1

The Impact of Internal Control Systems

On Financial Performance of Banks:

A Case of Banks in Pakistan

Muhammad Hanif

(051-10-113812)

A thesis submitted in partial fulfillment of the requirement for the degree of Bachelor in

Business Administration

Department of Management Sciences

IQRA UNIVERSITY, ISLAMABAD CAMPUS

(2015)

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Acknowledgement

I am happy to be a student in IQRA University that imparted my immense knowledge

about the Business Administration in bachelors Level. I had an opportunity to thank

the instructors who spared and spent the time to train me in this way. As per-requisite,

the thesis committee gave me an opportunity to prepare a research that discusses the

Impact of Internal Control Systems on Financial performance of private Banks. Many

people lent me a hand in this research; Ma’am Ayesha Rehan as a thesis supervisor

and a thesis teacher in IQRA University Islamabad Campus left no stone unturned to

help me gather data and discuss the solutions for the problems during the thesis

process.

Muhammad Hanif

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Chapter No 1

Introduction

1.1 Background

Internal controls can be referred as the ways introduced by a company in order to

make certain the accomplishment of company’s aims, targets, and objectives. They

are a set of strategies and methods taken up by an origination to make sure that all the

company’s deals are dealt in an effective way so as to ignore any kind of scam,

wastage, and exploitation of company’s resources. Internal controls are processes

planned and influenced by those in charge of supremacy, administration, and any

other private to offer a sound guarantee of the accomplishment of a company’s aims

regarding consistency of the financial reporting, efficiency and success of operations

and fulfillment of all the rules and regulations (Menon,2008).

It is very valuable to observe that internal controls only offers sound but not utter

deceleration to a company’s administration and board of directors that the aims of the

company will be accomplished. In order to ignore any wastage of resources,

accomplish industrial and performance objectives, facilitate the making of trustworthy

reports and make certain the fulfillment of rules, control systems are established by an

organization (Hayes, 2005).

It is generally believed that establishment and implication of effective internal control

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systems will direct towards better financial performance. It is also said that efficient

established internal control systems enhance the reporting procedure and also assist in

raising the level of reliable and trustworthy reports which improves the responsibility

task of administration of a company. However, current context still shows that despite

the fact that there Is presence of a system of controls in companies, financial

performance is vague in most of these companies (Sarens, 2011).

In this research, internal control systems were taken to mean a procedure influenced

by the organization’s board of managers, administration, and any other workers,

planned to offer sound guarantee related to the accomplishment of the following aims;

dependability of financial reporting, efficiency and value of actions, and obedience of

rules.

1.3 Problem Statement

Most institutions face the problem of liquidity, financial reports are not prepared on

time, responsibility for the financial resources of banks is still deficient, scams and

exploitation of organizational resources are still uncovered and quite some decisions

have not given the anticipated findings. Therefore, this study is carried out in order to

examine the constant bad financial performance from the view of internal controls

which are being avoided up till now.

1.4 Research Question

What is the impact of the control environment, internal audit and control activities on

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the financial performance of banks in Pakistan?

1.5 Rationale of the Study

The findings of this research will assist in discovering the disparity within the systems

of internal control in banks of great learning in Pakistan. The investigators also

believe that precious advantages to administration and those in charge of supremacy

in organizations of higher learning will appear on how to rationalize the systems of

internal controls hence making sure the improvement of financial performance and

eventually make certain the accomplishment of all the aims of organizations. The

research will also add up to the present information bank related to internal controls.

1.6 Objectives of the study

Following are the main objectives of the study:

To analyze the impact of control environment on financial performance in the

banking sector of Pakistan.

To analyze the impact of internal audit on financial performance in the banking

sector of Pakistan.

To analyze the impact of control activities on financial performance in the

banking sector of Pakistan.

1.7 Scope of the Study

The main purpose of this study was to check the influence of control environment,

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internal audit and control activities on the financial performance of banks in Pakistan.

The study was limited to banking sector of Pakistan.

The research was carried out in Islamabad city and was aimed at the workers of

banking sector located in Pakistan.

