,

information asymmetry (Williamson, 1985).

As an example of a service that might be relevant in relational governance

structures, Williamson (1985) mentioned architects. Architects are, like nurses,

doctors, engineers, lawyers, accountants and auditors, professionals that render

more or less specialised services on an occasional or recurrent basis to different

organisations. Some organisations hire their own professionals. Others make

arrangements for long-term relationships to meet their service needs. Finally,

there are organisations that contract professional services in the market when

needed. This means that studies of governance structures should take the diversity

of options into account and not be satisfied with a unified governance–market


GOVERNANCE STRUCTURES AND CONTRACTING OUT 447

contracting dichotomy or with a public-private provider dichotomy. Audit is a

professional service that involves ongoing relationships (transactions) between audi-

tors and auditees. These transactions are subject to asymmetric information and

asset specificity. Thus, audit bears on one of the main concerns of TCA, which is

the choice of governance structure, determining the borders of the organisation.

Municipal audit may become a highly suitable test-bed for studies of governance

structure in many public sector professional services. New knowledge about con-

tracting out municipal audit could be useful information for audit practitioners,

policy makers and for students of auditing and economic organisation theory.

The rest of this paper is outlined as follows. The next section explains how

we have applied TCA to develop hypotheses about municipal audit. The

third section is an outline of the research design and a description of the data

we have used. The fourth section documents the empirical results, including

a multiple regression analysis of how governance structures affected muni-

cipal audit fees per capita in Finland and Norway. The paper ends with a

discussion of the results and conclusions, and includes a summary of the

findings, limitations of the present study, implications for theory and prac-

tice, and suggestions for future research.

THEORY AND HYPOTHESES

TCA is an interdisciplinary new institutional theory in the intersection of law,

economics and organisation (Williamson, 1985). TCA is predominantly concerned

about the boundaries of the firm, or more precisely in our context, of the organisa-

tion. TCA maintains that any issue that either arises or can be recast as a problem

of contracting is usefully examined in terms of transaction cost and that all contract

schemes should be examined micro analytically and assessed in a comparative

manner. However, because of bounded rationality, contracts and governance

structures are assessed relative to one another in TCA and without the claim of

optimality that is common within neoclassical economics. Subsequently, any gov-

ernance structure that is in use may, as a starting point, be assumed to be efficient

relative to the local common knowledge concerning other relevant governance

structures.

Marsh (1998) wrote that TCA implications for local governance had only

recently been appreciated and held that TCA appeared to offer a weapon

against fragmentation. Fragmentation is the term that is often used to

describe the dysfunctional effects of excessive contracting out, privatisation,

use of networks etc. instead of the traditionally integrated and top-down

controlled public sector bureaucracy (the ‘hierarchy’ in TCA terms). Thus,

too much contracting out may result in relatively high transaction costs and

fragmentation, which may result in a hollowing out of the state and reduce

the steering capacity of public policy (Rhodes, 1997). However, Marsh

(1998) also identified several limitations in the assumptions underlying



TCA. Most notably, he argued that the decision about governance structures

is not restricted to minimising the sum of production and transaction costs

but also includes the optimisation of the net benefit, and that different

governance structures can produce different kinds of transactions. For

example, the nature of trust and the net benefit of municipal audit could

vary depending upon whether or not the audit is contracted in the

market, produced in relational contracting or provided internally.

TCA assumes bounded rationality, which means that there is uncertainty

and that planning is difficult. Human nature ‘as we know it’ is seen as being

prone to opportunism, which means that some individuals are not trust-

worthy all of the time. Because of bounded rationality and opportunism,

classical complete contracting is difficult and costly to agree upon and to

enforce. Consequently, TCA focuses upon ex-post governance structures

and neoclassical incomplete contracting and relational contracting that can

facilitate efficient exchange across organisational boundaries by minimising

total production and transaction costs. Transaction costs are the costs of

running an economic system and should be distinguished from production

costs. Transaction costs can be divided into ex-ante and ex-post types.

Ex-ante transaction costs are the costs of drafting, negotiating and safeguarding

an agreement. Transaction costs of ex-post type are costs related to mal-

adaptation from the contract, haggling costs to correct ex-post misalignment,

set-up and running costs associated with governance structures (courts and

other institutions) for the resolution of disputes, and bonding costs for effecting

secure commitments.

According to TCA, the decisions determining the appropriate governance

structure to minimise production and transaction costs will depend upon

asset specificity, uncertainty, and the frequency of the transactions. Asset

specificity is divided into four types; site, physical asset, human asset and

dedicated assets specificity. Each of the four types can be categorised into

non-specific, mixed or idiosyncratic investment characteristics for the trans-

actions in question. Audit can be classified as a product with so called mixed

investment characteristics. The auditors may have specific human assets and

certain audits, and most notably performance audit, may also have site

specificity. The financial audit of firms may be relatively non-specific and

recurrent, something that favours market contracting. It should be noted,

though, that professional audit firms might specialise in industries or

branches, enhancing asset specificity. Municipal financial audit, on the

other hand, requires competence in municipal accounting and public sector

regulation, and may include cameral accounting (Monsen and Nasi, 1996) in

addition to accrual accounting. Municipal performance audit may require

organisation and/or service specific tacit and formal knowledge that requires

the use of other professionals, for example, medics and engineers in addition

to accountants. Some performance audits may be recurrent and conducted

on an annual basis, but these audits will nevertheless not cover the same



services or issues regularly. These forms of human asset specificity, in add-

ition to the widespread asymmetric information that exists in professional

public sector services, strongly indicate that there are opportunities for

opportunism and substantial transaction costs related to municipal audit.

TCA distinguishes between non-strategic (structural/exogenous) uncer-

tainty and strategic (behavioural) uncertainty, where opportunism is of

special importance in TCA. For instance, a market situation with a large

number of bidders at the outset may be transformed into a bilateral supply

after a contract has been settled (the fundamental transformation problem).

It should be noted that there could be substantial interaction effects between

asset specificity, uncertainty and transaction frequency. Furthermore, TCA

distinguishes between occasional and frequent transactions.

Regarding transaction frequency, one can argue that financial audit is

recurrent and frequent because it is conducted annually or more often.

Performance audit is occasional. The same project, service or programme

is not regularly or routinely audited. However, the same organisation may

undergo performance audit regularly. Sometimes large organisations will

have annual performance audits.

When there are mixed or specific investment characteristics and recurrent

or occasional transactions, as with performance audits, then the transactions

may be efficiently organised either as a bi- or trilateral governance structure

or as a unified governance structure. The relatively non-specific financial

audit is likely to be contracted from the market, unless the financial audit is

bundled together with the performance audit. In addition, the entire ques-

tion about municipal audit governance structure is made even more complex

by the issue of plural forms (Bradach and Eccles, 1989). As some audits may

be non-specific and recurrent, especially financial audit, and other audits

may be specific and occasional, typically internal (or management) audit and

performance audit, several governance structures can be chosen. Some of

the municipal audit may be conducted within unified governance, by mixed

ownership or other relational contracts, by contracting professional account-

ing firms, or by combinations of all of these governance structures (plural

forms). Plural forms means, in our context, that a municipality may have

some audit in unified governance, participate in the inter-municipal owner-

ship of auditors, and contract some audits from the market, simultaneously.

Unified Governance

TCA assumes that organisations adapt to minimise the sum of production and

transaction costs. Unified governance is suitable when the transactions are rela-

tively recurrent and idiosyncratic. In this situation there may be few external

suppliers, and if the auditee is a large organisation then economy of scale can be

as well utilised as it is by an efficient external supplier. We can expect that



relatively large municipalities could utilise the economy of scale and provide all the

more or less specialised audit services internally (hypothesis 1).

H1: Large organisations have more unified governance of audit than

small organisations.

