INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN PRIVITIZED COMPANIES IN UGANDA: A CASE OF...
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INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN PRIVITIZED COMPANIES IN UGANDA: A CASE OF CENTRAL PURCHASING COMPANY LIMITED (CPCL) ABAS JASPER OLWOL DBS, Bsc Accts/Finance (Hons) 11/2/501/E/428 SUPERVISOR: Dr Henry Buwule Musoke PhD, Msc, BBA (Hons) A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS ADMINISTRATION DEGREE OF NDEJJE UNIVERSITY SEPTEMBER, 2013
INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN PRIVITIZED COMPANIES IN UGANDA: A CASE OF CENTRAL PURCHASING COMPANY LIMITED (CPCL)
1. INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN
PRIVITIZED COMPANIES IN UGANDA: A CASE OF CENTRAL PURCHASING
COMPANY LIMITED (CPCL) ABAS JASPER OLWOL DBS, Bsc Accts/Finance
(Hons) 11/2/501/E/428 SUPERVISOR: Dr Henry Buwule Musoke PhD, Msc,
BBA (Hons) A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS ADMINISTRATION
DEGREE OF NDEJJE UNIVERSITY SEPTEMBER, 2013
2. i DECLARATION I Abas Jasper Olwol do hereby declare that
this dissertation is my own original work and has not been
presented to any institution/University for academic award or
otherwise by any person. Signature Date. Abas Jasper Olwol Reg No:
11/2/501/E/428
3. ii APPROVAL This dissertation has been submitted for
examination with my approval as a University Supervisor Signature
Date DR. Henry Buwule Musoke
4. iii DEDICATION I dedicate this research dissertation to the
almighty God, my late Father Benjamin Okwenye, my Mother Ms Leah
Okwenye, my Wife Ms Deborah Olwol and Children (Glad, Gloria and
Gabriel), brothers and sisters, my friend Opio Amed Sunday and all
those whose desire has seen me where I am now. May God bless you
all
5. iv ACKNOWLEDGEMENT Most of all I thank the Almighty God for
being a source of inspiration and for providing me wisdom and the
Grace to complete this research. I am greatly indebted to my
Supervisor, Dr. Henry Buwule Musoke for his guidance, encouragement
and patience even when I seemed not to understand. I also extend my
profound appreciation and thanks to family and most especially my
parents the late Benjamin Okwenye and Ms. Leah Okwenye, my wife
Deborah and Children, brothers and sisters Robinson, Dianah, Janet,
Night and Gift for having been understanding, tolerant, supportive
for along time. My gratitude also goes to my colleagues especially
Opio, Filder, Nicho, Wanyana, Harriet, Olive, Maureen, Kamukama,
Cissy and Linda who assisted and offered me the academic company I
needed during the MBA program, my pastor Moses Kakembo together
with the family of Luzira Healing Springs Church. Special thanks go
to the Central Purchasing Company management for allowing me carry
out this research; I also thank all staff especially those who
participated in this research by responding to questionnaires. For
all the above various groups and individuals and many others that I
may not have mentioned, in this acknowledgement, I owe this
achievement to you all and I will always remain indebted to
you.
6. v TABLE OF CONTENTS DECLARATION........Error! Bookmark not
defined. APPROVAL.......Error! Bookmark not defined.
DEDICATION...iii ACKOWLEDGEMENT ..iv TABLE OF CONTENT....v LIST OF
TABLES......viii LIST OF FIGURES..ix ABBREVIATIONS AND
ACRYOMNS..... .x
ABSTRACT...........................................................................................................
xi 1.0 INTRODUCTION
..........................................................................................
1 1.1 Background to the study
.................................................................................
1 1.2 Statement of the
problem................................................................................
6 1.3 Objectives of the
study......................................................................................
7 1.3.1 General objective
...........................................................................................
7 1.3.2 Specific objectives
.........................................................................................
7 1.4 Research
Questions.........................................................................................
7 1.4.1
Hypothesis....................................................................................................
7 1.5 Significance of the
study.................................................................................
7 1.6 Conceptual frame
work.....................................................................................
8 1.7 Scope of the Study
............................................................................................
9 1.7.1 Geographical Scope
.......................................................................................
9 1.7.2 Content
Scope................................................................................................
9 1.7.3 Time
scope.....................................................................................................
9 1.8 Definition of Key Concepts used in this
Study................................................ 9 1.9
Organization of the
study................................................................................
11 CHAPTER TWO.....12 LITERATURE REVIEW
..................................................................................
13 2.1 The nature of Internal
Controls.......................................................................
13
7. vi 2.1.1 Preventive Internal
controls:........................................................................
14 2.2 Financial Reporting
Quality..........................................................................
26 2.3 Internal Controls and Financial Reporting
Quality......................................... 33 2.4 Preventive
Controls and Financial Reporting
Quality.................................... 35 2.4.1 Detective
Controls and Financial Reporting
Quality................................... 36 2.5. Conclusion
....................................................................................................
38 CHAPTER THREE.38 METHODOLOGY
.............................................................................................
39 3.1 Research
Design..............................................................................................
39 3.2 Study Area and Population
.............................................................................
39 3.2.1 Study Area
...................................................................................................
39 3.2.2 Study
Population..........................................................................................
39 3.3 Sampling Design and Sample Size
.................................................................
40 3.3.1 Sampling
Design..........................................................................................
40 3.3.2 Sample
Size..................................................................................................
40 3.4 Data Collection Sources, Methods and
Instruments....................................... 40 3.4.1 Data
Sources
................................................................................................
40 3.4.2 Data collection
methods...............................................................................
41 3.4.3 Data collection
instruments..........................................................................
42 3.5 Data Processing and
Analysis.........................................................................
43 3.5.1 Data
Processing............................................................................................
43 3.5.2 Data analysis
................................................................................................
43 3.6 Ethical Considerations
....................................................................................
43 3.7 Limitation of the
Study...................................................................................
44 CHAPTER
FOUR...............................................................................................
45 FINDINGS OF THE STUDY
............................................................................
45 4.1 Demographic
Characteristics..........................................................................
45 4.1.1 Gender and departments of
respondents......................................................
45 4.1.2 Length of Service in the
Organization.........................................................
46 4.3. Preventive and Detective Internal Controls
................................................... 48 4.4.
Financial Reporting
Quality...........................................................................
52 4.5. Relationship Between Internal Controls and
FRQ......................................... 55
8. vii 4.6. Regression
Analysis.......................................................................................
58 4.6.1 Qualitative Data Presentation
......................................................................
59 4.6.3 Internal controls
...........................................................................................
59 4.6.4. Effectiveness of internal
controls................................................................
60 4.6.5 Accountability
procedure.............................................................................
61 4.6.6 Reporting
procedure.....................................................................................
61 CHAPTER FIVE.......61 5.0 SUMMARY,CONCLUSIONS AND
RECOMMENDATIONS62 5.1 Summary of Major
Findings...........................................................................
62 5.1.1. Objective One.
............................................................................................
62 5.1.2. Objective
two..............................................................................................
62 5.1.3. Objective
Three...........................................................................................
63 5.2
Conclusions....................................................................................................
63 5.3 General Recommendations
.............................................................................
64 5.3.1 Objective one
...............................................................................................
64 5.3.2 Objective
Two..............................................................................................
65 5.3.3 Objective
Three............................................................................................
65 5.5 Recommendation for further research
............................................................ 65
REFERENCES..65 APPENDIX I SELF ADMINISTERED
QUESTIONNAIRE...................... 69 APPENDIX II INTERVIEW
GUIDE:..............................................................
73 APPENDIX III :( NATURE OF INTERNAL CONTROLS)
......................... 74 APPENDIX IV (NATURE OF FINANCIAL
REPORTING QUALITY)..... 75 APPENDIX V KREJICE AND MORGAN (1970)
.......................................... 76 APPENDIX VI
INTRODUCTORY LETTER..76
9. viii LIST OF TABLES Table 3.1: Sample Size
.........................................................................................
40 Table 3.2: The Content Validity Index
.................................................................
42 Table 3.3 Reliability Test
Table............................................................................
43 Table 4.1 Respondents and their departments
...................................................... 45 Table
4.2: Length of Service in the
Organization................................................ 46
Table 4.3. Age of
Respondents.............................................................................
46 Table 4.4 Level of Education of the Respondents
................................................ 47 Table
4.5.Likert
Scale...........................................................................................