Chapter no 2

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Literature Review

As per Hayes (2005) internal authority is comprised of 5 elements that are: the control

environment, the information, the communication systems, the entity’s risk

assessment procedure, authorize actions and the observation of controls. On the other

hand, for reasons of the given research, the study would only be concentrating on the

three elements of the internal control system. Those are the control environment;

internal, control activities and internal audit. Rest of the elements is held stable.

According to Garcia (2007), internal control as the scheme of company and all the

procedures and ways taken up by the administration of a unit to help in accomplishing

management aims of making certain as long as possible, the orderly and effective

conduct of its business, counting in devotion to administration strategies, the security

of assets, avoidance and exposure of scam and mistakes, the precision and fullness of

all the records and the compilation of economic knowledge and data through reliable

and trustable sources.

Hence we can observe from the above that, properly introduced systems of control

would make certain the comprehensiveness of all the deals carried out by a unit, that

all the assets possessed by the unit are secured from any kind of scam or robbery, that

all the deals in the financial accounts are written accurately, that there is an existence

of all the assets in organization’s financial accounts and that they can be recovered

and that the company’s business deals are presented accurately and appropriately as

per with relevant exposure framework (Reid, 2004).

Generally, the term internal control is used to outline how administration works out in

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order to make certain that a company is able to accomplish its economic and other

aims. Internal control systems not only play a role in administrative efficiency but

also contribute to essential tasks of company boards of directors (Watts, 2004).

According to Johnson (2011), there are two important kinds of internal controls linked

with the administration of huge businesses, especially varied businesses, which have a

really major impact on company novelty, those are; financial controls and strategic

controls. Strategic controls are about the usage of the long term and tactically

appropriate criterion for the evaluation of business level administrator’s practices and

performance. Mainly slanted and at times, instinctive criterions for evaluation are

highlighted through strategic controls. In order to make use of strategic controls,

business administrators need to have quite some knowledge regarding business level

markets and operations. There is also a requirement of a strong data exchange among

divisional and corporate managers.

While financial controls require objective criterion like return on investment (ROI) in

the valuation of business level administrator’s performance. Therefore, senior

administrators set up financial targets for every business and calculate the business

level director’s performance opposed to those targets. This method could be

challenging when the level of interdependence between business groups is great.

Hence, importance regarding financial controls needs each section’s performance to

be greatly independent (Anderson, 2008).

As the business expands particularly through achievement, it also develops in

difficulties and the various elements that business directors need to manage and

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control. As we can see, every attainment boosts up business manager’s requirement

for data processing, at times radically so. These variations make it very complicated

for directors to utilize strategic controls. To decrease the demands of information

processing, they might alter their stress from strategic to financial controls (Krishan,

2006).

Goodwin (2009) believes that the control environment establishes the tendency of the

company by impacting the control awareness of the individuals. They furthermore

declare that control environment is known as the basic groundwork for all the other

elements of internal control. Control environment factors are comprises of: honesty

and moral values of workers responsible for manufacturing, managing and observing

the controls, dedication and capability of persons practicing duties that one is assigned

to, directors or inspection groups particularly the degree of their autonomy from

administration, importance and experience, management idea and style of working in

terms of their fierceness which might detect the degree of threat they face and

industrial structure, which could be a well-established structure that offers for right

plotting, managing and monitoring functions or an incompetent structure that might

only supply in order to create confusion among the main players by making vague

parts.

Donald (2009) recommends that internal inspection is practiced as part of the

observation activity of a company. It includes the appreciation and examination of

internal controls and the effectiveness of which the certain departments of the

company are carrying out their tasks. It’s the duty of a general auditor to make sure

that a section clearly understands its tasks, is effectively operated, keeps better

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records, keeping the cash secure, inventory and other assets and collaborates with

other sections. The internal inspector usually gives reports to the high management.

On the other hand, Curtis (2007) believes that internal examiner is a free assessment

function founded a company to investigate and estimate its actions as a service to the

company. The aim of the internal investigator is to help members of the company in

the significant release of their duties.

A study conducted by (Ejoh, 2014) focused control systems relying on the poor

security networks. The researcher believed an efficient check and balance of overall

financial transactions is necessary for internal controls systems. Furthermore efficient

and effective security system is key to reducing theft, and loss of property.