Let X denote the proportion of a governance structure within a population,

let UG be unified governance, let L be a large municipality and S a small

municipality, and let i be period and j be country. We can then test hypoth-

esis 1 by studying if:

XðUGLÞij > XðUGSÞij :

Relational Contracting

One of the possible benefits of both relational contracting and market

contracting is to establish incentives for efficiency through contestable mar-

kets (Baumol et al., 1982). Contestability means that the sole supplier does

not have a permanent hold on the market or contract and could be replaced

by other suppliers. However, Williamson (1985) argued that due to asset

specificity, contestability through easy entry and exit of firms in the market

might not be feasible. After the contract has been settled between a munici-

pality and an auditor, the initial bidders may exit from the market and the

market may effectively disappear. This is called the fundamental (market)

transformation (Williamson, 1985). Relational contracting could have major

advantages compared to both unified governance and market contracting of

audit. In relational contracting the audit committee is not dependent on a

sole internal provider as in unified governance, and relational contracting

would not be subject to the fundamental transformation problem to the same

degree as in market contracting. Therefore, the auditee may try to minimise

audit (production) and transaction costs by establishing a long-term trust

based relationship with one or a few auditors.

Auditing is a professional service. It is therefore difficult for the audit

committee to identify the auditor’s competence, monitor efficiency and

verify audit quality regardless of governance structures. For instance,

Roberts et al. (1990) found that school districts in Texas that changed

auditors in order to cut audit fees, might have received audit of lower quality

than before. (In fact, some of this effect may even have been intended as

some of the districts wanted to avoid negative information provided by some of the

previously used auditors.) In establishing relational contracting the municipalities

may seek co-operation with other similar organisations in order to establish mixed

ownership of a shared auditor. This action could facilitate economy of scale in

audit production costs as well as a high professional standard in the contracting

process. This action could also enhance the municipalities bargaining power



relative to the auditor as well as sharing fixed contracting costs between the

municipalities. For instance: when the Finnish municipal audit market was deregu-

lated in 1997, Audiator OY (limited), a nation-wide auditor formed by many of

the previous internal municipal auditors, became the market leader. The interest-

ing issue is that Audiator OY, which was established in 1993, is owned 100 per

cent by the Association of Finnish Local and Regional Authorities. Since all

Finnish municipalities are members of the Association of Finnish Local and

Regional Authorities, the auditor that is now the market leader is owned indirectly

by its auditees. In Norway, an increasing number of municipalities have merged

their former internal auditors into district audits. As a consequence, we expect to

find relatively extensive use of relational contracting in auditing.

H2: Relational contracting is used relatively more than unified govern-

ance and market contracting in municipal auditing.

Let RC denote relational contracting and MC market contracting. We can

thus test hypothesis 2 by studying if:

XðRCÞij > XðUG; MCÞij :

The choice of governance structure is assumed to be a function of both

production and transaction costs. Consequently, the municipalities are

expected to choose that governance structure that minimises the sum of

production and transaction costs. If all costs related to governance structures

were randomly distributed, then we could expect a distribution of 1/3 for

each of the three governance structures. However, there is a large number of

small municipalities in both Finland and Norway and we expected that

relational contracting, due to economy of scale in production costs, would

be the dominant governance structure. We wanted to test whether or not

hypothesis 2 would be supported due to transaction costs. For that reason we

only tested hypothesis 2 in the group of large municipalities in both coun-

tries, assuming that most small municipalities due to economy of scale

reasoning would not use unified governance.

Market Contracting

We have specified two hypotheses regarding market contracting. Hypothesis

3 concerns the level of audit fees and hypothesis 4 concerns the volatility of

audit fees.

TCA makes the claim that if there are non-specific and occasional or

recurrent transactions, as is the case with yearly financial audits, then market

contracting is the best and most efficient governance structure.1 Contracting

out is understood as opening up for competition in the public sector, where

the provision of services is still seen as being a governmental responsibility.

One argument for contracting out audit is that competitive or financial



pressures force a concentration upon core competencies, increasing specia-

lisation and demands for new skills and competencies in auditing beyond

traditional financial and internal audits. A second common argument for

contracting out audit is the increased supply of high quality audit that can be

made available to the public sector by the big professional accounting firms

(Rittenberg and Covaleski, 1999; and Widener and Selto, 1999). According

to Domberger and Jensen (1997), two prominent scholars of contracting out,

expenditures, on average, can be reduced by 20% after contracting out.

However, some of Domberger et als’ methods and estimates have been

contested. Hodge (2000), on the other hand, based on a meta-analysis of

the available literature on contracting out for the period 1976–1994, esti-

mates the reduced costs to average from 6 to 12%. Furthermore, according

to Domberger and Jensen (1997) and Hodge (2000), one may expect the

quality of the services to be maintained or enhanced.

Research on the US municipal audit market indicated that increased

competition reduced audit fees (Sanders et al., 1995). However, Rubin

(1992) argued that private auditors in the US may charge higher audit fees

than municipal auditors. Rittenberg and Covaleski (1999) found that con-

tracting out internal audit in British government reduced costs by 25% on

average. Contracting out also led to more focused audit reports, and many of

the internal auditors began to co-operate with external suppliers in order to

enhance the quality of existing services. (This corroborates the underlying

critique and the implicit assumption of TCA, that contracting out will

promote homogenous transactions between governance structures.) We

expected that the municipalities would pragmatically choose that govern-

ance structure that minimised audit fees and transaction costs and optimised

the benefit of audit according to local circumstances. Consequently, we

expected a negative relationship between the use of market contracting

and an increase in audit fees per capita, after the deregulation in Finland.

Moreover, because all auditors are now facing competition, we expected the

overall level of audit fees per capita in Finland to decline in real terms. We

expected the Finnish audit fees to be lower and to have increased less than

the audit fees in Norway (hypothesis 3). This expectation was due to our

assumption that the already existing greater competition in the deregulated

Finnish market would reduce costs more than the increased threat of con-

tracting out would do in the Norwegian market.

H3: Increasing competition reduces audit fees.

We can test hypothesis 3 by studying if:

p1Finland > p2Finland and p2Finland < p2Norway:

In markets, where there are homogenous (non-specific) products and where

the identity of the supplier is irrelevant, price would be the major competition



factor. In relational contracting, costs would tend to be fixed and quantity rather

than price would more likely be adjustable (Williamson, 1985). This was indirectly

corroborated for the audit market by Hatherly and Brown (1996) who argued that

auditors (professional audit firms) compete on image and costs rather than directly

on audit quality unless quality is made much more visible than it is at the present.

Audit quality is commonly defined as the probability that the audited financial

statements contain material errors (Copley and Doucet, 1993). However, this

definition is less applicable to performance audit where decision relevance (Mays-

ton, 1985), volume of public funds involved, financial risk and political salience

(Keen, 1999) may be better criteria for audit quality. Furthermore, because there

is no general agreement on what performance audit is (Bowerman, 1996; and

Johnsen et al., 2001), performance audit is not a homogenous product. The

identity of the supplier may be important, and this may explain why there may

be relatively more relational contracting in municipal auditing. (This will be tested

in hypothesis 2.) Nevertheless, when the audit is contracted from the market, we

commonly expect price adjustments (hypothesis 4).

H4: Audit fees are more volatile in market contracting than in relational

contracting.

Thorne et al. (2001) concluded that audit fees on average were lower for

fixed-fee contracts than for cost-imbursement contracts. Moreover, they also

concluded that the probability for negotiating a fixed-fee contract increased

for governmental units with relatively high financial risk when they engaged

an independent auditor with a great deal of knowledge about the public

sector. We assumed that auditors engaged by municipalities should have a

great deal of knowledge about the public sector. Hence, fixed-fee contracts

should be common. However, the presence of strong incentives for cost

efficiency and lowballing in market contracting could (depending on compe-

tition) materialise in relatively low and volatile audit fees. If so, market

contracting of municipal audit would lead us to expect to see more adjust-

ments in prices (audit fees) relative to relational contracting (hypothesis 4).

