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The study sought to determine the effect of internal control system on financial performance of manufacturing firms in Tuyil pharmaceutical ltd. To achieve the objective of this study, the study used hypothesis testing research design. The study tested the following hypotheses: H1: Internal Controls and Financial Performance are positively related; H2: Internal Controls have a significant impact on Financial Performance. The population chosen for this study was 65 working staff of the Tuyil ltd. The study selected a sample of 20 working staff from a target population of 65 working staff. The sample was drawn using stratified random sampling technique. The study relied on both primary and secondary data. Primary data was collected using structured questionnaires while the secondary data was gathered from financial statements based on availability and accessibility of data.
The findings revealed that Tuyil pharmaceutical ltd had a control environment as one of the functionality of internal controls of the organization that greatly impacts on the financial performance of the firm. It was also established that the management had put in place mechanisms for mitigation of critical risks that may result from fraud. The study examined the effect of control activities on the financial performance of Tuyil pharmaceutical ltd. The results also revealed that the staffs were trained to implement the accounting and financial management systems (M=3.24, S.D=1.334), the security system identified and safeguarded organizational assets (M=4.20, S.D =1.334). The statistical results from the regression analysis show that there is a positive relationship between internal control and financial performance of Tuyil pharmaceutical ltd. The independent variables (Control Environment, Risk Assessment, Control Activities, Information and Communication and monitoring) contributed to 75.7% of the variation in financial performance as explained by adjusted R2 of 0.75.7% which shows that the model is a good prediction.
It was concluded that manufacturing firms that had invested on effective internal control systems had more improved financial performance as compared to those manufacturing firms that had a weak internal control system. Most large scales manufacturing firms that fully invested in strong internal control systems. The study further recommends that the governing body, possibly supported by the audit committee, should ensure that the internal control system is periodically monitored and evaluated. The limitation of this study is that the study was focused on Tuyil pharmaceutical ltd only while we have more than 500 manufacturing firms in Nigeria, therefore these findings may not be used for generalizations on all manufacturing firms in Nigeria. It is therefore important for a study to be conducted using wider scope and coverage then, the findings can be compared and conclusions drawn.
1.1 Background of the Study
Internal control as “Comprising the plan of an organization and all the co-ordinate methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data, prorate operational efficiency and adherence to prescribed managerial policies.” The definition of internal control is divided into financial internal control and non-financial (administrative) internal control.Financial internal control pertains to financial activities and may be exemplified by controls over company‟s cash receipts and payments financing operations and company‟s management of receipts and payments.Non-financial internal control on the other hand deals with activities that are indirectly financial in nature i.e. controls over company‟s personnel section and its operations, fixed assets controls and even controls over laid down procedures (Reid and Ashelby, 2002).
A sound internal control system helps an organization to prevent frauds, errors and minimize wastage.Custody of assets is strengthened; it provides assurance to the management on the dependability of accounting data eliminates unnecessary suspicion and helps in maintenance of adequate and reliable accounting records.This study therefore attempts to establish the effectiveness of internal control system in Tuyil pharmaceutical ltd (Amudo and Inanga, 2009).
Despite the fact that internal control system is expensive to install and maintain, it gradually evolved over the years with the greatest development occurring at the beginning of 1940‟s. Not only have the complexities of the business techniques
contributed to this development but also the increased size of business units which have encouraged the adoption of methods which while increasing efficiency of business, acts as a safeguard against errors and frauds.
Mawanda (2008), states that “there is a general perception that institution and enforcement of proper internal control systemswill always lead to improved financial performance”. It is also a general belief that properly instituted systems of internal control improve the reporting process and also give rise to reliable reports which enhances the accountability function of management of an entity. Preparing reliable financial information is a key responsibility of the management of every public company. The ability to effectively manage the firm‟s business requires access to timely and accurate information.