(Al-Matari, 2014) while researching on the effect of internal audit on firm

performance suggested the key characteristics of internal audit department increase

the overall firm productivity such as ; professional qualifications of the chief audit

executive of the Internal Audit , size, experience , and qualification.

Micheal (2010) states that there has to be a strong internal control system and the

internal investigator has to confirm the operations of the system in much the similar

method, as the external auditor. It includes the examination, footage, recognition and

view of fulfillment tests of control, they also disputed that efficient internal

investigator processes offer enough appropriate and trustworthy proof so as to identify

and putt off the scam.

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John (2011) separates internal controls into those that are general entity-wide controls

from those that are specific account-level controls. He believes that if management

was overriding control features in order to manage earnings, then one would expect to

find more Internal Control Weaknesses related to general controls, even if the specific

account-level controls are effective. On the other hand, a stronger argument could be

made that if general controls are in place and working, then one would expect to find

less Internal Control Weaknesses related to general controls.

Agency Theory describes firms as necessary structures to maintain contracts, and

through firms, it is possible to exercise control which minimizes opportunistic

behavior of agents. Accordingly, Menon (2008) posit that in order to harmonize the

interests of the agent and the principal, a comprehensive contract is written to address

the interest of both the agent and the principal. They further explain that the

relationship is further strengthened by the principal employing an expert to monitor

the agent.

Chapter no 3

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Research Methodology

3.1 Population and Sample

The target audience was the employees of the banking sector in Pakistan. Among 150

questionnaires distributed 130 were collected back .The sample size was 130

comprise of the employee’s of the Muslim commercial bank, Allied bank and Askari

bank located in Islamabad. Feedback forms were contributed to both male and female.

Convenient sampling method was used.

3.2 Instruments and measures

The questionnaire of this survey was adopted from (MAWANDA, 2008) .Five items

were about control environment, five were about internal audit, whereas five were

about control activities and the rest of five about financial performance. Data was

mainly compiled through the employee’s via five-point Likert scale, lying between

strongly disagree “1” to strongly agree “5. Regression Analysis was used to check the

impact of Independent variables over depends on variables, the regression equation

generated as follows:

Y = β1X1 + β2X2 + β3X3 +ε

Where Y is Financial Performance (Dependent Variable) X1 is Control Environment (Independent Variable)

X2 is Internal Audit (Independent Variable) X3 is Control Activities (Independent Variable)

3.3 Theoretical Frame Work

Independent variables Dependent variable

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3.4 HYPOTHESES

Researchers previously conducted suggest a connection between internal control systems and the financial performance, i.e. (Watts, 2004) suggested that Internal controls are necessary for achieving financial and economic objectives, hence leading

to better financial performance. Furthermore (Garcia 2007) suggested that effective control systems are key for conducting orderly and effective business. Based on much

literature support in this paper the below hypotheses were generated: H1: Control environment has a significant positive impact on Financial performance.

H1: Internal audit has a significant positive impact on Financial performance.

H2: Control activities have a significant positive impact on Financial performance.

3.5 Procedure

For the collection and analysis of the information, SPSS (statistical package for social

sciences) edition 17 was used. These examinations were used in studies which include

Internal Audit

Financial

Performance

Control

Activities

Control

Environment

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regression and correlation analysis. To check the impact of the independent variable

on the dependent variable, regression analysis was used. Correlation analysis was

used to verify the connection between independent and dependent variables. Scale

dependability analysis for the survey was done by discovering the Cronbach's alpha

figure by scale research SPSS. This study was done by a survey and was carried out

by an opinion poll. The questionnaires were divided among the participants

individually among the employees of banking sector located in Islamabad.

Chapter No 4

Results and Discussion

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Various statistical tests were used to find the impact of independent variables on the

dependent variable. Following is the results and findings from these tests:

4.1 RELIABILITY ANALYSIS

Table 4.1.1

Reliability Statistics of Control

Environment

Cronbach's Alpha N of Items

.753 6

Table 4.1.2

Reliability Statistics of Internal Audit

Cronbach's Alpha N of Items

.781 5

Table 4.1.3

Reliability Statistics of

Control Activities

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Cronbach's Alpha N of Items

.626 5

Table 4.1.4

Reliability Statistics of

Financial Performance

Cronbach's Alpha N of Items

.704 5

The given reliability table is indicating an important value of the survey. It gives a

0.704 figure which shows that the result of this survey can be trusted as they give

accurate outcomes.