48 Table 4.6.showing Descriptive statistics
controls................................................. 48 Table
4.7 showing Descriptive Statistic of FRQ...51 Table 4.8
Relationship between Internal Controls and FRQ.....54 Table 4.9
Relationship between preventive control and Compliance....55 Table
4.9.1 Relationship between preventive control and Reliability...55
Table 4.9.2 Relationship between detective control and
Compliance...56 Table 4.9.3 Relationship between detective control
and Reliability......56 Table 4.9.4 Model summary.......57 Table
4.9.5 Analysis of Variables (ANOVA)57 Table 4.9.6 Standardised
Coefficient.............58
10. ix LIST OF FIGURES Figure 1.1: Conceptual frame work of ICs
and FRQ in Privitised Companies in Uganda...........7
11. x ABBREVIATIONS AND ACRYNOMS ACCA Association of Chartered
Certified Accountants AICPA American Institute of Certified Public
Accountants COBIT Control Objectives for Information and Related
Technology COSO Committee of Sponsoring Organizations CPCL Central
Purchasing Company Limited CPD Continuing Professional Development
CVI Content Validity Index FCPA Foreign Corruption Practices Act
FRO Financial Reporting Organizations GCPC Government Central
Purchasing Corporation HRO Human Resource Organizations ICPAU
Institute of Certified Public Accountants of Uganda ICS Internal
Control System IFRS International Financial Reporting Standards
IIA-UK Institute of Internal Auditors- United Kingdom SAC System
Audit ability and Control SAIGA The South African institute of
government auditor SD Standard Deviation SOX Sarbanes- Oxley Act
SSA Sub Saharan Africa
12. xi ABSTRACT Whereas extensive studies have been carried out
to explore and explain internal controls and financial reporting
quality in Privatized Companies worldwide, very few of these have
focused on Developing Africa and Uganda as a whole. This study
assessed internal controls and financial reporting quality in
privatized companies focusing on central purchasing company limited
(CPCL). A conceptual framework was developed on the internal
controls and financial reporting quality of Central Purchasing
Company. The specific objectives were (i) To access the nature of
internal controls used by Central Purchasing Company Limited. (ii)
To examine the nature of financial reporting quality at (Central
Purchasing Company Limited). (iii) To establish a relationship
between Internal Controls and Financial Reporting Quality. A
quantitative correlational cross-section survey and a case study
research design were used to collect data. Stratified and purposive
sampling techniques were used to select the respondents. Microsoft
Excel and SPSS were used to analyze the data and to present the
findings. Findings indicates that, the company had average internal
controls and most of them were functioning properly .The
correlation coefficient of r=0.914 indicated that there is a strong
positive relationship between internal controls and financial
reporting quality. Its thus recommended that Central purchasing
company management should ensure that all its internal controls
that are implemented are properly functioning and are not
undermined by its staff as a way of attaining financial reporting
quality (B.K. Sebbowa, 2009), .(Gerrit and Mohammad J. 2010). In
conclusion, given the correlation coefficient above its evident
that there is a strong positive relationship between internal
controls and the financial reporting quality of the company.
Recommendations were made focusing mainly on the need to improve
the weak areas such as verification of documents an aspect internal
control so as to achieve sustainable financial reporting
quality.
13. 1 CHAPTER ONE 1.0 INTRODUCTION This study presents internal
controls and financial reporting quality in privatized companies
with Central Purchasing Company as a case study. This Chapter
covers the background to the study, statement of the problem,
objectives of the study, research questions, hypotheses,
significance of the study, scope of the study, the conceptual frame
work and definition of key terms, and organization of the study.
1.1 Background to the study An internal control is a process
implemented by an organization structure work and authority flows,
people and management information systems, designed to help the
organization accomplish specific goals or objectives with means of
directing, monitoring and measuring of organization resources.
(COSO, 2005). Internal control activities have been established by
practitioners, primarily auditors. Rather than investigate to
control activities themselves, academics focused their research
efforts on issues surrounding the controls using an explicit, or
implied, assumption that the properties of the control activities
are known. (Barra & Roberta 2010; Ashton1974; Bodner 1975;
Cushing1974; Doty et al1989; Hornik and Ruf 1997 Simon 1974 and
Curtis1998) Aldridge and Colbert (1994) define internal control as
the process designed and effected by those charged with governance,
management and other personnel to provide reasonable assurance
about the achievement of the entitys objectives with regard to the
reliability of financial reporting, effectiveness and efficiency of
operation and compliance with applicable laws and
regulations.(Gerrit and Mohammad J. 2010), Also internal control is
defined as a process designed to provide reasonable assurance
regarding the achievement of financial reporting quality through
reliability of financial reporting and compliance with applicable
laws and regulations. (Schaefer& James 2010; Peluchett &
Joy 2009). Internal control is a process effected by an entity's
board of directors, management, and other personnel designed to
provide reasonable assurance regarding the achievement of
objectives in
14. 2 the following categories: reliability of financial
reporting, effectiveness and efficiency of operations, compliance
with applicable laws and regulations.( Stephen H, 2003), Internal
controls have existed from ancient times. It is common knowledge
among practicing accountants, managers and business scholars that
good internal controls prevent errors and frauds leading to
unqualified auditors opinion. External auditors may test the
effectiveness of internal controls and place reliance on the
underlying records as a basis for the preparation of financial
reports. (ACCA- Managerial Finance Paper 8; 2010; and Panday;2008)
. In the United States many organizations have adopted the internal
control concepts presented in the report of the Committee of
Sponsoring Organizations of the Tread way Commission (COSO).
Published in 1992.COSO describes internal control as consisting of
five essential components. These components, which are subdivided
into seventeen factors, include:The control environment Risk
assessment Control activities Information and communication
Monitoring The COSO model is depicted as a pyramid, with control
environment forming a base for control activities, risk assessment,
and monitoring. Information and communication link the different
levels of the pyramid. As the base of the pyramid, the control
environment is arguably the most important component because it
sets the tone for the organization. Factors of the control
environment include employees' integrity, the organization's
commitment to competence, management's philosophy and operating
style, and the attention and direction of the board of directors
and its audit committee. The control environment provides
discipline and structure for the other components. (Gerrit &
Mohammad J, 2010). Risk assessment refers to the identification,
analysis, and management of uncertainty facing the organization.
Risk assessment focuses on the uncertainties in meeting the
organization's financial, compliance, and operational objectives.
Changes in personnel, new product lines, or rapid expansion could
affect an organization. Sebbowa , (2009),
15. 3 Control activities include the policies and procedures
maintained by an organization to address risk-prone areas. An
example of a control activity is a policy requiring approval by the
board of directors for all purchases exceeding a predetermined
amount. Control activities were once thought to be the most
important element of internal control, but COSO suggests that the
control environment is more critical since the control environment
fosters the best actions, while control activities provide
safeguards to prevent wrong actions from occurring. Sarens, G.
& De Beelde, I. (2006b) Information and communication
encompasses the identification, capture, and exchange of financial,
operational, and compliance information in a timely manner. People
within an organization who have timely, reliable information are
better able to conduct, manage, and control the organization's
operations. Monitoring refers to the assessment of the quality of
internal control. Monitoring activities provide information about
potential and actual breakdowns in a control system that could make
it difficult for an organization to accomplish its goals. Informal
monitoring activities might include management's checking with
subordinates to see if objectives are being met. A more formal
monitoring activity would be an assessment of the internal control
system by the organization's internal auditors.In Hellenistic Egypt
there was a dual administration, with one set of bureaucrats
charged with collecting taxes and another with supervising them.
The sacking of Troy was a classic example of the failure of
internal controls. Mwindi (2008). Internal Control System (ICS) is
a very important function in the achievement of the organizational
success and successful management functions (The South African
institute of government auditor SAIGA 2003). It further pointed out
that when administrative and financial management decisions go
wrong, reference is usually made to ICS to seek out possible
reasons. On the other hand, financial statement is a written report
which quantitatively describes the financial health of a company or
an organization which usually includes the income statement,
balance sheet, cash flow statement and the statement of retained
earnings. (Myojung; Kim and Lim 2010).
16. 4 Financial report Quality on the other hand refers to
statements prepared to the required accounting financial reporting
standards to show the financial position of the business at the end
of the financial/accounting year and these statements must meet the
following characteristics which include; understandability,
comparability, relevance and fair presentation.(Aharony, J and A.
