The Audit Commission has been particularly worried that authorities have in some instances exceeded what they were legally entitled to do.
The conduct of the Hammersmith and Fulham council on interest rate swaps was found to be unlawful and outside its powers. Other councils, such as North Tyneside and Westminster, breached their powers by offering employees excessive severance and pension benefits to persuade them to take voluntary redundancy.
Audit Commission lawyers have also argued that councils have very limited power to conduct work for other organisations. Local authorities, they say, have no power to trade for profit and no authority to cover legal loss that may arise from risk involved in going for profit.
Local authority powers to trade, said the Audit Commission, arose from the 1970 Goods and Services Act, which allows councils to make a profit but only as a by-product. It does not permit councils to employ staff to undertake activities on behalf of others. Councils may conduct work on behalf of others only if it is marginal and short-term, and requires no additional employees or equipment to fulfil it. It is not permissable for employees' jobs to be dependent on work conducted for others.
Agency arrangements, in which a district council conducts work on behalf of a county council on road maintenance, for example, was not affected by the Audit Commission's legal interpretation. Legal advice taken by local authorities and their associations has suggested that councils do have a general power to undertake work for other public bodies.
The Audit Commission's view was welcomed by the Department of the Environment. When John Redwood was minister he made it clear to local authority associations that he did not believe councils should be in competition with the private sector. He accepted, however, that clarification was needed because of the difficulties caused to local authorities.
Local authority associations say this initiative has collapsed since Mr Redwood moved on. The DoE now simply confirms the Audit Commission's opinion, which has significant implications for local government reorganisation.
The creation of smaller unitary authorities may undermine the ability of many direct service organisations to be maintained, unless they are able to undertake work for neighbouring authorities to assist them with economies of scale. The result could be a significant boost for the private sector in winning council contracts.
There will be particular difficulties with those services where there is at present no private sector supply, as in some aspects of the social services, according to the Association of County Councils. It fears there will be undemocratic joint boards putting out contracts to a private sector without experience and with no pricing pressure - and possibly ending up with monopoly suppliers.
Direct Team, Lewisham council's direct service organisation (DSO), suggests that the underlying reason for the Audit Commission action is that DSOs have become too efficient for the Government's liking, proving successful in defeating the private sector in open competition. 'Some DSOs have become extremely effective. Direct Team ousted Initial and won London Fire's cleaning contract, despite paying twice the wages,' said Gillian Marston, business development manager for the DSO. But she suggested that the controls imposed by the Audit Commission have badly effected DSOs such as Lewisham's Direct Team.
'The maintenance of the royal parks went out to tender and we weren't able to quote, even for Greenwich Park which is very local to us,' she said.
Direct Team has been permitted by the district auditor to tender for and work on low value contracts, such as London Fire's building cleaning, parking enforcement for Greenwich borough and work for housing associations. Higher value work, in excess of pounds 2m, is precluded, such as taking on refuse collection contracts for other boroughs - which Lewisham would like to tender for.
'It is a very slurred situation for us,' said Ms Marston. 'It has never actually been tested in court - local authorities don't want to test it - but it does mean we are very restricted in where we can work.'
Lewisham believes that undertaking contracts for other public bodies has benefits to all involved. 'We can spread our overheads over a much larger income base, and share management, administration and information technology functions across a much larger area. It is advantageous to an area, provided money is not at risk - and we have strict guidelines to ensure that it is not,' Ms Marston added.
'It makes a lot of sense for local authorities to share costs, and it can save a council from spending money to develop its own service where a neighbour has already developed one, such as the parking enforcement arrangement with Greenwich,' she said.
Councils have also been questioned on their catering provision, both in running a service for charities or the general public. This could suggest there may be problems in the future for those councils that have not contracted out their management of leisure centres, which often sell food and drink.
Other councils have found difficulty in undertaking work for utility companies to reinstate roads after maintenance operations.
Authorities do have more leeway in providing services to grant-maintained schools, which can buy in administrative support not only from their local authority but also from neighbouring councils. Here, too, services can be provided by councils operating only 'within their margins of capacity'.
A spokesman for the education department explained: 'They can't employ extra people. If they supply within existing resources, that's fine. Otherwise they are, in effect, just re-employing people to maintain GM schools.'
The definition of a council's margin of capacity is for the district auditor to decide. Once that is done, a council must apply to the Secretary of State for Education for a two-year extension, beyond which the school must find alternative sources of supply. The clarity of this situation with grant-maintained schools is in contrast with the confusion on the wider general front. 'What councils are doing is keeping their heads down - not asking questions,' said John Roberts of the Association of Direct Labour Organisations. 'It seems to have gone quiet, but it will come to a head again with reorganisation.'
At some point before that, it will become imperative to clarify the legal situation is. That time might be now.