Appropriate questions are asked in the survey. The outcomes of the reliability and

validity experiments reveal that the instrument used for this survey is reliable and

valid as it give the Cronbach's alpha value 0.704>0.6.

4.2 Frequency distribution

Table 4.2.1

age

Frequency Percent

Valid

Percent

Cumulative

Percent

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Valid 18-30 45 34.6 34.6 34.6

31-50 76 58.5 58.5 93.1

>50 9 6.9 6.9 100.0

Total 130 100.0 100.0

Interpretation:

In the given table 4.2.1 and its supplementary pie chart frequency division of

claimants are shown according to their age. This table shows that out of 130

respondents, around 45 or 34.6% are in a group of age 18-30 whereas 76 or 58.5%

consists of a group which includes age group of 31 to 50 and 9 or 6.9% is in the age

group of 50>. Therefore, it indicates a large number of respondents around the age of

31 to 50.

Table 4.2.2

gender

Frequency Percent Valid Percent

Cumulative

Percent

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Valid male 98 75.4 75.4 75.4

female 32 24.6 24.6 100.0

Total 130 100.0 100.0

Interpretation:

The above table and its associated value represent frequency distribution of claimants

in accordance with the gender. It indicates that 98 or 75.4% are male whereas female

respondents are around 32 or 24.6% out of 130 claimants. This clearly shows that

males participated more as compared to females.

4.3 Correlations

Table 4.3.1

Correlations

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Pearson correlation analysis is used to authenticate the Impact of Control

Environment, Internal audit and control activities on the financial performance of

banks in Pakistan.

The above table specifies that Pearson correlation research was used to confirm the

connections among the dependent variable. Correlation study proves an important

connection (at p<0.01 range) between all variables. The values 0.700**, 0.583** &

0.810** gives a significant connection between these variables that is dependent

variable (financial performance) and independent variable (Control Environment,

Internal audit and control activities).

4.4 Regression Analysis

Control

Environment

Internal Audit

Control

Activities

Financial

Performance

Control Environment

Pearson Correlation 1 .649** .649** .700**

Sig. (2-tailed) .000 .000 .000

N 130 130 130

Internal Audit

Pearson Correlation 1 .515** .583**

Sig. (2-tailed) .000 .000

N 130 130

Control Activities

Pearson Correlation 1 .810**

Sig. (2-tailed) .000

N 130

Financial Performance

Pearson Correlation . 1

Sig. (2-tailed)

N

**. Correlation is significant at the 0.01 level (2-tailed).

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Table 4.4.1

Model Summary

Model R R Square

Adjusted R

Square

Std. Error of

the Estimate

1 .847a .717 .710 .54344

a. Predictors: (Constant), Control Environment, Internal

audit and control activities

R square figure shows the percentage of change independent variable caused by the

independent variable. Around 71% difference is discovered independent variable

caused by independent variables.

Adjusted R square tells the fraction of variation after the amendments of mistakes in

the information independent variable (financial performance) and independent

variable (Control Environment, Internal audit and control activities).

Table 4.4.2

ANOVAb

Model

Sum of

Squares df Mean Square F Sig.

1 Regression 94.324 3 31.441 106.462 .000a

Residual 37.212 126 .295

Total 131.536 129

a. Predictors: (Constant), Control Environment, Internal audit and control

activities

b. Dependent Variable: Financial performance

The given table beneath the regression one shows a better fit of the model. The above

chart tells connotation figure is (p=.000), so can say that dependent variable (financial

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performance) and independent variable (Control Environment, Internal audit and

control activities) are situated in their proper places.