Dotan, 2004) According to Welsch and Chesley(1990) the notes of
balance sheets, cash flows statement, statements of changes in are
integral part of financial statements and help users interpret the
statement, elaborated on accounting policies, major financial
effects and certain non quantifiable events that may contribute to
the success or failure of the business. The objective of financial
statements is to provide financial information about the reporting
entity that is useful to present and potential equity investors,
lenders and other creditors in making decisions in their capacity
as capital providers. (Murray, 2010). The Financial Accounting
Standards Board and the International Accounting Standards Board
releases a joint exposure draft proposing significant changes to
how businesses present their financial statements. Two major
objectives of the proposed financial statements are disaggregation
and "cohesiveness." Disaggregation means, simply, that information
on the financial statements will be broken into more detail than is
currently done, Cohesiveness means that financial information
expenses on the statement of comprehensive income to specific
assets or liabilities on the balance sheet and to specific cash
flows on the statement of cash flows. (Wagoner, Joel, 2011).
According to Osborne and Gaebler 1992, privatization is the shift
of functions, activities and responsibilities from the public
(government) sector to the private sector. It involves a process
where the government gradually and progressively eliminates their
involvement in direct service provision while maintaining
responsibility and authority over key functions such as
standardization, certification and accreditation. According to
Megginson and Netter 2001, Privatization is the deliberate sale by
a government of state-owned enterprises or assets to private
economic agents.Andrews and Dowling, 1998 describe Privatization as
a process by which state owned enterprises are sold to the private
sector
17. 5 In 1991/92 financial year, Uganda had about 140
State-Owned Enterprises covering a diverse range of activities from
trade and commerce, agricultural production and processing,
manufacturing, hotel and tourism, banking, insurance and utility
services. Over 85% of these State-Owned Enterprises were commercial
in nature and were considered unlikely to survive in competition
with the emerging private sector without significant continuing
government subsidy (Adam Smith Institute, 2005). In 1993,
privatisation and reform supporting legislature, the Public
Enterprises Reform and Divestiture Statute 1993, Statute No. 9,
(thereafter referred to as the PERD 1993 Statute) was then passed
by parliament and enacted to give legal backing to the policy
reform objectives. This was a pre-reform set of activities and an
enabling law formulation that legalized the Economic Reform
process. The law served to safe guard outcomes of the operations
and future legal consequences. However some of the enterprises such
as Lake Victoria bottling company a soft drinks company and Nile
Breweries had already been privatised before the law was passed!
The PERD 1993 Statute provided guidelines for the reform and
divestiture. It categorized the enterprises that were to be
reformed or divested under the programme, laid down the
implementers and the modes of privatisation that would be used in
the process. There were subsequent amendments to the statute along
the way. Following continued criticism from the World Bank and
International Monetary Fund (IMF) regarding poor performance of
public enterprises especially in Sub-Saharan Africa (SSA), many
governments have had to implement Structural Adjustment Reforms to
try and improve their economies and to gain access to financial
credit facilities and so did Uganda (Tangri et al. 2001). In May
1987, Uganda government took a stand to embrace a radical Economic
Recovery Programme (ERP) to improve the performance of the economy
and ensure sustainable growth. This programme introduced
privatisation into the economy and this involved rationalization of
state ownership, liberalization, rehabilitation, divestiture,
consolidation and liquidation. The privatisation programme is part
of the overall Economic Recovery Programme (ERP) and its adoption
was intended to invigorate the private sector so that it could make
the private sector play a leading role in the development of the
economy (Privatisation Unit 2005).
18. 6 The Central Purchasing Company was formed following the
divestiture of the Government Central Purchasing Corporation
(GCPC). GCPC had been set up by government to procure common-user
items in bulk and supply these materials to Government at lower
prices taking advantage of economies of scale. GCPC eventually
started supplying to the private sector as well. In June 2000, GCPC
was privatized by way of a Management Employee Buyout under which
the former employees of GCPC forfeited their terminal benefits for
stock in the company. The company which was originally owned by
eighty six (86) individuals now trades as the Central Purchasing
Company Ltd (CPCL) with its main business being procurement and
trading for both the public and private sector. The company set up
should be designed to realize the objective of the company. However
an evaluation of the company structure, management of staff,
financial performance, decision making structures and levels that
procurement function did not portray alignment to the objectives.
For instance Companys capacity assessment of 1999 conducted by
private sector foundation revealed that most private companies go
down in business due to weakness and laxity in control systems.
B.K. Sebbowa, (2009) 1.2 Statement of the problem Despite the
availability of professional staff and their continued development,
internal and external auditors contribution in most Companies still
experience difficulty in presenting financial reports that reflect
the financial condition and results of operations in rational and
meaningful manner. According to Blackbeard (2006), information is
often delayed, inaccurate and relayed from person to person rather
than via reports; making it hard for Organizations to achieve
financial reporting quality . However despite all the above
efforts, the company still struggles with meeting acceptable
financial reporting quality, financial reports are not made timely,
accountability for the financial resources are still wanting,
frauds and misuse of the Companys resources have been unearthed (
Auditors Report,2011). If the Company continues in this direction,
decisions made may not be informed and this may lead to declined
performance. While there are many factors that affect Financial
Reporting Quality of privatized Companies, particularly Central
Purchasing Company Limited, Internal Controls may be playing a
significant role. It is for this reason that the
19. 7 researcher embarked on this study relating Financial
Reporting Quality (Compliance and Reliability) to Internal
Controls, specifically preventive and detective controls in Central
Purchasing Company Limited. 1.3 Objectives of the study This sub
section spells out the general and specific objectives of the study
1.3.1 General objective The general objective of the study was to
find out the effect of internal controls on financial reporting
quality in privatized companies in Uganda, using CPCL as a case
study. 1.3.2 Specific objectives i) To assess the nature of
Internal Controls used by CPCL. ii) To examine the nature and
Quality of Financial Reporting at CPCL. iii) To establish a
relationship between Internal Controls and Financial Reporting
Quality in CPCL. 1.4 Research Questions i) What internal controls
are being used by Central Purchasing Company? ii) What is the
nature and quality of financial reporting at CPCL? iii) What
relationship exists between the internal controls and the Financial
Reporting Quality? 1.4.1 Hypothesis There is no significant
relationship between Internal Controls and Financial Reporting
Quality. 1.5 Significance of the study. (i) The study may help
management of CPCL in setting policies that are relevant to
companys performance in improving their financial reporting. (ii)
The study may provide information and knowledge to academicians and
other researchers and also the study findings can generate
knowledge for the government about why privatized companies fail to
comply with financial reporting requirements. This can help the
government to identify what kind of technical support they should
provide the privatized companies before giving them any funding in
order to ensure acceptable quality of financial reports.
20. 8 (iii) The study may provide information that will assist
workers of CPCL and other stakeholders to improve on the existing
internal controls in the Company (iv) The study findings can also
help privatized companies in improving their compliance to
financial reporting requirements and thus improving their
capability to attract more development and ensure their companys
sustainability. 1.6 Conceptual frame work Independent Variable
Dependent Variables Mediating Variables Source: Conceptualized by
Researcher Figure 1.1 Relationship between internal controls and
financial reporting quality. Fig.1.1 provides a conceptual
framework relating internal controls to financial reporting
quality. The independent variables are internal controls and the
framework depict two elements of internal controls, namely
preventive controls and detective controls, all conceptualized to
have an effect on financial reporting quality. The dependent
variable in this study is the financial reporting quality which was
measured in terms of compliance to International financial
reporting standards and reliability for its purpose. The framework
further shows that there are moderating variables such as company
policies and systems, organizations efficiency through experience,
skills, knowledge and ethical behavior of staff ,For example,
despite the expected relationship between internal controls and
Financial Reporting Quality, organizational inefficiency can have
an opposite effect. Financial Reporting QualityInternal Controls
Compliance Reliability Preventive Controls Segregation of Duties
Approvals, Authorizations, and Verifications: Detective Controls
Reviews of Performance Reconciliations Internal Audit Company
policies and systems Organizational Efficiency Experience, skills
and knowledge of Staff
21. 9 1.7 Scope of the Study This sub section covers
geographical scope, content scope and time scope. 1.7.1
Geographical Scope The study was undertaken at the head office of
Central Purchasing Company Ltd located on plot 56 Bell Avenue West,
Jinja and two branches in Jinja District and Malaba in Busia
District. The researcher selected Central Purchasing Company Ltd
because it was the first Government Corporation to be sold to its
own employees under the privatization unit and pioneer of takeover
by employees in Uganda. The locations were chosen because Jinja and
Malaba office are the only remaining operational offices of Central
Purchasing Company Limited. 1.7.2 Content Scope The study focused
on accounting controls and was limited to two dimensions of
accounting controls ( preventive controls and detective controls)
as independent variables and financial reporting quality measured
in terms of compliance and reliability of financial reporting as
standards of measurement under internal financial reporting . 1.7.3
Time scope The study covered the period from 2002 to 2009 in order
to review the significance of internal controls on financial
reporting quality so as to come up with the necessary conclusions
and recommendations which would be generalized and applicable to
justify the study. The researcher was interested in this period
because it was the time Central Purchasing Company started selling
off its properties in Kampala and laying off employees. 1.8
Definition of Key Concepts used in this Study. Internal controls:
refers to a control environment and control procedures adopted by
management of an entity, to assist in achieving the practicable;
the orderly and efficient conduct of its business, adherence to
management policies, safeguarding assets, prevention and detection
of fraud and error, accuracy and completeness of records and timely
preparation of reliable financial information. (ISA 400 Risk
assessment and Internal control), Internal controls are those
measures which ensure the accuracy of financial statements through
preventive and detective control. Millichamp, (1996).