RESEARCH DESIGN, SAMPLE AND DATA

Research Design

A characteristic of empirical research in transaction cost economics is that

the main variables of study, transaction frequency, asset specificity and

uncertainty, are difficult to measure and often require the use of proxies.

For instance, accounting data, even detailed accounting data, are often

poorly suited for the needs of TCA. Therefore, direct measurements of

transaction costs are rarely attempted. Comparative institutional analyses

are often used to study the attributes of the transactions and those are tested



against the TCA’s predictions regarding governance structures. This is done

instead of directly measuring transaction costs. Moreover, Williamson (1985)

called for more depth (fewer and more relevant data) compared to breadth

(more observations) in research design tradeoffs, for the near term.

Ideally, we wanted to compare the effects of contracting out in Finland by

collecting data before and after the contracting out ‘experiment’ started in

1997. Our hope was to be able to use Norwegian data as a control. However,

due to changes in the Finnish municipal accounting system in 1997, some

municipalities were unable to report audit fees prior to 1997. As a result, we

decided to use audit fees data for 1997 and 2000, in Finland, and for 1996

and 2000, in Norway.

Finland

Finland had a population of 5.1 million inhabitants in 2000. Finnish local

government had only one tier and that consisted of 452 municipalities.

According to the Local Government Act of 1995 §71, 72 and 73, Finnish

municipalities were required to have both performance auditing and exter-

nal financial auditors, but the municipalities were free to select the external

auditor. The auditors’ terms were fixed for the entire four-year period of

municipal council government. The municipal audit committees decided on

the performance audits that were subsequently produced either through the

system of unified governance (local government officials and/or members

of the audit committees) or with the assistance by the contracted external

auditors. The five largest auditors operating in the Finnish local government

market in the 1997–2000 period were Audiator Oy, Suomen Kuntatarkastus

Oy, SVH Julkistarkastus Oy, KPMG Kunta Oy, and Kuntatarkastajien Oy

Clavis. Moreover, there were three other smaller firms. Audiator had a

leading position in many rural areas but not in urban areas. The other

four auditors were private firms, and they were subsidiaries of large audit

firms (including KPMG and Deloitte & Touche). In 2001, a total of 13

authorised audit firms expressed their interest in operating within the muni-

cipal audit markets. This shows that there has been a keen interest in

entering the municipal audit market and that the municipal options for

selecting auditors have increased relative to the period of time that we

have studied.

Norway

Norway had 4.5 million inhabitants in 2000. Norway had two tiers of local

government with 435 municipalities and 18 counties. There were 82 muni-

cipal and 18 county auditors in 2000, but we only studied the municipal

auditors. The municipal audit was regulated by the Municipal Act of 1992

and was mandatorily performed by municipal or district auditors (§60.3).



All municipal and district auditors were independent by regulation of the

Municipal Act of 1992 and reported directly to the municipal councils’ audit

committees. Furthermore, all the Norwegian municipal auditors audited the

municipalities on a non-profit basis. The municipal audit committees were

responsible for conducting financial, management and performance audits

that were produced by mandated municipal auditors. (The municipal audi-

tors were also responsible for auditing some non-municipal operations, but

in this study we have only collected data on municipal audit fees.) The

municipal councils decided the audit budgets (fees) annually, but even

though contracting out was not allowed, the municipalities were free to use

internal auditors (unified governance) or district auditors, which were jointly

owned inter-municipal entities (mixed ownership). In 2000, the district

auditors were responsible for the audit of 2–18 municipalities each.

Data Collection and Measurements

Sample

The primary data on municipal audit fees were collected from annual

reports and by postal surveys in Finland and by postal surveys in Norway.

In Finland, we collected data from 47 (10.4%) of the 452 municipalities. The

47 municipalities comprise a sample that has been used for many years in

examining the politics, economy and management of local government in

Finland. It is meant to be a representative sample of the different municipal

characteristics, including type of municipality (rural/urban), number of

inhabitants, language used (Finnish or Swedish), and size (large/small).

Although the sample is relatively small compared to the Norwegian sample,

all the five largest Finnish auditors that operated in the municipal audit

market in 2000 were represented in the data from the 47 municipalities in

the sample.

In Norway, we sent the questionnaires to all of the 82 municipal auditors.

After one round of following up the non-respondents, 56 (68.3%) of the

municipal auditors responded with data for both 1996 and 2000. These

auditors audited 298 (68.5%) of the 435 Norwegian municipalities. Many

of the non-respondents came from the northern-most regions where the

municipalities were small and rural, but the data represent auditors and

municipalities from all the regions of Norway.

Audit Fees

The dependent variable in this study is municipal audit fees per capita. Note

that the audit fees include internal (management) audit and performance

audit, when feasible, in addition to the traditional financial audit. Since

many of the Finnish municipalities did not procure external performance



audit, the costs for such audits are not included for all municipalities in our

data. The Finnish audit fees exclude a 22% value added tax (VAT). The

Norwegian data are without VAT costs, since municipalities in Norway were

exempted from paying VAT in the first place. The surveys distinguish

between financial audit fees and performance audit fees and also provide

total audit fees. Only a minority of the auditors were able to specify financial

and performance audit fees separately. As a consequence, we analysed the

total municipal audit fees but included a control variable for the inclusion of

performance audit in the Finnish data, see below.

Governance Structures

In this paper we have distinguished four governance structures, from no to

full market contracting. The first is internal municipal audit (unified govern-

ance). The second is audit provided in co-operation or mixed ownership with

other organisations (relational contracting). The third is audit procured from

private or public auditors in the market (market contracting). The fourth is

audit services provided in a combination of the former three governance

structures (plural forms). The last category, plural forms, did not apply to our

level of analysis as we lacked sufficiently detailed data to use this category,

but the entire Finnish market might be considered as belonging to this

category.

Performance Auditing

We assumed that performance auditing is related to human asset specificity

and we had reason to believe that the municipal auditors, during the 1990s,

emphasised performance audit more than they previously had done. (Per-

formance audit was made mandatory by the Local Government Acts, in both

countries, during the 1990s.) In order to measure changes (increase) at the

municipal level, we included a dummy variable with the value 0 if there was

no performance audit in either 1996/97 or 2000 or performance audit in

both 1996/97 and in 2000 (meaning no change) and the value 1 if there was

no performance audit in 1996/97 and some performance audit in 2000. Five

of the 47 Finish municipalities (10.6%) went from no performance audit in

1997 to some in 2000. However, our Finnish data were incomplete on this

issue. For instance, one Finnish municipality (Joroinen) had performance

audit in 1997 but not in 2000. This was coded as 0 because we had no reason

to assume that the municipality did not undertake any performance audit,

for instance, internally, in 2000. In 1996, 10.7% of the 298 municipalities in

Norway had no performance audit, but in 2000 all the Norwegian munici-

palities in the sample had at least some performance audit. In any case, the

trend of increased performance audit has required the focused training and

the recruitment of staff with specific competence, and we have identified this



as being an increase in human assets specificity in the municipal audit. Based

on the above data and on previous studies (Johnsen et al., 2001), we had no

reason to believe that these developments were significantly different at the

national level in the two countries that we have studied.

In addition to governance structure and the change in human asset

specificity, as independent variables, we also included a number of control

variables that were used in previous audit market studies.