Moreover, investors must be able to place confidence in a firm‟s financial reports if the firm wants to raise capital in the public securities markets. Management‟s ability to fulfill its financial reporting responsibilities depends in part on the design and effectiveness of the processes and safeguards it has put in place over accounting and financial reporting. Without such controls, it would be extremely difficult for most business organizations especially those with numerous locations, operations, and processes to prepare timely and reliable financial reports for management, investors, lenders, and other users. While no practical control system can absolutely assure that financial reports will never contain material errors or misstatements, an effective system of internal control over financial reporting can substantially reduce the risk of such misstatements and inaccuracies in a company‟s financial statements (Kaplan, 2008; Cunningham, 2004; INTOSAI, 2004).
Cunningham (2004) states that internal control systems begin as internal processes with the positive goal of helping a corporation meet its set objectives. Management primarily provides oversight activity; it sets the entity's objectives and has overall responsibility over the ICS. Internal controls are an integral part of any organization‟s financial and business policies and procedures. Internal controls consist of all the measures taken by the organization for the purpose of; protecting its resources against waste, fraud and inefficiency; ensuring accuracy and reliability of accounting and operating data; ensuring compliance with the policies of the organization; evaluating the level of performance in all organizational units of the organization.
ICS are applicable to each organization in relation to key risks and are embedded within the operations and not treated as a separate exercise. ICS should be able to respond to changing risks within and outside the company and they are a means to an end, not an end itself . Cunningham (2004), further states that Internal controls are effected by people not merely policy manuals and forms, but people functioning at every level of the institution. Internal control only provides reasonableassurance to the firm‟s leaders regarding achievement of operational, financial reporting and compliance objectives; promoting orderly, economical, efficient and effective operations; safeguarding resources against loss due to waste, abuse, mismanagement, errors and fraud. Internal controls lead to the promotion of adherence to laws, regulations, contracts and management directives and the development and maintenance of reliable financial and management data, and accurately present that data in timely reports (Kaplan, 2008; Cunningham, 2004; INTOSAI, 2004).
Treba (2003) states that internal control is a tool for ensuring that a firm realizes its mission and objectives. He further notes that much as internal controls are often
thought to be the domain of accountants and auditors; it is actually management that has primary responsibility for proper controls. A critical element of any comprehensive Internal Control Systems is regular monitoring of the effectiveness of internal controls to determine whether they are well designed and functioning properly (Treba, 2003).
Treba (2003) explained that weaknesses in internal control systems (control over the payroll, over expenditure commitments and over procurement processes) lead to failure to ensure that resources are allocated to defined priorities and to guarantee that there is value for money will be attained in public spending.The findings of the Treadway Commission Report of 1987 in the United States (USA) confirmed that the absence of internal controls or the presence of weak internal controls is the primary cause of many cases of fraudulent company financial reporting. The widespread global corporate accounting scandals in recent years inform this study.
Notable cases include Enron and WorldCom in the USA, Parmalat in Europe and Chuo Aoyama in Asia. In South Africa, cases of accounting scandals have been recorded in JCI and Randgold and Exploration companies. In Nigeria, the managing director and chief financial officer of Cadbury Nigeria were dismissed in 2006 for inflating the profits of the company for some years before the company‟s foreign partner acquired controlling interest.These scandals emphasize the need to evaluate, scrutinize, and formulate systems of checks and balances to guide corporate executives in decision-making. These executives are legally and morally obliged to produce honest, reliable, accurate and informative corporate financial reports periodically (Hayes et al, 2005).
In the study, internal controls shall be interpreted as “A process that guides an organization towards achieving its objectives.” These objectives include operational efficiency and effectiveness, reliability of financial reporting and compliance with relevant laws and regulations.” Financial performance is considered in terms of measures like profitability (using absolute and relative measures), liquidity (using liquidity ratios like current ratio, acid test ratios), the ease with which the entity settles its financial obligations and accountability.
Dixon et al (1990) found out that appropriate performance measures are those which enable organizations to direct their actions towards achieving their strategic objectives.Stoner (2003) refers to performance as the ability to operate efficiently, profitably, survive, grow and react to the environmental opportunities and threats. In recent years the aspect of internal control system has achieved great importance since it is designed to safeguard the company‟s assets against misuse, ensure compliance with the company‟s laid policies, ensure the company‟s personnel are efficiently utilized and the company runs in an orderly and efficient manner.