22. 10 These are measures which ensure the accuracy of
financial statements. Once financial statements are known to be
accurate, there will be increased reliance on the underlying
accounting system as a basis for the preparation of accounting
reports. Accounting control may include authorization, management
accounts (profit, loss account and balance sheet) produced monthly,
periodic stocktaking and valuation and reconciliation of bank
statements with the cash book. Millichamp (1996). Detective
Internal Controls: These controls are meant to expose those frauds
and errors that have not been prevented. An audit, both internal
and external will serve to detect errors and frauds, reconciliation
of bank accounts, reconciliation of debtors ledgers to their
controls accounts, cash and stock accounts will detect anomalies
that need to be investigated and decision to correct them made by
management. Supervision is also a detective control. (Institute of
Chartered Accountants of Britain and Wales, sept.1999).
Administrative Internal Controls are controls that are put in place
by management to ensure operational efficiency, effectiveness and
compliance with management policies in all departments or sections
of an organization. Administrative control may include
authorization to use equipment or entry to certain offices,
security of all the assets of the organization. Finance Markets
Authority (AMF).January2007. Financial Reporting. According to
Frank wood and Sangster, (1998) financial reporting is defined as a
discipline concerned with the preparation and presentation of
financial statements. While ACCA, (Foulks Lynch, 2005), defines
financial reporting as preparation of financial statement in
accordance to accounting standards. Its a statements prepared to
the required accounting financial reporting standards to show the
financial position of the business at the end of time period and
also the operating results by which the business arrives at this
financial position .It is of view that accountants rely on record
keeping systems particularly, double entry to produce meaningful
financial reports that summarize both the past and current
financial positions of the organization. Also financial
23. 11 reporting show past and projected finances and these
reports are both the sources of tax information and the means of
analyzing the business. Blake J (1999), Brookson (2001. Financial
reporting quality. Financial report is said to be of quality when
it meets all its characteristics like reliability, comparability,
relevancy, understandability and also measures a company's
financial performance during a specific accounting period.
Compliance of financial reporting. Compliance refers to practical
application of the existing laws and regulations and internal
policies in relations to IFRS framework. Coco indicates that
control comprises: those elements of an organization (including its
resources, systems, processes, culture, structure and tasks) that,
taken together, support people in the achievement of the
organization's objectives. Reliability of financial reporting is
all about information being fit for purpose. Where people have a
clear responsibility to do something and they need to use
information to do this, it brings the whole issue of reliability
into focus. The purpose for any financial information is aiding
management with clear decision concerning financial matters as
reliability is seen as an important concept in a number of other
fields such as engineering and research we are keen to see if the
theory in these areas may help us to understand how reliability
relates to audited financial statements. 1.9 Organization of the
study The Study covered five chapters as follows Chapter one covers
the background to the study, statement of the problem, general
objectives of the study, specific objective of the study, research
questions, hypothesis tested, significance of the study, the
conceptual frame work, and scope of the study, definition of key
terms and organization of the study. Chapter two presents a review
of related literature on internal controls and financial reporting
quality. Chapter three is the detailed descriptions of the research
methods and instruments employed in the study.
24. 12 Chapter four is a presentation and discussion of the
study findings based on the objectives aiming at internal control
system and financial reporting quality for the last seven years.
Chapter five presents the summary of the results, conclusion and
recommendations from the study.
25. 13 CHAPTER TWO LITERATURE REVIEW This chapter comprises the
concepts and views of authorities in this area of study that is
internal control and financial reporting quality and the
relationship between the two variables of the study. 2.1 The nature
of Internal Controls There are numerous definitions of internal
control, most of them having been drafted by professional
accountants organizations. This is the case for the definition of
internal control provided in 1977 by the French Institute of
Chartered Accountants: internal control is the set of security
measures which contribute to the control of a company. Its aim is
to ensure, on the one hand, the security and safeguard of assets
and the quality of information, on the other hand, the application
of instructions given by Senior Management, and to encourage
improvements in performance. It is evidenced through the
organization, methods and procedures for each of the companys
activities, so as to ensure the continuity of that company. Finance
Markets Authority (AMF).January2007. Internal control is a companys
system, defined and implemented under its responsibility, which
aims to ensure that: Laws and regulations are complied with; the
instructions and directional guidelines fixed by Executive
Management or the Management Board are applied, The Companys
internal processes are functioning correctly, particularly those
implicating the security of its assets. In determining its policies
with regard to internal control, and thereby assessing what
constitutes a sound system of internal control in the particular
circumstances of the company, the boards deliberations should
include consideration of the following factors: the nature and
extent of the risks facing the company; the extent and categories
of risk which it regards as acceptable for the company to bear; the
likelihood of the risks concerned materializing; the companys
ability to reduce the incidence and impact on the business of risks
that do materialize; and the costs of operating particular controls
relative to the benefit thereby obtained in managing the related
risks. (Institute of Chartered Accountants of Britain and Wales,
sept.1999).An internal control is broadly classified into
administrative and accounting controls.
26. 14 Administrative internal controls are controls that are
put in place by management to ensure operational efficiency,
effectiveness and compliance with management policies in all
departments or sections of an organization. Administrative control
may include authorization to use equipment or entry to certain
offices, security of all the assets of the organization. Accounting
internal controls are those measures, which ensure the accuracy of
financial statements. Once financial statements are known to be
accurate, there will be increased reliance on the underlying
accounting system as a basis for the preparation of accounting
reports. Accounting control may include authorization, management
accounts (profit, loss account and balance sheet) produced monthly,
periodic stocktaking and valuation and reconciliation of bank
statements with the cash book. Mill champ (1996).This control is
further classified into; Preventive, Detective and Corrective
internal controls. 2.1.1 Preventive Internal controls: These are
controls that are put in place by management to prevent the
accuracy of errors and frauds in the financial statements. These
controls include internal audit, recruitment of the right people
with adequate training and experience in the right places,
segregation of duties, authorization and approval of transactions
and surprise cash accounts in the cash office among many more. Coe,
Charles K, Ellis, Curtis (2010) Separating Approval and Payment. A
requirement that an employee who is authorized to initiate a
payment to a vendor is not also authorized to sign vendor payment
checks would be a preventive control. Among other things, such a
control is designed to reduce the risk of unauthorized payments,(
Krishnan, J. 2005). Limiting Access to IT Systems. Controlling
access to software programs related to accounting or payment
functions through the use of passwords and access codes is another
type of preventive control. Limiting the persons who can change IT
programs reduces the risk of unauthorized transactions. (Conor,
Errol &Divesh, 2006). Segregation of Duties: One of the
building blocks of internal control is segregation of duties. This
concept involves assigning responsibility for different parts of a
process to different people so that no one person can control the
entire process. The importance of segregation of duties stems in
part from the fact that collusion between two individuals is less
likely than misconduct
27. 15 by a single individual. Segregation also reflects the
lower probability that two persons will make the same error with
respect to the accounting for a transaction. Assigning
responsibility for physical access to a supply room to a different
person than the individual who is responsible for maintaining the
records of the supplies inventory is an example of segregation of
duties. (COSO, 2010). Approval, verification, and authorization The
first step towards controlling financial reporting is to ensure
that all transactions are properly authorized in accordance with
managements policies. Management authorizes employees to perform
certain activities and execute certain transactions within limited
parameters. In addition management specifies those activities or a
transaction that needs supervisory approval before they are
performed or executed by employees. A supervisors approval (manual
or electronic) implies that he or she has verified and validated
that the activity or transaction conform to established policies
and procedure (Rezaee, I&Zabihellah.B, 2002). Authorization is
the delegation of authority and it may be general or specific.