Political Preferences

Banker et al. (1992) argued that political competition is a distinguishing

characteristic of the public sector, and that this variable is a highly relevant

one to include, as an explanatory variable for contracting out municipal

auditing. We used the ratio of left-wing representatives in the municipal

councils, as an indicator to measure political preferences, assuming that the

preferences of the majority or of the largest group are influential in the

political competition (Baber, 1983). In Finland, the political preference

variable included representatives from the Social Democratic Party of

Finland, the Left Alliance, the For Peace and Socialism – Communist Worker’s

Party, and the Communist Party of Finland. In Norway, this variable

included representatives from the Labour Party, the Socialist Left Party,

the Red Election Alliance, and the Norwegian Communist Party. We

expected that the higher the ratio of left-wing representatives in the muni-

cipal council, the more the council would rely upon unified governance or

mixed ownership (relational contracting) rather than market contracting.

Decisions on governance structures and contracting out require some time

in order to be implemented. Consequently, we measured political prefer-

ences on 1 January, 1997, in Finland, and after the 1995 local elections in

Norway, in order to conform to the regression analysis assumption that cause

should precede effect.

Auditor’s Size

We identified this variable as the auditors’ turnover in 1999, for Finland,

and as gross municipal audit fees, including estimated but not actually paid

property rents, IT support and other costs that the municipalities granted

the municipal auditors in 2000, for Norway. We expected that the large

auditors, due to their anticipated relatively high market power and compe-

tence/expertise, were positively related to audit fees per capita.

Municipal (Auditee) Size

Many studies have focused upon the relation between auditing fees and

auditee (organisational) size (Baber et al., 1987; Rubin, 1988; and Copley,



1989). All three studies found significant relationships between local govern-

ment audit fees and government size. In these studies, municipal size was

used as proxy for audit complexity. We expected that economy of scale and

the large municipalities’ relatively strong bargaining power would result in

lower audit fees per capita for large municipalities than for small munici-

palities. We used two indicators to measure municipal size: gross municipal

operating income in 1999, and the number of municipal inhabitants on

31 December, 1999, in Finland, and on 1 January, 2001, in Norway.

The smallest and the largest municipal population figures in our sample

were 1,161 and 209,667, in Finland, and 232 and 508,726, in Norway,

respectively.

Municipal (Audit) Financial Risk

During the 1990s there has been increasing attention on audit quality and on

auditors’ independence and financial responsibility. Auditor independence is

defined as the probability that the auditors will report a discovered breach

(Watts and Zimmerman, 1983), and as the absence of collusion between the

auditor and the manager of the client firm (Lee and Gu, 1998). There is an

increasing risk for the external auditors to be financially liable. We expected

that external auditors would raise their fees in order to compensate for the

anticipated financial risk involved in the audit. We used debt per capita

defined as long-term liabilities divided by municipal inhabitants (Rubin,

1988), to measure the financial risk in the municipalities. We expected

a positive relationship between debt per capita and audit fees per capita. More-

over, we expected this relationship to be stronger in Finland than in Norway.

Agency Costs and Municipal Dependence on Constituency Groups

Public officials may have incentives to demonstrate accountability to major

stakeholders. Ward et al. (1994) found some evidence indicating that audit

fees were positively related to agency variables that measured the extent of

taxpayer funding of services. We measured the agency cost variable with

municipal personal income taxes per capita as indicator. If the public

officials use audit to demonstrate or verify accountability, then we could

expect relatively high audit fees in highly taxed environments.

Municipal Urbanisation/Centrality

There were reorganisations in the municipal audit markets in the 1990s, in

Norway and Finland, resulting in bigger auditors in Norway and the

entrance of private audit firms into the market in Finland. We expected

that these new audit entities had their offices centrally located and that

auditing centrally located urban municipalities would be less expensive



than auditing more peripheral and rural municipalities. We included muni-

cipal urbanisation/centrality as an explanatory variable for relative audit

production costs that could lead to differences in audit fees. The degree of

municipal urbanisation/centrality was measured with an ordinal level scale.

The municipal urbanisation/centrality category indicator for Finland was

originally: 1¼ urban, 2¼ densely populated, 3¼ rural. We reversed this

scale to match the Norwegian indicator. For Norway we applied a four-

category centrality scale used by Statistics Norway. The categories were

originally: 0¼ least central, 1¼ less central, 2¼ quite central, and 3¼most

central. We merged the two lowest categories into the value 1.

Performance Audit Productions Costs

Because the Finnish data were incomplete regarding inclusiveness of all

relevant audit costs, we added a dummy variable for Finland that measured

the inclusion of performance audit in the total audit fees. Thirty percent of

the Finnish and 100 percent of the Norwegian municipalities had some

performance audit included in our audit fees data for 2000.

Analysis and Comparison

We assumed that both non-strategic (environmental) and strategic uncer-

tainty (opportunism), and transaction frequency were relatively equal in the

municipal services and in the municipal audit for Finland and Norway. On

the other hand, there are some issues that make direct comparisons of the

data between the two countries difficult. There are important institutional

differences regarding accounting and audit between many European coun-

tries (Maijoor et al., 2000). Due to the fact that the two countries have

dissimilar institutions and possibly different content in their audit services,

the municipal audit fees cannot be directly compared between the two

countries. There are several possible reasons for pre and post contracting

out differences in the content of the audit fees.

First, different traditions and institutions may have shaped the audit

markets in varying ways. Norwegian local government may have been

more under the control of central government, implying relatively extensive

use of municipal audit. Finland has undergone considerable restructuring

in the economy during the recession in the early 1990s. The recession in

Finland was linked to the collapse of its major trading partner the Soviet

Union in 1989, to the poorly designed deregulation of financial markets

in the 1980s, and other related unsuccessful policies and institutions. (See

Kiander and Virtanen, 2002.) Data from OECD Productivity Database

show that the annual average growth rate in the Finnish GDP was �0.8%

for the 1990–1995 period. In comparison, the annual average growth rate

in GDP in Norway was 3.9% in the same period. The accompanying



restructuring in the Finnish economy, including the public sector, during this

period may have resulted in better long term efficiency relative to Norway.

Finnish local government had only one tier while Norway had two. Finnish

municipalities and auditors were on average larger than Norwegian munici-

palities and auditors. Finnish government had harmonised the municipal

accounting system to accrual accounting. These factors and possibly others,

may have resulted in different economies of scale and transaction costs in

the municipal audit and subsequently led to different governance structures,

audit activities, audit costs and accounting practices between the two coun-

tries.

Second, the accounting (book keeping) practices may have been different

in the two countries. In Norway, the municipal audit fees covered financial,

management and performance audit. In Finland, the audit committees

were responsible for contracting the financial auditors and for producing

management and the annual performance audit. However, in many munici-

palities audit firms provided assistance in the performance audit process. It is

likely that some costs related to management and performance auditing, in

Finland, were not included in the Finnish audit fees data, while these costs

were encompassed by the Norwegian audit fees data. For those reasons,

we think that the Norwegian audit fees, which were the highest, measured

as municipal audit fees per capita, may have contained more costs related

to management and performance audit than was the case for the Finnish data.

Lastly, and perhaps most importantly, contracting out in Finland may

have ‘pruned’ the content of the audit, relative to Norway, in such a way that

the audit content and perhaps the quality of the audit are incommensurable

between the two countries. We assumed that there were different market

regulations and accounting institutions within each of these two countries

and that there were probably significant differences in the pre and post

contracting out audit content in Finland compared to the audit in Norway.

The data on municipal audit fees, for these reasons, are not directly com-

mensurable between Finland and Norway. As a consequence, we performed

separate analyses for each country and compared our findings.

RESULTS

Univariate and Bivariate Analysis

The descriptive statistics of mean, standard deviation and correlation coeffi-

cients are given for Finland and Norway, in Tables 1 and 2, respectively.

Eighty-five percent of the Finnish and 98 percent of the Norwegian munici-

palities in our sample used auditors with mixed ownership. (In fact, in 2000,

only 9 (2%) of all the 435 municipalities in Norway had unified governance.

Our sample included 7 of the 9 municipalities with unified governance.)



Table

1

DescriptiveStatisticsandCorrelationsforMunicipalAuditin

Finland(N

¼47)

Variable

Mean

St.Dev.