Most importantly it ensures the company‟s reliable records which are a source of information necessary for managerial decision making processes are availed whenever required by management or both the external and internal auditors. It is therefore clear that the adoption of a sound internal control system is not only helpful to the management, but also to the external auditors. However, it‟s worth noting that internal controls only provide reasonable but not absolute assurance to an entity‟s management and board of directors that the organization‟s objectives will be achieved. “The likelihood of achievement is affected by limitations inherent in all systems of internal control,” (Hayes et al, 2005).
1.1.1 Internal Controls
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 a firm‟s objectives in the effectiveness and efficiency of operations, reliability of financial and management reporting, compliance with applicable laws and regulations and protect the organization‟s reputation (Kaplan,2008; Cunningham, 2004; INTOSAI, 2004; Committee of Sponsoring Organizations (COSO), 1992; Auditing Practices Board (APB), 1999).
Effective internal control system operates when some specific procedures are adopted by the management. International Accounting Standards (IAS) categorizes internal control types as a plan of organization, segregation of duties, control of documents, safeguarding of assets, competence of staff, arithmetic and accounting controls, recording and record keeping , supervision, authorization and approvals, vocation and rotation of duties, cost feasibility , routine and automatic checks.
Saleemi (1989) refers to plan of organization as an organization chart showing the organization structure of a company. The purpose of this chart is to show how the company has been divided into departments and departments into sections and most important to show what responsibilities and duties are assigned to each officer. Authority and responsibilities are clearly defined. Employees perform their duties according to the organization plan. This plan allocates and defines responsibilities and identifies lines of reporting for all aspects of business operations. The plan of organization is needed for effective internal control.
Internal controls consist of five components namely: i) Control environment- This is the foundation for all the other components of internal control. It comprises of factors like integrity and ethical values of personnel tasked with creating, administering and monitoring the controls, commitment and competence of persons performing assigned duties, board of directors or audit committees, management philosophy and operating style and organizational structure, Risk assessment process, this refers to the careful assessment of factors that affect the possibility of objectives of the organization not being achieved. It refers to the identification and analysis of relevant risks associated with achieving the objectives of the organization.
Risk assessment is the process of identifying and analyzing management relevant risks to the preparation of financial statements that would be presented fairly in conformity with general accepted accounting principle, information and communication systems Internal controls require that all pertinent information be identified, captured and communicated in a form and time frame that enable people to carry out their financial reporting responsibilities.
Firms should adopt internal control and information systems that produce operational, financial and compliance-related information reports to make it possible to run and controls the business. Effective communications should occur in a broad sense with information flowing down, across, and up within all the sections of the organization (Millichamp, 1999)
Control activities refers to policies, procedures, and mechanisms put in place to ensure directives of the management are properly carried out. Appropriate and accurate documentation of policies and procedural guidelines helps to determine how
the control activities are to be executed. Monitoring of controls is the process of assessing the quality of the internal control structure over time. Since internal controls are processes, it is usually accepted that they need to be adequately monitored in order to assess the quality and the effectiveness of the system‟s performance over time.
Millichamp (1999) stated that the term segregation of duties is used these days for internal duties. One of the prime means of control is the separation of those duties which would if combined would enable one individual to record and process a complete transaction. This practice reduces risk of intentional manipulation of accounts and increases element of checking. This makes fraud more difficult to be committed because one transaction is completed by different employees.
Batra el al (1992) said that control of documents involves control of company‟s sensitive documents for example receipts, cheques, local purchase orders, debit and credit notes. These documents must be handled by a responsible officer and should be pre numbered to ensure control and minimize misuse. They must be kept and controlled from a central point like headquarters or any other reliable control point.
