EFFECT OF INTERNAL AUDIT ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS IN KENYA

EFFECT OF INTERNAL AUDIT ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS IN KENYA

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ABSTRACT
Financial performance requires appropriate internal audit practices to enhance efficiency. For the purpose of this study the researcher sought to determine the effect of internal audit on financial performance in commercial banks in Kenya. Internal audit was looked at from the perspective of internal audit standards, professional competency, internal controls and independence of internal audit.The study selected one senior manager in the finance department. The researcher administered a survey questionnaire to each member of the target population since it was the most appropriate tool to gather information. Quantitative analysis and regression analysis were used as data analysis technique. Descriptive statistics such as mean, standard deviation and frequency distribution were used in the analysis of data. Data presentation was done by use of tables for ease of understanding and interpretation.
From the findings, the study concludes that internal audit standards, independence of internal audit, professional competency and internal control had a positive relationship with financial performance of commercial banks, the study found that a unit increase in internal audit standards would lead to increase in financial performance of commercial banks, a unit increase in independence of internal audit would lead to increase in financial performance of commercial banks, a unit increase in professional competency would lead to increase in financial performance of commercial banks and further unit increase in internal control would lead to increase in financial performance of commercial banks.
The study recommends that management in commercial banks in Kenya should adopt effective internal audit practices such as internal auditing standards, independence of internal audit, professional competency and internal controls to enhance financial performance of the banks.