12a

2b

34

56

78

9

1Governance

structure

a0.15

0.36

2aChangein

perform

ance

auditb

0.13

0.34

�0.16

2b

Perform

ance

auditc

0.30

0.46

�0.14

0.59***

3Left-w

ingrepresentatives

0.33

0.14

�0.13

0.12

0.04

4Auditorturnoverd

28776.00

11018.00

�1.00***

0.16

0.15

0.03

5Municipalinhabitants

17725.00

32648.00

0.31**

0.05

�0.11

0.12

�0.29**

6Operatingincomed

409260.00

782310.00

0.33**

0.05

�0.12

0.12

�0.32**

1.00***

7Debtpercapitad

4.68

2.67

�0.07

�0.10

�0.28*

0.29**

0.06

0.03

0.02

8Taxpercapitad

9.50

1.82

0.13

0.13

�0.04

0.39***

�0.12

0.56***

0.57***

�0.06

9Centrality

1.70

0.91

�0.06

�0.15

�0.15

0.65***

�0.06

0.53***

0.53***

0.26*

0.57

10

Auditfeesper

capitae

6.36

2.82

�0.37**

�0.07

0.25*

0.13

0.36**

�0.39***

�0.39***

�0.09

�0.33**

�0.15

Notes:

aDummyvariable:0¼mixedownership

and1¼marketcontracting.

bDummyvariable:0¼noperform

ance

auditin

1997and2000and1¼noperform

ance

auditin

1997butsomeperform

ance

auditin

2000.

cDummyvariable:0¼noperform

ance

auditin

2000and1¼perform

ance

auditin

2000.

d1,000FIM

.eFIM

percapita.



Table

2

DescriptiveStatisticsandCorrelationsforMunicipalAuditin

Norw

ay(N

¼298)

Variable

Mean

St.Dev.

12a

34

56

78

9

1Governance

structure

a0.98

0.15

2aChangein

perform

ance

auditb

0.11

0.31

0.05

3Left-w

ingrepresentatives

0.35

0.15

�0.00

0.10

4Auditorturnoverc

3970.59

3621.54

�0.22***

0.00

0.02

5Municipalinhabitants

11435.93

34707.44

�0.61***

�0.02

0.07

0.55***

6Operatingincomec

410181.61

1715634.46

�0.55***

�0.02

0.06

0.56***

0.98***

7Debtpercapitac

21.56

9.22

0.13**

�0.03

0.07

�0.24***

�0.16***

�0.12**

8Taxpercapitac

11.92

4.08

�0.13**

�0.00

�0.13**

0.14**

0.19***

0.21***

�0.18***

9Centrality

1.72

0.86

�0.23***

�0.08

�0.02

0.30***

0.26***

0.19***

�0.37***

0.04

10

Auditfeespercapitad

100.34

61.26

0.12**

0.12**

�0.08

�0.06

�0.20***

�0.13**

0.34***

0.33***

�0.44***

Notes:

aDummyvariable:0¼unifiedgovernance

and1¼mixedownership.

bDummyvariable:0¼noperform

ance

auditin

1996and2000and1¼noperform

ance

auditin

1996butsomeperform

ance

auditin

2000.

c1,000NOK.

dNOK

percapita.



Thus, the answer to our first research question is that the municipalities in

both countries predominantly used auditors with mixed ownership (rela-

tional contracting) as their governance structure. The correlation coefficients

between governance structure and gross municipal operating income was

0.33 (p< 0.05) in Finland, and �0.55 (p< 0.01) in Norway. These figures

indicate that the small municipalities in Finland mostly used market con-

tracting and the small municipalities in Norway mostly used relational

contracting. The negative correlation of �0.13, in Finland, between the

ratio of left-wing representatives and governance structures corroborated

our expectation that municipalities with left-wing councils had relatively

less market-based governance structures. The correlation had the same

sign, but was hardly noticeable (�0.00), in Norway. However, since Norway

had no contracting out, it seems reasonable to assume that there were

no specific political preferences regarding the choice between internal or

district auditors in Norway. The correlation coefficients between audit fees per

capita and municipal inhabitants were �0.39 (p< 0.01) in Finland, and �0.20

(p< 0.01) in Norway, indicating economy of scale in the municipal audit.

Further analysis showed that there were decreasing audit fees per capita until

ca. 16,000 inhabitants, in Finland, and ca. 10,000 inhabitants, in Norway.

Multiple Regression Analysis of Audit Fees Per Capita

The regression analyses in Tables 3 and 4 address our second research

question on the relationship between governance structure and audit fees.

Because gross municipal operating income and municipal inhabitants were

highly correlated (see Tables 1 and 2), we only included municipal inhabi-

tants as the independent variable in the regression equation, in order to

avoid co-linearity.

The governance variable with three values was transformed into a dummy

variable for each country. For Finland, the governance variable had the

value 0 for mixed ownership and 1 for market contracting. For Norway, the

variable had the value 0 for unified governance and 1 for mixed ownership.

The resulting general regression equation is given by:

ðMunicipal audit fees per capitaÞ ¼ b0 þ b1ðgovernance structureÞþ b2aðchange in performance auditingÞ þ b3ðleftist political preferencesÞþ b4ðauditor sizeÞ þ b5ðmunicipal sizeÞ þ b6ðdebt per capitaÞþ b7ðmunicipal income tax per capitaÞ þ b8ðmunicipal centralityÞþ b2bðperformance auditing ½only for Finland�Þ þ e:

To test for the assumption of normally distributed data in regression

analysis, we run one-sample Kolmogorov-Smirnoff tests of normality. We

found all the size related variables, auditor turnover, municipal inhabitants



Table

3

RegressionofMunicipalAuditFeesa

PerCapitain

Finland(N

¼47)

ModelI(basicmodel)

ModelII

(som

elogtransformed

independentvariables)

ModelIII(som

elogtransformed

independentvariablesandlog

transformed

dependentvariable)

Independent

Variables

Regression

Coefficients

Standardised

Regression(Beta)

Coefficients

Regression

Coefficients

Standardised

Regression(Beta)

Coefficients

Regression

Coefficients

Standardised

Regression(Beta)

Coefficients

Constant

14.07

25.19*

4.99***

Governance

structure

b�6.30

�0.80

�2.15

�0.27

0.23

0.16

Changein

perform

ance

audit

�2.56*

�0.31

�1.11

�0.13

0.06

0.04

Left-w

ingrepresentatives

7.71*

0.38

5.50

0.27

�0.55

�0.15

Auditorturnovera

�0.00

�0.51

––

––

(Log)Auditorturnovera

––

�0.00

�0.05

0.00

0.14

Operatingincomea

�0.00

�0.04

––

––

(Log)Operatingincomea

––

�0.00***

�0.62

�0.00***

�1.04

Debtpercapitaa

�0.00

�0.15

�0.00

�0.07

0.00

0.01

Taxpercapitaa

�0.00

�0.28

�0.00

�0.22

0.00

0.05

Centrality

�0.50

�0.16

0.93

0.30

0.13

0.24

Perform

ance

audit

1.77*

0.29

1.34

0.22

�0.00

�0.01

AdjustedR2

0.25

0.39

0.75

F-value

2.67**

4.28***

16.52***

Notes:

aFIM

.bDummyvariable

(Finland):0¼mixedownership

and1¼marketcontracting.

Significance

levels:*¼p<0.10,**

¼p<0.05,***¼p<0.01.