Giving a department permission to expend funds from an approved
budget is an example of general authorization, specific
authorization relates to individual transactions; it requires the
signature or electronic approval by a person with approval
authority. Approval of a transaction means that the approver has
reviewed the supporting documentation and is satisfied that the
transactions is appropriate, accurate and comply with the
applicable laws, regulations, policies and procedures. Generally
approvers review supporting documents, question usual items and
make sure that necessary information is present to justify the
transactions before they sign off on the transaction. As a general
rule, authorizations do both of the following (COSO, 2010).Require
advance approval, require written documentation of approval,
Dittenhofer, M. (2001). 2.1.2 Detective internal controls: These
controls are meant to expose those frauds and errors that have not
been prevented. An audit, both internal and external will serve to
detect errors and frauds, reconciliation of bank accounts,
reconciliation of debtors ledgers to their controls accounts, cash
and stock accounts will detect anomalies that need to be
investigated and decision to correct them made by management.
Supervision is also a detective control, (Hayes et al. 2005).
28. 16 Review of performance : While business firms require
ongoing changes in organizations' activities (Alles et al, 2006),
they also provide internal control effectiveness thoroughly
understanding in the way continuous monitoring adequacy is because
continuous monitoring ensures that firms are subject to operational
effectiveness, reliability of financial reporting, and regulatory
compliance. Therefore, continuous monitoring adequacy is a
component of internal controls that it serves preventive and
detective control, for example, when staff members who know their
work as well, they always perform their duties. In this research,
continuous monitoring adequacy is defined as the sufficient and
appropriate process of methodology for issuing the extent of firm
to monitor and evaluate internal control system, involvement of
long and short term action plan that the organization uses to
assess their plan on strategic objectives. The appropriate and
sufficient monitoring control includes of a performance by firm's
evaluators who respect, trust, and believe the operational control
system. The monitors such as internal auditors or to whom a company
assigns their duty to be continuous or ongoing monitoring by using
a highly a control skills, knowledge, and ability that they can
evaluate, summarize, and control effectively. Hence, continuous
monitoring leads to preventive and corrective firms' control system
before all members have gotten an effect on organization's goals.
The continuous monitoring adequacy will provide the strongest
support for company reporting, particularly, a reliance of
financial reporting (Shapiro and Matson, 2008) Communication:
Within organization, communication is very important baseline in
business firms for both inside and outside the firms (Duxbury and
Neufeld, 1999). However, particular intra organization
communications want more links from the staff members and college
to encourage information and knowledge (Zhang et al, 2005). When
firm acquires new information or company rules of internal control,
the senior management will make connections with the target groups
and might be aware of information and consciousness within the firm
(Yang and Maxwell, 2011). Therefore, the role of intra organization
communication needs a clear communication skills, or communication
in practice. Effective communications within organization allows
employees to recommend and suggest internal control guidance on
practical performance which is used in the day to day operations of
a business (Harvey et al., 2000). Organization communication has
been defined as a comprehensive and thorough of firm members who
are receiving or addressing on particular internal control topics
and issues
29. 17 completely, clearly, reliability and timeliness. The
potential of intra origination communication may address or stress
on the awareness between organization staffs regarding how a
quickly was relation with internal control information it is. If
firm members felt that their behavior had received incomplete or
not clear information that firm sends from the firm particular
internal control policies announcement, they perhaps feel most
dissatisfied consequently internal control doesn't effectiveness
(Oberg and Walgenbach, 2008). The control of channel communication
distribution information can help build effectiveness of internal
control mechanism (Nunlee, 2005). Firm must be quickly expanding
internal control information to all employees' levels. Moreover,
firm policies should show that its reliability can be assisted by
providing internal control actually happening at the intra
communication level within organization (Carlsson et al 2010;
Hogard et al, 2005).) Intra-firm communication possess is sharing
information, a potential adapter collect information before making
a decision impact on innovation in finance (Everdingen and Wiernga
2002). On the other hand, intra organization communication should
be designed to help both users and contributors to communicate and
share information within organization easily (Yang and Maxwell,
2011; Bardir et al 2009; Russo and Harrission, 2005; Millson and
Wilemon, 2002). The wide domain of potential intra organization
communication related to internal control effectiveness has a
significant criterion such as task performance and respect
(Driskill and Downs, 1995) especially accounting policy and firm
member belief or behavior respectively. (COSO). 2007 Risk
assessments: At present, every business firms requires risk
assessment to avoid and mitigate firm risk purposes. Risk
management system consists of manager's style and his philosophy,
linked with business strategy, and objective setting in operating
(Arena et al., 2010). The risk management today has moved from the
entity area of the firm to the corporate cover the firm (Arena et
al., 2010, Power, 2009). The sufficient and appropriated risk
management procedure may present internal control effectiveness by
senior executive management and board of director policies. Hence,
the senior management and board of director must understand risk
appetite more as the consequence organizational process (Power,
2009). The clear and sufficient accounting policies can make
appropriate internal control effectiveness (COSO, 2004). Therefore,
risk management efficiency is intended to reflect that firm has
been updated rules, standard of work,
30. 18 guidance, and especially a quality of compliance.
However, organizations using a weaker risk management process
focused on control compliance and experience are with more
difficulty (Arnold et al., 2011). The outcome of risk management
efficiency on the internal effectiveness is reliability of
financial reporting. Hence, risk management efficiency is a part of
the internal control effectiveness. Therefore, internal control
system is stemmed from the attitude and behavior of senior
executive management and Board of Directors' behavior that must
transparency, integrity, accountability, and competiveness, (B.K.
Sebbowa, 2009). Reconciliations. Independently comparing two sets
of records that relate to the same transaction and analyzing any
differences is a detective control. Reconciling the cash account
balance on the companys books to its bank records could identify
whether any payments recorded by the com- pany were not received by
its bank, or whether any withdrawals reported by the bank were not
accounted for by the company, (B.K. Sebbowa, 2009). Internal Audit,
Whittington & Pany (2001) suggest that internal auditing is
performed as part of the monitoring activity of an organization. It
involves investigating and appraising internal controls and the
efficiency with which the various units of the organization are
performing their assigned functions. An Internal Auditor is
normally interested in determining whether a department has a clear
understanding of its assignment, is adequately staffed, maintains
good records, properly safeguarding cash, inventory & other
assets and cooperates harmoniously with other departments. The
internal auditor normally reports to the top management. (Gupta,
2001) on the other hand asserts that Internal audit is an
independent appraisal function established within an Organization
to examine and evaluate its activities as a service to the
organization. The objective of internal audit is to assist members
of the organization in the effective discharge of their
responsibilities. According to Gupta the scope of internal audit is
determined by management. This may however, impair the internal
auditors objectivity and hampers his independence, it is quite hard
to report negatively on someone who determines the scope your work.
Although at a Seminar organized by the Institute of Certified
Public Accountants of Uganda (ICPAU), Sebbowa, 2009 in his
presentation The role of Internal Audit function in Organizations,
states that Independence is established by organizational and
reporting structure and that Objectivity is achieved by an
appropriate mindset. Sebbowa, 2009 also
31. 19 defines Internal auditing is an independent, objective
assurance and consulting activity designed to add value and improve
an organizations operations.ICPAU,(2009). It helps an organization
accomplish its objectives by bringing a systematic, disciplined
approach to evaluate and improve the effectiveness of risk
management control and governance processes. He further mentions
the principles of Internal audit to include; Integrity,
Objectivity, Confidentiality and Competency. However, given that
Internal Auditors are appointed by management, report to
management, and are employees of an organizations, their
objectivity is usually highly compromised Adams, M. B. (2006). In
accordance to Institute of Internal Auditors (IIA-UK; 1997),
independence is applicable to all categories of auditors. This
means the opportunity granted to the auditors to report directly to
the top authority. Woolf (1986), says, although an internal auditor
is an employee of the enterprise and cannot therefore be
independent of it, he should be able to plan and carryout his work
as he wishes and have access to the highest level of management.