Table 4.4.3

Coefficients

Model

Unstandardized

Coefficients

Standardized

Coefficients

t Sig. B Std. Error Beta

1 (Constant) -.396 .195 -2.031 .044

Control Environment .203 .062 .231 3.250 .001

Internal audit .136 .068 .127 2.009 .047

control activities .699 .074 .594 9.417 .000

a. Dependent Variable: Financial Performance

Coefficient indicates the influence that has on dependent variable due to the

independent variable. The given figure of beta tracks the path of independent variable

towards the dependent variable. Dependent variable (financial performance) is

significantly influenced by independent variable (Control Environment) at (β=.231,

P=.001), and a significant impact has been noticed on dependent variable (financial

performance) caused by independent variable (Internal audit) at (β=.127, P=.001), and

dependent variable (financial performance) is greatly influenced by independent

variable (control activities) at (β=.594, P=.000). Hence, it provides evidence that

alternate hypothesis H1, H2, and H3 are acknowledged.

CHAPTER NO 05

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CONCLUSION & RECOMMENDATIONS

5.1 Conclusion

The focal point of this research is to investigate Impact of Internal control systems on

Financial Performance of banking sector in Pakistan. The results of this research are

even with the last investigation, which reveals many high degrees of control activities,

an association of economic planning regarding the internal audit, and financial threat

tolerance are connected with much insistent financial performance. This investigation

is dynamic in that three of these variables were examined at the same time. This will

permit us to build the comparative impact of the three forecasters. So, in the end, it

has been determined that internal audit, control activities and control environment has

efficiently influenced financial performance of financial institutions in Pakistan. All

in all, even though this kind of investigations offers challenges, it participates to our

knowledge of the elements that encourage workers to perform efficiently. Present

research determines comings from the center of its struggle and showed outcomes that

are well suited to the hypothesis of research presented and unspecified. Furthermore,

reliable and effective internal control systems will increase the financial performance

and along with that reduce the theft and losses occurring due to negligence. Strong

investment in internal control systems will also mitigate fraud.

5.2 Discussions:

The correlation coefficient of control activities with the dependent variable Financial

Performance is .810 suggesting a strong uphill (positive) relationship. This means a

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direct relationship is present between the variable and which is also significant as p-

value is less than .005

Furthermore, the correlation coefficient of internal audit with the Financial

performance is .583 showing a moderate uphill relationship. P-value settles at .000

suggesting a significant relationship.

In the case of control activities, the co-correlation coefficient presents a value of .700

and also showing a significant relationship as p-value is less than .005. A strong uphill

relationship can be found between these two variables.

Moving forward toward regression analysis, Analysis of variance presents a Sig. the

value of .000 proofing the model as a good fit model. Beta occurs at .594 for control

activities, .127 for internal audit and .231 for control environment suggesting a

positive relationship between Independent variables with the dependent variables.

In the light of literature, this study is inconsistent with previous researchers

suggesting the relationships of Internal control systems with financial performance

and also highlights the importance of such measure in Banks can enhance the

performance.

5.3 Recommendations

It has been recommended that to be greatly successful, printed objects, media

movements, and office interference plans designed to stimulate internal audit must be

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targeted at workers on the foundation of their financial performance. This will enable

the bar to rise with respect to the way financial performance courses are carried out.

Mostly nowadays group based interferences are inclined to cast a huge net while the

contestant solicitation stage. Concentrating more on small, all the same, compartment

of workers, yet, will permit performance analyst and interference experts to build

strong statements related to workers emotional predispositions, which will enable

them to polish up their point to the customer.

Economic consultants must utilize the outcomes of a first psychological evaluation

with the workers for therapy and learning reasons. For instance, a worker with less

financial information may take advantage from getting informational packages

regarding financial performance along with long scale performance aim setting

practices. This will contain the influence of concurrently improving the worker’s

knowledge of financial preparation, whereas expanding their attention on the

performance as well.

5.4 Future Research

This study focused only on the impact of Internal Control Systems on Financial

Performance of Banks thus further study should be conducted to evaluate its impact

on other organizations and financial institutions.

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Due to lack of resources, this study was limited to Islamabad region only; further

study can be done in other areas of the country covering large sample size.

This study is limited to Private sector banks only; another study should be conducted

to study the impact of internal control systems on financial performance in

government sector as well.