Table

4

RegressionofMunicipalAuditFeesa

PerCapitain

Norw

ay(N

¼298)

ModelI(basicmodel)

ModelII

(som

elogtransformed

independentvariables)

ModelIII(som

elogtransformed

independentvariablesandlog

transformed

dependentvariable)

IndependentVariables

RegressionCoefficients

Standardised

Regression(Beta)

Coefficients

Regression

Coefficients

Standardised

Regression(Beta)

Coefficients

Regression

Coefficients

Standardised

Regression(Beta)

Coefficients

Constant

41.74

452.74***

19.22***

Governance

structure

b�16.07

�0.04

�67.70***

�0.17

�2.53***

�0.18

Changein

perform

ance

audit

20.89**

0.11

24.07***

0.12

0.62***

0.09

Left-w

ingrepresentatives

�24.59

�0.02

36.70**

0.09

�0.16

�0.01

Auditorturnovera

0.00***

0.18

––

––

(Log)Auditorturnovera

––

0.01***

0.17

0.00***

0.12

Operatingincomea

�0.00***

�0.23

––

––

(Log)Operatingincomea

––

�0.04***

�0.69

�0.00***

�0.78

Debtpercapitaa

0.00***

0.30

0.00***

0.22

0.00***

0.13

Taxpercapitaa

0.00***

0.40

0.00***

0.40

0.00***

0.31

Centrality

�24.95***

�0.35

�8.76***

�0.12

�0.15

�0.06

Perform

ance

audit

––

––

––

AdjustedR2

0.40

0.66

0.66

F-value

25.71***

73.59***

72.68***

Notes:

aNOK.

bDummyvariable

(Norw

ay):0¼unifiedgovernance

and1¼mixedownership.

Significance

levels:*¼p<0.10,**

¼p<0.05,***¼p<0.01.



and gross municipal operating income, as well as the dependent variable

audit fees per capita, to be significantly non-normally distributed (p< 0.05).

We also used models with natural log transformed variables in the analyses,

but the auditor turnover variable remained significantly non-normally dis-

tributed. In order to test for the assumption of no co-linearity between

the independent variables, we examined the tolerance and variance inflator

(VIF) indexes. Only governance structure (dummy variable) and auditor turnover,

in Finland, (where Audiator OY was very large and had a market share of 85%, in

our sample) were the independent variables in our models that exceeded the

critical values of being below 0.10 or above 10, respectively.

Tables 3 and 4 present the results from ordinary least square (OLS)

multiple regression analyses with municipal audit fees per capita as the

dependent variable for Finland and Norway, respectively. The main hypo-

thesis in our study, hypothesis 3, that competition (less use of unified govern-

ance) is related to relatively low audit fees per capita, was corroborated in

both Finland and Norway, but the relationship was significant (p< 0.01) only

for two models with the Norwegian data. Change in performance audit as

proxy for increased asset specificity was positive, as expected, in one model

for Finland, and positive and significant (p< 0.05) for all three models for

Norway. The ratios of left-wing representatives in the municipal councils

were both negatively and positively related to audit fees per capita in Finland

and Norway, resulting in an indeterminate conclusion on this issue. There

was an indeterminate relationship in Finland, but a positive relationship

(p< 0.01) in Norway, between auditors’ turnover and audit fees per capita.

The coefficients for the relationship between audit fees per capita and the

municipalities’ bargaining power indicator (log of) municipal income, were

negative in Finland and Norway, and significantly so (p< 0.01) in five

models. Our expectation of a positive relationship between debt per capita

and audit fees per capita was corroborated in one model, for Finland, and

significantly (p< 0.01), in all three models for Norway. However, Nordic

municipalities have a relatively high credit rating. As a consequence, exter-

nal auditors may not consider their own financial risk to be a matter of

concern in their appraisals of the financial situation of their municipal

clients, and the issue may not be a major decision variable in any of the

Nordic municipal audit markets. Our expectation that agency costs (audit

fees per capita) were positively related to municipal personal income taxes

per capita, was supported in one model for Finland, and was significantly

supported (p< 0.01) for all three models in Norway. We expected a negative

relationship between centrally located municipalities and audit fees per

capita, and this expectation was supported in one model in Finland, and it

was significantly supported (p< 0.01) in all models for Norway. In Finland,

the inclusion of performance audit in the data was positively related to audit

fees per capita in two models and the relationship was significant (p< 0.10)

in one of the three models.



Multivariate Analysis of Governance Structure and Audit Fees Per Capita

The above analyses documented that governance structure and investment

in asset specificity do seem to have an effect on audit fees. Furthermore, the

auditors’ and the auditees’ relative bargaining strengths and agency and

production costs may also matter. We may now turn our attention to how

the actual governance structures conform to production and transaction

costs reasoning, in greater detail, keeping in mind that transaction costs

are unobservable variables in our research design.

Table 5 shows the results for audit fees per capita by governance struc-

tures and municipal size in Finland and Norway. All of the 1996 and 1997

audit fees in the analyses have been inflated to 2000 currency, using the

consumer price index (CPI). Table 5 shows that no Finnish municipality in

our sample (apparently) used unified governance2 and obviously no Nor-

wegian municipality used market contracting. The Norwegian data showed

that no municipalities with less than 15,000 inhabitants used unified govern-

ance. These findings corroborate our first hypothesis. Hypothesis 1 states

that large organisations have more unified governance of audit than small

organisations. However, it may be the case that some Finnish municipalities

had unified governance of some audit but did not include or report the costs

for this as audit fees. Interestingly, most of the Finnish (85%) and even more

of the Norwegian municipalities (98%) chose to use an auditor with mixed

ownership, despite the fact that relational contracting was relatively costly,

measured as mean audit fees per capita, for most of the municipalities in

both Finland and Norway. Relational contracting was the dominant govern-

ance structure in the group of large municipalities in both Finland and

Norway. This finding supports hypothesis 2.

Table 5 presents the data for testing hypothesis 3, that increasing compe-

tition reduces audit fees. It shows that the mean audit fee per capita was

apparently much lower in Finland than in Norway. The audit fees per capita

were FIM 6.30 in Finland, and NOK 100.30 in Norway, corroborating our

notion that there might be substantial differences between the two countries

in the content of the audit. The findings support the notions that competi-

tion and contracting out may have effects on the content of the audit and on

audit fees. (In order to compare the audit fees directly, the currencies must

be converted. See the notes to Table 5.) Contracting out in Finland might

have resulted in relatively low audit fees due to high efficiency and to

lowballing. At the same time, audit fees in Norway may initially have been

relatively high, due to the lack of competition in the Norwegian municipal

audit market. However, and as stated above, audit fees should not be

compared directly between the two countries. Table 5 also shows that the

mean municipal audit fees per capita, in Finland, rose by 7.4% from 1997 to

2000. This was an annual increase of 2.5%. The audit fees per capita, in

Norway, rose by 6.5% from 1996 to 2000. Audit fees per capita, in Norway,



Table

5

MeanMunicipalAuditFeesPer

Capitain

Finland(N

¼47)andNorw

ay(N

¼298)byGovernance

Structure

andMunicipalSize

Finland(FIM

)Norway

(NOK)

Governance

1997

2000

1996

2000

Structure

Smalla

Largeb

Total

Smalla

Largeb

Total

Smalla

Largeb

Total

Smalla

Largeb

Total

Unified

––

––

––

–50.28

50.28

–53.43

53.43

governance

––

––

––

–(10.96)

(10.96)

–(10.18)

(10.18)

––

––

––

–[37.52–70.74]

[37.52–70.74]

–[40.92–70.99]

[40.92–70.99]

n¼0

n¼0

N¼0

n¼0

n¼0

N¼0

n¼7

N¼7

n¼7

N¼7

Relational

6.45

5.51

6.19

7.19

5.70

6.78

101.05

50.51

94.45

109.14

50.40

101.47

contracting

(3.13)

(2.68)

(3.01)

(2.79)

(2.46)

(2.76)

(56.72)

(12.67)

(55.74)

(62.29)

(13.68)

(61.55)

[2.26–13.34]

[1.46–10.65]

[1.46–13.34]

[2.38–14.38]

[3.02–10.91]

[2.38–14.38]

[34.23–457.59]

[21.40–81.47]