However, Millichamp (1993) says, effective internal audit should be
carried out by an independent personnel though they are employees
appointed by management, for them to work efficiently, they should
have scope to arrange priorities and activities have un restricted
access to records, assets and personnel. Adams, M. B. (1994)
According to Bhatia (2003), Internal Auditing is the review of
operations and records sometimes undertaken within the business by
especially assigned staff. Its also an independent appraisal
function established within an organization to examine and evaluate
the effectiveness, efficiency and economy of managements control
system (Subramaniam, 2006). Its objective is to provide management
with re-assurance that their internal control systems are adequate
for the need of the organization and are operating satisfactorily
(Reid & Ashelby, 2002). It is a component of the internal
controls set-up by management of an enterprise to examine, evaluate
and report operations of accounting and other controls. The quality
and effectiveness of internal audit procedures in practice are
necessary since internal auditors cover a wide variety of
assignments, not all of which will relate to accounting areas in
which the external auditor is interested. For example, its common
these days for internal audit to undertake the extensive and
continuous task of setting management goals and monitoring its
performance (Woolf, 1996).
32. 20 Emasu (2010) notes that The effectiveness of internal
audit function partly depends on; legal and regulatory framework,
placement of the function and its independence, existence of audit
committees, resources allocated to the function and professionalism
of internal audit staff. It is however a bitter reality that
internal audit departments are rarely adequately facilitated.
Regarding the size and facilitation of the Internal Audit Function,
Gerrit and Mohammad (2010), found evidence in support of the
monitoring role of the Internal Audit Function. They specifically,
found evidence that management ownership is positively related to
the relative size of the Internal Audit Function, which is
inconsistent with traditional agency theory arguments that predict
a negative relationship, but more in line with recent studies on
earnings management. This finding suggests that increased
management ownership may influence the board of directors to
support larger Internal Audit Functions to allow them to closely
monitor managers performance. It is also plausible that management
with higher share ownership is motivated to invest in larger
Internal Audit Function for better monitoring of earnings and for
signaling to the board of directors that, despite their high stake
in earnings, they are convinced that appropriate use of resources
has to be assessed on a regular basis. Gerrit and Mohammad also
believe that the proportion of independent board members to have a
negative effect on Internal Audit Function size. This finding may
indicate a substitution effect, which means that independent board
members may be considered as an alternative monitoring mechanism to
the Internal Audit Function. They further assert that the control
environment has a significant effect on the relative size of the
Internal Audit Function. Specifically, a supportive control
environment characterized by formalized integrity and clear ethical
values, a high level of risk and control awareness, the perception
that risk management is important and the fact that
responsibilities with respect to risk management and internal
control are clearly defined is associated with a relatively larger
Internal Audit Function. ACCA (2010) Using a US sample, Wallace
& Kreutzfeldt (1991) found that companies with internal audit
departments are observed to be significantly larger, more highly
regulated, more competitive, more profitable, more liquid, more
conservative in their accounting policies, more competent in their
management and accounting personnel, and subject to better
management controls. Carey et al. (2000) found that agency
variables do not explain the voluntary use of internal audit
by
33. 21 Australian family firms. More recently, a study by
Goodwin-Stewart & Kent (2006), using a sample of Australian
listed companies, shows that the existence of an Internal Audit
Function is positively associated with firm size and commitment to
risk management. Sarens & De Beelde (2006) also show that the
risk and control awareness have an influence on the scope of the
Internal Audit Function. These results suggest that when management
is aware of risks and control activities, they are more likely to
understand the role of the Internal Audit Function in monitoring
risk and control activities, thus it is more likely that they will
support a relatively larger Internal Audit Function (Sarens &
De Beelde, 2006a; Selim & McNamee, 1999). Meigs et al (1988)
holds that there must be a strong internal control system and the
internal auditor must verify the operations of the system in much
the same way, as the external auditor. It involves the
investigation, recording, identification and review of compliance
tests of control, they also argued that effective internal audit
procedures provide sufficient relevant and reliable evidence in
order to detect and prevent fraud. ACCA (2009/2010) Kochan (1993),
considers auditing procedures in one company and describes steps
taken in implementing a quality assurance system, she discusses the
use of internal audits as an essential part of ISO 9000
certification process. Boakye-Bonsu (1999) asserts that internal
audit procedures are seen as ends in themselves rather than a means
towards a specific objective, with such an approach our rambler
would undoubtedly get lost. Internal audit procedure is a form and
content manual that includes audits notes and responsibilities,
documentation standards, local reporting standards and targets,
training requirements and expectations and performance measures and
indicators (Watts, 1999). Effectiveness is the achievement of goals
and objectives using factor measures provided for in determining
such achievement. However, it has been traditional in internal
auditing that determination of internal auditing effectiveness can
be accomplished by evaluating the quality and effectiveness of
internal auditing procedures that result in determination by the
internal auditors of the character and the quality of effectiveness
of the auditees control operations and if the auditing procedures
are effectively carried out, then the evaluative results are
positive (Dittenhofer, 2001). Maitin (1994) says efficiency and
effectiveness of internal audit procedures is not a simple task,
successful operation is governed by the extent to which the element
of internal audit procedures receive attention which include;
expertise, independence, objectivity and totality. Effectiveness of
internal audit procedures is a measure of the ability of the
programme to produce a desired effect or results that can be
34. 22 qualitatively measured (Harvey, 2004). Zabihollah (2001)
argues that, there should be effective internal audit procedures to
ensure reliability of financial statements, operational reports
safeguarding corporate assets and effective organizational
controls. Benston (2003) further supplements that perception and
ownership, organization and governance framework, legislation,
improved professionalism and resources were identified as functions
in the public sector derived from the effectiveness of the internal
audit procedures. How far internal audit procedures succeed in
their effort of effectiveness is mainly judged by three factors
that include; frequency of irregularities committed by the staff in
the organization in form of errors or fraud, the promptness with
which such irregularities are detected by the authorities and the
planning which makes possible repetition of such irregularities in
future more difficult (Reid & Ashelby, 2002). The work of the
internal auditor should appear to be properly planned, controlled,
recorded and reviewed. Examples of the due professional care by the
internal auditor are the existence of an adequate audit manual,
general internal audit plans, procedures for controlling individual
assignments and satisfactory arrangements for reporting and
following up. Earnest and Young (1995), The need for an internal
audit function will vary depending on company-specific factors
including the scale, diversity and complexity of the companys
activities and the number of employees, as well as cost/benefit
considerations. Senior Management and the board may desire
objective assurance and advice on risk and control. An adequately
resourced internal audit function (or its equivalent where, for
example, a third party is contracted to perform some or all of the
work concerned) may provide such assurance and advice. There may be
other functions within the company that also provide assurance and
advice covering specialist areas such as health and safety,
regulatory and legal compliance and environmental issues. In the
absence of an internal audit function, management needs to apply
other monitoring processes in order to assure itself and the board
that the system of internal control is functioning as intended. In
these circumstances, the board will need to assess whether such
processes provide sufficient and objective assurance. Kombo &
Tromp (2009) Assurance. When undertaking its assessment of the need
for an internal audit function, the board should also consider
whether there are any trends or current factors relevant to the
companys
35. 23 activities, markets or other aspects of its external
environment that have increased, or are expected to increase, the
risks faced by the company. Such an increase in risk may also arise
from internal factors such as organizational restructuring or from
changes in reporting processes or underlying information systems.
Other matters to be taken into account may include adverse trends
evident from the monitoring of internal control systems or an
increased incidence of unexpected occurrences.
http://audit.unlv.edu/InternalControls.htm The importance of
internal controls A companys system of internal control has a key
role in the management of risks that are significant to the
fulfillment of its business objectives. A sound system of internal
control contributes to safeguarding the shareholders investment and
the companys assets. Internal control (as referred to in paragraph
20) facilitates the effectiveness and efficiency of operations,
helps ensure the reliability of internal and external reporting and
assists compliance with laws and regulations. Kochan, A. (1993).
Effective financial controls, including the maintenance of proper
accounting records, are an important element of internal control.