De Paula et al (1990) also noted that internal controls require that business assets like plant and machinery, equipment, motor vehicle, stock and cash should be kept safely and access should be limited to authorised personnel only. The procedures designed and security measures taken to safeguard assets are known as Physical Controls. The type of physical controls common to most companies include employment of watchmen, alarm system, strong electrified fence, strong room, safes and security lights.
Spicer & Pegler (1978) stated that the proper functioning of any system depends on the competence and integrity of those operating it. The staff employed in an organization should be competent and experienced. The company should employ qualified, experienced, competent, motivated and capable people who will have interest in what they do and the company as well should regard their employees as its assets. These employees should be reliable and responsible in order to ensure efficiency in business operations.
Woolf (1997) also stated that arithmetic and accounting controls should be implemented as they aim at ensuring accuracy of transactions and ensuring proper recording of company transactions according to the Generally Accepted Accounting Principles (GAAPs). When examining the internal control system, the auditor should consider the possibility of collusion between close relatives working in related parts of the firm, this may conceal irregularities. The recording of business transactions should be accurate and arithmetically correct hence some controls are introduced e.g. checking of totals, reconciliations, control accounts and trial balances.An effective control system therefore requires implementation of arithmetical and accounting controls and its adequacy has to be examined by the internal auditor differently for different firms.
Woolf (1997) indicated that all transactions must be authorized and approved by the right and responsible officer. This is aimed at preventing frauds, safeguarding the company assets, streamlining the flow of authority to avoid bureaucracy and conflicting authorized activities for example purchases invoices should be approved before payment is made to suppliers, and wages payment be approved before cash withdrawal from the bank. Internal control requires proper system of authorization
and approval whose main objective is to prevent fraud and safeguard company assets.Vocation and rotation of duties should also be upheld in organization.
Manasseh (1990) said that the company must give its employees leave especially to accounting staff who should not overstay their leave. This is aimed at checking the efficiency of officers and preventing frauds and errors. It also boosts the efficiency of officers concerned through rest and the company‟s internal check.Routine and automatic checks are put to practice. Saleemi (1989) said that surprise checks should be conducted especially for such items as petty cash, stock count, cash at hand and wages payment. This will prevent errors and frauds and also will promote the morale at work.
Woolf (1997) noted that with rapidly changing technology, there is need to restructure the controls of various firms to support these documents. The auditor works directly with computers and its records as they exist in suitable machine sensible forms. The auditor therefore concentrates on proving the initial inputs and checking their validity and the calculate output manually which is then compared with computer output.
De Paula et al (1990) noted that there are some system developments controls designed to ensure that a satisfactory standard is maintained in designing, testing, implementing and documenting new system and programs. An auditor has to review controls to ensure the installation staff is divided into a number of sections e.g. system analysis, programming, controlling, library and computer. He must also ensure that there is a clear definition of duties and divisions of responsibilities between the sections.Therefore the auditor should ensure that all computer routines have been properly documented, any unauthorized people are not allowed into the computer
room, programmers do not have access to the computers except if necessary when testing programs and that computer operators don‟t access source documents and are not allowed to amend programs.
1.1.2 Financial Performance
Positive financial performancein a manufacturing firm can be achieved by eradicating waste in benefits services processes and systems. The “critical success factor” for a manufacturing firm is the degree to which it fulfills its set objectives and mission in terms of being efficient, effective and economical. The information obtained from a sound internal control system as reflected from financial statements will provide a report on a firm‟s financial performance and position that is useful to a wide range of users for assessing the stewardship and making economic decisions (Glendinning, 1998; Davies, 2007).
Internal Control Systems are very instrumental in achieving the firm‟s set mission and objectives; hence Value for Money. The main approach to VFM is the firm‟s control over the use of resources in order to achieve its set objectives. Heads of departments should establish sound arrangements for planning, appraising, authorizing and controlling operations in order to achieve positive Financial Performance.Financial Performance and Value for Money are used to assess whether or not a firm has obtained the maximum benefit from the goods and services it acquires and / or provides, within the resources available to it (LGIAM, 2007).
Value for Money is not paying more for a good or service than its quality or availability justifies as well public spending implies a
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