[21.40–457.59]

[37.79–560.56]

[18.29–84.36]

[18.29–560.56]

n¼29

n¼11

N¼40

n¼29

n¼11

N¼40

n¼253

n¼38

N¼291

n¼253

n¼38

N¼291

Market

5.25

2.01

4.32

4.77

1.81

3.92

––

––

––

contracting

(2.89)

(0.57)

(2.85)

(0.95)

(0.44)

(1.65)

––

––

––

[2.14–9.54]

[1.60–2.41]

[1.60–9.54]

[3.20–5.61]

[1.50–2.12]

[1.50–5.61]

––

––

––

n¼5

n¼2

N¼7

n¼5

n¼2

N¼7

n¼0

n¼0

N¼0

n¼0

n¼0

N¼0

Total

6.28

4.97

5.92

6.83

5.10

6.36

101.05

50.47

93.41

109.14

50.87

100.34

(3.08)

(2.79)

(3.03)

(2.74)

(2.68)

(2.80)

(56.72)

(12.30)

(55.51)

(62.29)

(13.14)

(61.27)

[2.14–13.34]

[1.46–10.65]

[1.46–13.34]

[2.38–14.38]

[1.50–10.91]

[1.50–14.38]

[34.23–457.59]

[21.40–81.47]

[21.40–457.59]

[37.79–560.56]

[18.29–84.36]

[18.29–560.56]

n¼34

n¼13

N¼47

n¼34

n¼13

N¼47

n¼253

n¼45

N¼298

n¼253

n¼45

N¼298

Notes:

aSmallmunicipalities<15,000inhabitants.

bLargemunicipalities�15,000inhabitants.

FIM

andNOK

in2000valuespercapita.The1997auditfeeswere

inflatedto

2000valuesbyusingtheFinnishconsumerprice

index(C

PI).TheCPIwas101.8

in1997and108.0

in2000with1995asthebase

year.The1996auditfeeswere

inflatedto

2000valuesbyusingtheNorw

egianconsumerprice

index(C

PI).TheCPIwas95.3

in1996and106.7

inDecember2000with1998asthebase

year.

Standard

deviationsin

parenthesis()

andminim

um

andmaxim

um

valuesin

brackets

[].

Thecu

rrency

exch

angerates31December,2000,were:1NOK¼0.7202FIM

¼0.07641GBP¼0.1211EURO.



rose only by 1.6% annually, from 1996 to 2000. On the basis of these

statistics, we can see that the annual increase in audit fees per capita was

higher in Finland, which we assumed had become relatively more competi-

tive, than in Norway. However, this finding must be seen in relation to the

high initial audit fees per capita, in Norway, the decrease in population in

some Finnish municipalities, and to the possible lowballing in Finland when

the market was deregulated in 1997. Thus, hypothesis 3, which claims that

more competitive markets have relatively lower audit fees, was corroborated,

but the notion that the most competitive market also experienced the lowest

increase in audit fees, was not supported. Note, however, that if the audit

fees had been measured in terms of the costs of external audit per audit day

purchased, the conclusion is different. These costs did not rise in Finland,

from 1997 to 2000, when the costs are adjusted for inflation. This finding

would support our hypothesis.

Hypothesis 4 predicted relatively volatile audit fees in market contracting.

In Finland, the audit fees in relational contracting rose by 9.5% while the

audit fees in market contracting fell by �9.3%. There are, however, too few

observations of municipalities with market contracting to be able to test

hypothesis 4 in any rigorous manner. Consequently, based on our evidence,

there was at best only partial corroboration for hypothesis 4.

There may be several reasonable explanations for the many substantial

changes in audit fees, in the Finnish market, during the period of our study,

which was the first contract period for auditors after the 1997 accounting

reform. There may have been uncertainties regarding the new accounting

and market regulations and inexperience in negotiating new and incomplete

contracts. There may well have been renegotiations concerning the content

of the audit and the level of audit fees, in many municipalities, during the

first four-year contract period. In addition, many Finnish municipalities

experienced a decline in population during this period of time, which may

partially explain the relatively large increase in audit fees per capita in

relational contracting. Moreover, in Finland, many municipalities owned

Audiator OY indirectly, through the Association of Finnish Local and

Regional Authorities. This may well have resulted in relatively weak muni-

cipal bargaining power, relative to this auditor, since Audiator OY was so

very large. In comparison, findings for the large municipality group with

mixed ownership, in Norway, show that audit fees per capita fell, from 1996

to 2000. Finally, for market contracting, there may well have been low audit

fees that were due to lowballing.

DISCUSSION AND CONCLUSIONS

In this study we have documented three main findings: First, widespread use

of relational contracting in the municipal audit market in both Finland and



Norway; second, low municipal audit fees (possibly partly due to lowballing)

and then a growth in audit fees in Finland; and third, relatively high (initial)

municipal audit fees in Norway.

A striking feature of the data was the large proportion of the municipal

audit that was governed through mixed ownership (relational contracting)

despite the fact that the audit fees per capita were seemingly relatively high

for this governance structure in both Finland and Norway. On the other

hand, the audit fees did not reflect transaction costs. If the majority of the

municipalities chose the most efficient governance structure, then there must

have been the anticipation of relatively high transaction costs, low audit

quality, or high political costs associated with using municipal auditors in

unified governance or contracted from the market. Low decision relevance

may have stemmed from a paucity of performance audit relative to economic

and organisational needs or called for by the government or by the munici-

palities. Such considerations have been major arguments for the establish-

ment of district audits in Norway. In Norway, 98% of the municipalities

chose district audits rather than unified governance. To a large extent,

Finnish municipalities have continued to use the auditors they had before

the 1997 reform (Audiator OY). However, one criterion for selecting market

contracting, for small Finnish municipalities, was to acquire general eco-

nomic and financial expertise, which means management audit and consult-

ing services, in addition to the traditional municipal audit. The majority of

the Finnish municipalities chose relational contracting, even though market

contracting is seemingly cost efficient. This finding strengthens the case for

asset specificity and economy of scale, as important factors for deciding upon

the governance of municipal audit. The finding of extensive use of relational

contracting supports Williamson’s (2000) call for an enhanced attention to

hybrid forms (mixed ownership, relational contracting) as a relevant and

important governance structure in studies of institutional economics and

organisation. A tentative conclusion might be that municipalities chose

relational contracting because the sum of audit fees, transaction costs and

political costs were minimised and the net benefit of audit were optimised in

this governance structure.

Relational contracting may have several economic advantages. Engaging

in long-term relational contracting instead of market contracting could avoid

recurrent start-up costs, which are high in the audit market (DeAngelo,

1981). Relational contracting of audit in mixed ownership could also facil-

itate economy of scale that only large municipalities with unified governance

or large accounting firms could otherwise have achieved. Mixed ownership

allows auditors to audit more than one municipality and to become larger

than would be the case in unified governance. These auditors can specialise

and invest in idiosyncratic human capital, a requirement to be able to

competently undertake public sector specific activities, like performance

auditing.



Relational contracting may have the lowest transaction costs for most

municipalities. Even though there is extensive uncertainty and asset specifi-

city in auditing, the high level of commitment in relational contracting (De

Ruyter and Wetzels, 1999) may save the audit clients the costs of continu-

ously monitoring the auditor (DeAngelo, 1981). Simultaneously, the govern-

ance structure of mixed ownership may facilitate sharing economic risk and

monitoring costs by the municipalities. The mixed client and ownership

status may also give municipalities an enhanced bargaining position to

counter opportunism (and reduce audit fees) relative to the auditors. More-

over, by relying on relational contracting the municipalities can potentially

avoid ex post contracting problems, in the circumstance that the initial

contract provides the auditor with a first mover advantage that prohibits

effective competition for subsequent contracts. Potential contracting out

would always pose the threat of competition and facilitate incentives for

efficiency. Finally, and perhaps most importantly, the long-term relationship

may develop trust in a way that substantially reduces opportunism and

related transaction costs, limiting the contingencies of incomplete contracts.