They help ensure that the company is not unnecessarily exposed to
avoidable financial risks and that financial information used
within the business and for publication is reliable. They also
contribute to the safeguarding of assets, including the prevention
and detection of fraud. I. M. Pandey (2010). A companys objectives,
its internal organization and the environment in which it operates
are continually evolving and, as a result, the risks it faces are
continually changing. A sound system of internal control therefore
depends on a thorough and regular evaluation of the nature and
extent of the risks to which the company is exposed. Since profits
are, in part, the reward for successful risk taking in business,
the purpose of internal control is to help manage and control risk
appropriately rather than to eliminate it. (Institute of Chartered
Accountants of Britain and Wales, sept.1999) Does the company have
clear objectives and have they been communicated. So as to provide
effective direction to employees on risk assessment and Control
issues? For example, do objectives and related plans include?
Measurable performance targets and indicators? Are the
36. 24 significant internal and external operational,
financial, compliance and other risks identified and assessed on an
ongoing basis? Significant risks may, for example, include those
related to market, credit, liquidity, technological, legal, health,
safety and environmental, reputation, and business probity issues.
Is there a clear understanding by management and others within the
company of what risks are acceptable to the board? Internal control
will also be evaluated by the external auditors. External auditors
assess the effectiveness of internal control within an organization
to plan the financial statement audit. In contrast to internal
auditors, external auditors focus primarily on controls that affect
financial reporting. External auditors have a responsibility to
report internal control weaknesses (as well as reportable
conditions about internal control) to the audit committee of the
board of directors. (Nigel Turnbull, Rank Group Plc) Internal
control must be evaluated in order to provide management with some
assurance regarding its effectiveness. Internal control evaluation
involves everything management does to control the organization in
the effort to achieve its objectives. Internal control would be
judged as effective if its components are present and function
effectively for operations, financial reporting, and compliance.
The boards of directors and its audit committee have responsibility
for making sure the internal control system within the organization
is adequate. This responsibility includes determining the extent to
which internal controls are evaluated. Two parties involved in the
evaluation of internal control are the organization's internal
auditors and their external auditors. (Tim Row bury Internal, Audit
Consultant) At the specific transaction level, internal control
refers to the actions taken to achieve a specific objective (e.g.,
how to ensure the organization's payments to third parties are for
valid services rendered.) Internal control procedures reduce
process variation, leading to more predictable outcomes. Internal
control is a key element of the Foreign Corrupt Practices Act
(FCPA) of 1977 and the SarbanesOxley Act of 2002, which required
improvements in internal control in United States public
corporations. Internal controls within business entities are also
referred to as operational controls.
37. 25 Limitations of internal controls Internal controls are
procedures and policies to be followed when carrying out financial
transactions. Policies are mere guides to action to ensure
consistency in treatment of similar item at different times; being
guides they are subject to personal error of judgment. It is in the
interest of the organization that set procedures are followed when
handling financial transactions. Internal controls can offer only
reasonable assurance that management objectives are reached, this
is because of certain inherent limitations as follows;- Menon, K.
& Williams, J. D. (1994), Due attention is devoted to day to
day operational matters, but at the finalization stage of financial
reports, major adjustments are passed which may contain errors and
fraud. Internal controls can lead to internal rigidities that delay
decisions and financial reports. Internal controls already in use
may prevent creativity because procedures were set and must be
followed without deviation. Collusion among staff can be used to
undermine the internal control procedures leading to loss of
assets. Management resistance to controls. In a situation where
management does not support internal control procedures, it may
override controls to its own advantage. Internal controls work well
where management support is evident. Management support could arise
in form of staff recruitment policies, reviews of financial
information and taking corrective action where deviation from
control procedures is reported, Sarens, G. & De Beelde, I.
(2006b). Some internal control procedures are not cost effective;
the cost of a control is disproportionate to the cost of potential
loss due to errors and fraud. The effectiveness of internal control
system is always affected due to carelessness, distraction and
misunderstanding of instructions. Human weaknesses tone down the
effectiveness of internal control systems, Emasu (2007). Changing
business environment may cause inadequacy in procedural conduct of
business and thereby compliance with procedures becomes difficult.
(M.S. Ramaswamy, 1997). In the control activities, Authority
usually flows from the Board of Director to general
management.
38. 26 General management therefore exercises delegated
authority to ensure that all transactions both financial and non
financial are authorized. Separation of duties is implemented to
prevent intentional and unintentional errors and misstatements.
Duties such as custody of assets should be separate from
authorization; posting of ledgers should be separate from payments
and receipting of cash, ( Subramanian, N. 2006).. Documentation and
record keeping provide proof for the accuracy of transactions.
Transactions must be supported by third party invoices, receipts
and claim forms. Every transaction has to be recorded permanently
in the books of the organization, Ogneva, M., K. R. Subramanyam,
and K. Raghunandan. 2007. Unauthorized access to some offices like
cash, computer and stores is implemented to avoid loss of portable
assets and also to avoid deliberate damage to say computer
programs. (KPMG Audit Manual, 1988) 2.2 Financial Reporting
Quality. According to Collins and Collins (1978), a financial
report is a means of portraying financial accountability. In order
for an organization to review the financial activities of the past
year and make plans for the future it prepares and publishes annual
accounts or financial reports. According to Samuel (1991), these
are outputs of an accounting system and they are prepared at the
end of the year, hence the name final accounts. According to Horne
(1998), the financial reports should include a narrative
description of the organizations activities and audited financial
statements. He argues that these enable the stakeholders to see the
organizations performance and the overall financial situation of
the organization. Samuel (1991), states that managers and
accountants are usually required to defend the results shown in the
financial reports as part of the accountability process. According
to Gale (2003), financial reports must exhibit certain qualities
that make them useful to the stakeholders and these include
relevance, reliability, understandability and timeliness.
Australian Accounting Research Foundation (1990), stated that it is
important for financial reports to be relevant. They must have
value in terms in making and evaluating decisions about the
allocation of scarce resources and in assessing the rendering of
accountability by the providers. The reports must also be reliable
because users use them for decision making. Reliability means that
information is reasonably free from error and
39. 27 bias and faithfully represents what it purports to
represent. Understandability is the ability of users to understand
the financial reports. This will depend in part on their own
capabilities and in part on the way in which the information is
displayed. Timeliness of financial reports is very crucial because
reports which are relevant and reliable may be rendered irrelevant
if there is undue delay in presenting them, (ACCA- Managerial
Finance Paper 8; 2010; and Panday; 2008). . According to Gale
(2003), poor quality of financial reports greatly diminishes the
quality of NGOs. Quality information is one that is readable,
reliable, comparable, consistent, complete, timely,
decision-useful, accessible and cost effective. The integrity of
the nonprofit sector is served best if NGOs are accountable (Gale,
2003). Financial reporting quality can be associated with
investment efficiency in at least two ways. First, it is commonly
argued that financial reporting mitigates adverse selection costs
by reducing the information asymmetry between the firm and
investors, and among investors (Verrecchia, 2001). For instance,
Leuz and Verrecchia (2000) find that a commitment to more
disclosure reduces such information asymmetries and increases firm
liquidity. On the other hand, the existence of information
asymmetry between the firm and investors could lead suppliers of
capital to discount the stock price and to increase the cost of
raising capital because investors would infer that firms raising
money is of a bad type (Myers and Majluf, 1984). Thus, if financial
reporting quality reduces adverse selection costs, it can improve
investment efficiency by reducing the costs of external financing
and, as discussed in more detail below, the potential for financial
reporting quality to improve investment efficiency is greatest in
firms facing financing constraints, (Gale, 2003).. Second, a large
literature in accounting suggests that financial reporting plays a
critical role in mitigating agency problems. For instance,
financial accounting information is commonly used as a direct input
into compensation contracts (Lambert,2001) and is an important
source of information used by shareholders to monitor managers
(Bushman and Smith, 2001). Further, financial accounting
information contributes to the monitoring role of stock markets as
an important source of firm specific information (e.g., Holmstrom
and Tirole, 1993; Bushman and Indjejikian, 1993; Kanodia and Lee,
1998). Thus, if financial reporting quality reduces agency
40. 28 problems, it can then improve investment efficiency by
increasing shareholder ability to monitor managers and thus improve
project selection and reduce financing costs,( Reid, K.
&Ashelby, D. 2002). Based on the discussion above that
financial reporting affects both adverse selection and agency
conflicts, I predict an average negative relation between financial
reporting quality and both underinvestment and overinvestment.