It would be interesting to conduct a study on the determinants of internal control

systems and their implications on financial performance; this will shed more light on

the appropriate model to choose when implementing better internal control systems

that enhance the financial performance of firms.

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References

Anderson, D., Francis, J. R. & Stokes, D. J. (2008). Auditing, directorships and the

demand for monitoring, Journal of Accounting and Public Policy, 4 (1), 190-286.

Curtis C. Verschoor. (2007). Corporate Performance is Closely Linked to a Strong

Ethical Commitment, 8 (5), 375-390.

Donald Kisilu Kombo & Delano L. A. Tromp (2009). Proposal and Thesis Writing,

An Introduction. Pauline Publications Africa. Nairobi, Kenya.

Garcia, B.M. A. (2007). Audit Reports on Financial Statements Prepared Accounting

to IASB Standards, 7 (1), 302-341.

Goodwin-Stewart, J. & Kent, P. (2009). The use of internal audit by Australian

companies, Managerial Auditing Journal, 2 (1), 42-56.

Hayes et al. (2005). Principles of Auditing Pearson Education Limited.

John J. Morris., (2011). The Impact of Enterprise Resource Planning (ERP) Systems

on the Effectiveness of Internal Controls over Financial Reporting, 2 (4), 652-680.

Krishnan, J. (2006). Audit committee quality and internal control: An empirical

analysis. The Accounting Review, 6 (3), 472-490.

Menon, K. & Williams, J. D. (2008). The use of audit committees for monitoring,

Journal of Accounting and Public Policy, 6 (2), 582-590.

Michael A. Hitt, Robert E. Hoskisson, Richard A. Johnson, Douglas D. Moesel.

(2008). The Market for Corporate Control and Firm Innovation, 4 (2), 249-321.

Reid, K. & Ashelby, D. (2004). The Swansea Internal Quality Audit Processes

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Quality Assurance in Education, 10 (4), 461-473.

Sarens, G. & De Beelde, I. (2011). The relationship between internal audit and senior

management: an analysis of expectations and perceptions, International Journal of

Auditing, 4 (3), 98-121.

Watts, H. (2004). A Conceptual Framework to Financial Reports and Internal Audits,

9 (3), 753-778.

John J. Morris K., (2011). The Impact of Enterprise Resource Planning (ERP)

Systems on the Effectiveness of Internal Controls over Financial Reporting, 5 (1),

439-492.

Mawanda, s. P. (2008). Effects of internal control systems on financial performance in

an institution of higher learning in Uganda.

atari, E. M. (2014). The Effect of the Internal Audit and Firm Performance: A

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Development .

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QUESTIONNAIRE

Demographic Variables

Age: 18-30

31-50

51 above

Genders: Male Female

Note: Please mark your appropriate response.

1 2 3 4 5

Strongly Disagree

Disagree Neutral Agree Strongly Agree

Control Environment

1 2 3 4 5

1. This Bank has an accounting and financial management system.

2. Management is committed to the operation of the system.

3. Management closely monitors implementation of internal

control systems in this Bank.

4. Appropriate measures are taken to correct misfeasance in the operation of our Accounting & Finance Management

System.

5. This Bank has an objective, independent and active audit committee.

Internal Audit

1 2 3 4 5

1. This Bank has an internal audit department.

2. Our internal audit is sufficiently staffed.

3. Internal audit staff conducts regular audit activities in this

Bank.

4. Internal audit staff conducts regular audit activities in this Bank.

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5 Internal auditor makes appropriate recommendations for management to improve.

Control Activities

1 2 3 4 5

1. This Bank has a clear separation of roles.

2. There is appropriate supervision by senior staff on the work of their juniors.

3. The staff is trained to implement the accounting and financial management system.

4. Controls are in place to exclude incurring expenditure in

excess allocated funds.

5. Our security system identifies and safeguards Institutional

Assets.

Financial Performance

1. This Bank has enough cash to meet its obligations effectively. 1 2 3 4 5

2. The fees charges by this Bank is appropriate to cover the costs of running the courses.

3. All institution fees are duly corrected.

4. This Bank accounting system adequately identifies the receipts and expenditure of grant contracts.

5. The Bank asset base has greatly increased over time.