The majority of the municipalities may have chosen relational contracting in

order to avoid being dependent upon internal production or (large) external

accounting firms.

In addition to production costs and transaction costs, there may also be

political costs that have influenced the dominant choice of mixed ownership.

We have noted that Norwegian municipal councils were apparently more

‘left-wing’ than Finnish municipal councils, and that Norway did not allow

contracting out municipal audit while Finland did. Contracting out munici-

pal audit can become a contestable political question and generate substan-

tial political costs. As such, the extensive use of mixed ownership could

reduce the political costs relative to contracting out, as well as serve eco-

nomic purposes. Since mixed ownership is not pure market contracting, it

would probably not generate as much political resistance, from unions and

the Left, as full market contracting would have done.

Our study has essentially been an analysis of (a) market(s) in transition.

The research design has major limitations with regard to internal and

external validity claims. Results must be regarded as preliminary. Based on

the available evidence, we have no reason to put forward any claim that the

widespread use of relational contracting (instead of market contracting) in

municipal audit will continue. It may be the case that municipal audit has a

product life cycle (PLC) like many ordinary products. If so, then there may

very well be new developments where and when municipal audit technology

becomes relatively more common. Over time, a fully developed market

supply of municipal audit may evolve. An increase in market supply may

reduce the incentives to provide municipal audit in unified governance or in

relational contracting and this may be especially true for small municipali-

ties. If municipal audit conforms to PLC reasoning, then the seemingly



dominant governance structure of relational contracting/mixed ownership

may be a transitional state. When more municipalities get experience with

the diversity of available governance structures, they may begin to use

several governance structures simultaneously. Municipal audit markets

could evolve into more plural forms, subject to production costs, transaction

costs and the hazards of fragmentation.

Municipal audit fees in Finland had a larger annual increase than the

audit fees in Norway in the late 1990s. Price increases in the Finnish market

may have many explanations. Auditors may have competed for market

shares in the initial rounds, after the 1997 reform, by lowballing and reduced

audit fees in general. It is possible that audit fees in Finland rose because

pricing strategies within private audit firms included attempts at making

profits in the longer run. Finnish municipalities may have had problems

with incomplete contracts. In particular, too little audit time may have been

bought initially, due to inexperience with competitive tendering. More audit

time may subsequently have been bought at higher prices in later years.

Increased competition and contracting out municipal audit could lead to

higher audit fees, in the long run, in the market than would be the case with

a regulated market. This potentiality would depend upon a slew of factors,

including accounting regulation, uncertainty, initial market efficiency, bar-

gaining power, entry barriers and market rivalry. However, since we did not

have data for Finland prior to deregulation and since the long-run outcome

in Finnish and Norwegian markets are still uncertain, we can only speculate

about this matter at this time.

More inclusive book keeping of performance audit costs might explain

some of the relatively high audit costs in Norway as compared to Finland.

Despite this, we could still make a case for questioning the relatively high

(initial) costs in Norway. We might claim that inefficiency results whenever

non-optimal governance structures in the municipal audit market are cho-

sen. We might further claim that inefficiency will result when there is an

absence of sufficient competition in the municipal audit market. Finally, we

might claim that inefficiency will result when there are high monitoring costs

associated with keeping an idiosyncratic municipal accounting system and a

two tier local government structure with many small municipalities. Unfor-

tunately, at present, we have no evidence to firmly support any of these

claims.

Much of the preceding analysis of transaction costs has assumed rational

choice. But we might as easily have assumed that Norway and Finland have

organised the municipal audit market in an inefficient manner. That could

well lead to the understanding that if relatively more municipal audit were

contracted out, then the overall municipal audit market performance would

improve, at least in Norway. The Norwegian government could alternatively

or additionally harmonise the municipal accounting system to accrual

accounting, which could lower the overall municipal monitoring costs and



reduce the entry barriers in the municipal audit market for private auditors.

Moreover, the Norwegian government could re-organise the local govern-

ment structure resulting in larger municipalities with relatively more bar-

gaining power. However, these considerations are tentative because we only

had a small number of cases of unified governance and market contracting

available for our comparative analysis.

There are at least three viable research strategies for pursuing studies of

municipal audit and transaction costs further. A first strategy is to study the

development of municipal audit fees as the municipal auditors re-organise

and merge under the threat of possible market competition. Norway, during

the 1990s and early 2000s, may be an opportune case. A second strategy is to

study audit and transaction costs when municipal accounting systems are

harmonised with accrual accounting and generally accepted accounting

practice. Sweden’s reform in 1987, and Finland’s reform in 1997, may be

candidate cases. A third strategy is to pursue further studies of deregulated

municipal audit markets with longitudinal panel data studies or with case

studies of municipal audit contracting. Common for all three research

strategies is the need to develop agreed upon definitions and readily avail-

able and comparable statistics on municipal audit fees. In conclusion:

Although the available data in this study to some extent has supported

many of the TCA and contracting out propositions, how contracting out

affects municipal audit in the long run is still an open question.

ACKNOWLEDGEMENTS

Thanks to Juha-Pekka Martikainen for assistance in data collection for Finland.

Thanks to Liv Bente Hannevik Friestad, Ole Kristian Rogndokken and the

Norwegian Municipal Auditor Association for their help and comments in the

data collection for Norway. The authors acknowledge the comments received

when earlier versions of this paper were presented at: the 16th Nordic Conference

on Business Studies, Uppsala University, Sweden, August 16–18, 2001; the Nor-

wegian Association for Municipal Auditors Management Meeting, Gardermoen,

24 October 2001; the 10th Nordic Conference in Municipal Research, Turku,

23–25 November 2001; the Norwegian Research Council Workshop on Public

Sector in Transition, Høsbjør, 26–27 November 2001; the 11th Annual Confer-

ence in Management, Norwegian School of Economics and Business Administra-

tion, Bergen, 10–11 January 2002; the European Institute for Advanced Studies in

Management (EIASM) International Conference on Accounting, Auditing and

Management in Public Sector Reforms, University College Dublin, September 5–

7, 2002; and at the Nordic Workshop on Transaction Cost Economics in Business

Administration, Norwegian School of Economics and Business Administration,

Bergen, 20–21 June 2003. Lastly, the authors acknowledge the comments from

Lawrence Young and two anonymous referees.



NOTES

1 One could possibly argue that classical market contracting of audit does not exist and that allaudits are either internal or relational. When a municipality buys audit from an accountingfirm, the contract is a relation for a specific period and the municipality still has to assist inthe process. Moreover, in order to secure buyer competence, some supplier competence maybe maintained by keeping some audit internally, at least in large organisations. Contractingout of mandatory audit could thus be classified as (bi-lateral) relational contracting and onlya few audits, and mostly non-mandatory management services (consulting), are strictlyspeaking market contracting. Even these services could be termed relational contractingbecause one of the motives for lowballing could be to position the auditor in order to obtainconsulting services from the audit client on a regular basis (Firth, 1997 and 2002). Lowballingis the pricing strategy where audit firms quote audit fees that are below their start-up costswith new clients. It is a practice that is based upon the belief that future fees will exceedfuture marginal audit costs (Dopuch and King, 1996). However, in this study we havecategorised the contracting out of mandatory audit as market contracting, but we acknow-ledge that this is an operational definition and that the conceptual definition relative to TCAwarrants more clarification.

2 Unified governance is not allowed in municipal financial auditing in Finland. The LocalGovernment Act requires that municipalities contract out the mandatory financial audit.Furthermore, the certified public sector financial auditors may not work for the auditeeorganisation. This issue has been understood as a matter of auditor independence.

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Governance Structures and Contracting Out Municipal Auditing in Finland and Norway

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