These links complement research in Bushman, Piotroski, and Smith
(2005), which studies the relation between country measures of
timely loss recognition and the country propensity to liquidate bad
projects (i.e., mitigate overinvestment), and in Wang (2003) which
explores the relation between capital allocation efficiency and
accounting information quality for a sample of US firms, without
making a distinction between under- and overinvestment, Piotroski,
and Smith (2005). 2.2.1 Compliance of financial reporting
Compliance refers to practical application of the existing laws and
regulations and internal policies in relations IFRS framework. Coco
indicates that control comprises: those elements of an organization
(including its resources, systems, processes, culture, structure
and tasks) that, taken together, support people in the achievement
of the organization's objectives,( Boubakri et al 2004). Currently,
many business firms have adhered to compliance financial reporting
quality which is a mechanism tool for the financial reporting
procedure. Due to business, firms that senior management use
internal controls allow them to review and teach all staff how to
achieve companies' goals via policies. Firms that have staffs
member activities with compliance qualities also influence
reliability of financial reporting. The compliance quality,
particularly all firms accept compliance of financial control
practice that it is very important in every part of the business
(COSO, 2004). The ultimate aim must appear on financial reporting
that firm has to consider how compliance quality can be achieved
with regard to the company performance goals. For one reason, at
least, the company requirement is to appoint stakeholders to
implement and monitor systems for achieving quality of financial
reporting through internal control effectiveness. Firm should be
appropriate and complete an internal control system and the quality
of compliance monitored by manager. Including of all staff members
of audit committee,
41. 29 stakeholders, external auditor, and also internal
auditor should be encouraged to comment upon any matters which
could improve the compliance quality on the internal control
effectiveness, Sarens, G. & De Beelde, I. (2006b). Guidelines
and procedures, Financial reporting process must relate with the
agency rules and procedures significantly to determine whether firm
financial practices are in accordance with the statutory regulatory
principles set by the financial reporting standard board. For
example, if a firm has implemented a corporate financial management
approach, its effectiveness will be significantly determined by
user rules and procedures which prescribe use of financial
informations. Where client server e-mail is in use, e-mail specific
guidelines will be in use which account for the greater control
exercised by users and the decreased irretrievability of
information (Adolph, 1998). Regulators and accounting
standard-setters establish laws, rules, and standards relating to
the preparation of financial statements for external purposes.
These financial reporting rules and standards form the basis upon
which management specifies suitable objectives for the entity and
its subunits. When specifying suitable external reporting
objectives relating to the preparation of financial statements,
management considers the accounting standards that are applicable
to that entity and its subunits. Management also specifies the
accounting principles that are appropriate in the circumstances.
For example, management may set an entity-level external financial
reporting objective as follows: Our Company prepares reliable
financial statements reflecting activities in accordance with
generally accepted accounting principles.Management specifies
suitable sub-objectives for divisions, subsidiaries, operating
units, and functions with sufficient clarity to support
entity-level objectives. For example, a US company applies
accounting principles generally accepted in the United States of
America (US GAAP) to all subunits in preparing its consolidated
financial statements, and it applies International Financial
Reporting Standards (IFRS) to those subunits that submit subsidiary
financial statements in statutory filings in non-United States
jurisdictions, O. Ray Whittington & Kurt Pany (2001).
42. 30 Further, management specifies appropriate accounting
principles (e.g., US GAAP, IFRS) to apply to transactions and
events of the entity. For example, management specifies that FASB
Accounting Standard Codification No. 605 Revenue Recognition and
SAB 101A Revenue Recognition in Financial Statements (US GAAP) or
IAS 18 Revenue Recognition (IFRS) apply to all sales transactions
as applicable to the entity or subunits respective external
financial reporting objective,IFRS,(2010). 2.2.2 Reliability of
financial reporting Increasingly, reliability of financial
reporting in accounting context is very important for the investors
who used the information for decision management (Jenning et al.,
2008). The reliability of financial reporting is effective to
internal control efficiency to insure that the transactions of
account bookkeeping are appropriate and properly authorized, valid,
correctly record, complete, and on time. Moreover, it is very
important that companies are fairly summarized of accounting
information data disclosure. However, in general, a quality
reporting is affected by internal control mechanism. The internal
control is essential corporate governance mechanism of the firm
based on internal control statement quality that it should be to
control effectiveness and also influences the reliability of
financial reporting both in internal and external's firm (Skaife et
al, 2007) . This research project is intended to promote original
thinking to bring to life the concept of reliability as applied to
financial reporting. In particular, it will consider how auditors
could enhance users' confidence that information contained in
audited financial statements is reliable for the purposes for which
they want to use it. Reliability is all about information being fit
for purpose. Where people have a clear responsibility to do
something and they need to use information to do this, it brings
the whole issue of reliability into focus. As reliability is seen
as an important concept in a number of other fields such as
engineering and research we are keen to see if the theory in these
areas may help us to understand how reliability relates to audited
financial statements, Maitin, T.P. (2004).. Reliability and audited
financial statements
43. 31 We are starting from a strange set of circumstances. On
the one hand, financial reporting standard setters have taken steps
to move away from the concept of reliability, to the extent that it
no longer exists in the IASB/FASB Joint Conceptual Framework. At
this report, we also saw auditing standard setter, IAASB, is
inclined to accept the IASB/FASB view of reliability as well. And
so from the perspective of standards we are not supposed to talk
about reliability. Yet on the other hand, in reality, people
(including regulators) still refer to the need for reliability of
financial statements. There are a number of credible sources for
this. For instance, Hans Hoogervorst, the incoming Chair of the
IASB, said in a speech to a European Commission conference on 9
February 2011 that 'Financial statements should contain information
that is as unbiased and reliable as possible.' Also, the recent FRC
paper on effective company stewardship refers to the importance of
reliable information and that Investors and capital markets require
reliable in-depth information about the business of a company and
that Directors should describe in more detail the steps that they
take to ensure the reliability of the information on which the
management of a company, and therefore the directors stewardship is
based. The FRC paper goes on to say that the reliability of
financial statements is dependent on, among other things the
quality of the external audit. Short summaries of some of the
relevant fields and issues they raise are set out below. These are
presented in a way that introduces the idea of various levels to
how we may think about reliability, for example, from the starting
point of reliability of individual numbers through to audited
financial statements as a whole and all the way up to reliability
of organizations whole financial reporting processes. Such a way of
looking at reliability might help us to resolve some of the mixed
messages received from users, ACCA (2009/2010). Applying the
concept of reliability to financial reporting quality The intention
is to come up with some different approaches that might help to
connect with how people are talking about reliability in practice
in relation to financial reporting quality. It might also provide a
far better understanding of the role the auditors play in helping
to enhance reliability in audited financial statements.
44. 32 We have been looking at research on how investors rely
on financial reporting information and talking to investors about
what information is being used and how relevant and reliable it is
for their purposes. It exposes a mix of perspectives and objectives
of investment professionals. The problem is that investors are not
necessarily clear about what they need and why and that parties in
the financial reporting process (including standard setters,
companies and auditors) do not fully understand how they use and
rely on this information. We think that by mapping investors
different views on reliability to the different types of
reliability identified through looking at other fields it might
help our understanding of them and help piece together the
different types of reliability that investors look for in audited
financial statements. This will be the next phase of our work.
Materiality of financial reporting, a material weakness is a
deficiency, or a combination of deficiencies, in internal control
over financial reporting, such that there is a reasonable
possibility that a material misstatement of the companys annual or
interim financial statements will not be prevented or detected on a
timely basis. A significant deficiency is a deficiency, or a
combination of deficiencies, in internal control over financial
reporting that is less severe than a material weakness; yet
important enough to merit attention by those responsible for
oversight of the companys financial reporting. A deficiency exists
when the design or operation of a control does not allow management
or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely basis.
PCAOB Auditing Standard No.5 Understandability of financial
reports, Madison (2010) was of the view that the objective of
financial statements is to provide about the financial position of
an organization that is useful to wide range of users in making
economic decisions. Financial statements should be understandable,
relevant, reliable and comparable. Reported assets, liabilities and
equity are directly related to an organizations financial position.
Financial statements are intended to be understandable by readers
who have a reasonable knowledge of business and economic activities
and accounting and who are willing to study the information
diligently. Financial statements may be used by users for different
purposes. Owners and manager require statements to make important
business decisions that affe