CHAPTER ONE
INTRODUCTION
1.1 Background of Study
For most of its history internal audit has served as a simple administrative procedure comprised mainly of checking documents, counting assets, and reporting to Board of Directors, Management or External Auditors. In recent times, however, a combination of different forces has led to a quiet revolution of the profession. Organizations have to demonstrate accountability in the use of shareholders money and efficiency in the delivery of services. Organizations now demand great competency and professionalism from internal audit, and scarce resources must be deployed more efficiently to minimize and manage risks. Technological advancement makes it possible to track and analyse data with continually increasing speed thus making it essential for organizations to be well advised by the internal audit department. Internal audit varies from one organization to another, and making change to modern internal audit can be a substantial undertaking. The transition from merely ensuring compliance with rules and regulations to truly delivering added value requires more than just organizational changes. In many bank institutions staff is poorly paid and unmotivated, ethical standards are weak, and governance practices are ineffective leading to asset mismanagement (Ramamoorti, 2003).
All over the world there is a realization that the Internal Audit activity has the potential to provide hitherto unparalleled services to management in the conduct of their duties. This potential has been turned into a challenge and embodied in the new definition of Internal Auditing from the Institute of Internal Auditors (the IIA). Commercial banks have come to the realization that internal audit is essential in improving management of assets in the banks leading improved financial performance of banks (Basel Committee, 2002).
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1.1.1 Internal Audit
According to Robertson (1976) Internal Auditing may be defined in several ways depending upon what purpose is to be served. Pickett (1976) stated that ―internal audit is an independent, objective assurance and consulting activity designed to add value and improve an organization‘s operations. 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‖. This definition actually seeks to demonstrate the depth and breadth of the internal audit activity within an institution as against the previous orientation of reviewing payment transactions over the years.
Internal Audit is an objective and independent appraisal service within an organization on risk management, control and governance by measuring and evaluating their effectiveness in achieving the organization‘s agreed objectives. In addition, internal audit‘s findings are beneficial to the Board of Directors and line management in the audited areas. The service applies the professional skills of internal audit through systematic and disciplined evaluation of the policies, procedures and operations that management put in place to ensure the achievement of the organization‘s objectives, and through recommendations for improvement (Dumitrescu, 2004).
The Board of Directors of the Institute of Internal Auditors in June 1999 described internal audit as an independent, material and consultancy activity, which adds value and improves the functioning of an organisation. It helps the organisation achieve its aims by means of a systematic, disciplined approach to evaluating and improving the effectiveness of risk management, control and the management process.
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Internal audit has several aims and principles which it is necessary to adhere to. It is the board of directors of the bank, however which bears final responsibility that the bank‘s management applies an appropriate and effective system of internal audit, a system of evaluating banking activity risk and risks concerning bank capital, appropriate methods of monitoring compliance with laws, measures and internal procedures. Likewise, the bank's management is responsible for drawing up procedures which identify measure, monitor and control the risks that the bank faces.
Internal audit is a part of the repetitive monitoring of the internal control systems of the bank and its procedures for evaluating internal capital. As such, it assists management and the board of directors in the effective performance of their responsibility as outlined above (Gramling, 1997).
Although the need for objectivity and impartiality is of particular importance for the internal audit department in a banking institution, this does not exclude the possibility that this department, too, may contribute to advisory and consultancy activity, if the independence of analyses and evaluations is ensured. Some banks have also introduced a system of evaluating their activities, which does not replace, but supplements the function of the bank‘s internal audit. This is a formal and documented process whereby management and employees analyse their activities and evaluate the effectiveness of the related internal control procedures (Hawkes, 1994).
1.1.2 Financial Performance
There are many aspects of the performance of commercial banks that can be analysed. Muga (2012) stated that the importance of bank profitability can be appraised at the micro
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and macro levels of the economy. At the micro level, profit is the essential prerequisite of a competitive banking institution and the cheapest source of funds. It is not merely a result, but also a necessity for successful banking in a period of growing competition on financial markets. Hence the basic aim of every bank management is to maximize profit, as an essential requirement for conducting business. At the macro level, a sound and profitable banking sector is better able to withstand negative shocks and contribute to the stability of the financial system. Bank profits provide an important source of equity especially if re-invested into the business. This should lead to safe banks, and as such high profits could promote financial stability.
Schiuma (2003) mentioned accounting- based performance using three indicators: return on assets (ROA), the return on total equity (ROE) and Return on Investment (ROI).These are widely used to assess the performance of firms, including commercial banks. Bank regulators and analysts have used ROA and ROE to assess industry performance and forecast trends in market structure—as inputs in statistical models to predict bank failures and mergers—and for a variety of other purposes where a measure of profitability is desired. The main purpose of this study was to examine if internal audit can actually enhance banks financial performance.
1.1.3 Internal Audit and Financial Performance
Most internal audit professionals argue that an effective internal audit function correlates with improved financial performance. According to Beyanga (2011), an effective internal audit service can, in particular, help reduce overhead, identify ways to improve efficiency and maximize exposure to possible losses from inadequately safeguarded company assets all of which can have a significant effect on the financial performance of an organisation.
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He also stated that internal audit is an ―invaluable tool of management for improving performance‖. Fadzil et al (2005) also noted that internal auditors help run a company more efficiently and effectively to increase shareholders value‖. Finally Hermanson and Rittenberg (2005) argued that the existence of an effective internal audit function is associated with superior organizational performance.
At the empirical level, a survey conducted by KPMG (1999) found that the internal audit function in organizations where it exists, contributes substantially to performance improvement and assist in identifying profit evidence in corporate disasters, particularly financial fraud consistently documents an association between weak governance. Thus internal audit by acting as a watchdog could save the organization from malpractices and irregularities thus enabling the organization to achieve its objectives of ensuring high level of productivity and profit.
1.1.4 Commercial Banks in Kenya
The Banking industry in Kenya is governed by the Companies Act, the Banking Act, the Central Bank of Kenya Act and the various prudential guidelines issued by the Central Bank of Kenya (CBK). Commercial Banks are an institution which accept deposits, makes business loans and offers related services. They also allow for a variety of deposits accounts, such as checking, savings and time deposit. These institutions are run to make profits. Commercial banks are licensed and regulated by the central banks of their jurisdiction (countries) in which they operate. In Kenya, the Central Bank of Kenya (CBK) licenses, supervises and regulates commercial banks as mandated under the Banking Act.
Over the last few years, the Banking sector in Kenya has continued to growth in assets, deposits, profitability and products offering. The growth has been mainly underpinned by,
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an industry wide branch network expansion strategy both in Kenya and in the East African community region and automation of a large number of services and a move towards emphasis on the complex customer needs rather than traditional ‗off-the-shelf‘ banking products. This has led to an increased need for internal audit in banks to enhance asset management, control of risks and management controls. Players in this sector have experienced increased competition over the last few years resulting from increased innovations among the players and new entrants into the market. Currently there are 43 licensed commercial banks in Kenya.
1.2 Research Problem
Recent corporate accounting scandals and the resultant outcry for transparency and honesty in reporting have given rise to two disparate yet logical outcomes. First, Internal Auditing skills have become crucial in untangling the complicated accounting manoeuvres that have obfuscated financial statements. Second, public demand for change and subsequent regulatory action has transformed corporate governance. Increasingly, company officers and directors are under ethical and legal scrutiny. Both trends have the common goal of responsibly addressing investors‘ concerns about the financial reporting system. However there has been laxity in implementation of internal audit findings and recommendations.
Kenyan banks have not been without crisis, the shortcomings of Kenya's banking sector prior to the banking crisis of the late 1980s, and then the effect of the measures subsequently introduced by Kenya's Central Bank. Banks could be established by any investor almost at will, shareholders and directors escaped any vetting procedure, the role of external auditors was poorly defined and due diligence and banking supervision
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inadequate. These shortcomings led to what Karugor Gatamah of the Centre for Corporate Governance based in Nairobi describes as "imprudent lending practices, excessive investment in fixed assets and inadequate systems to measure, identify and control risk".
Various local studies on this topic include: Mutua (2012) researched on impact of risk based audit on financial performance of commercial banks in Kenya. She observed that financial performance requires appropriate risk based audit practices hence effective and efficient internal audit. From the findings, the study concluded that risk based auditing through risk assessment, risk management, annual risk based planning, internal auditing standards and internal auditing staffing should be enhanced.
Otieno (2012) researched on effects of corporate governance on financial performance of commercial banks in Kenya. He concluded that corporate governance plays an important role on bank stability, performance and bank‘s ability to provide liquidity in difficult market conditions. From the findings, corporate governance factors account for 22.4 % of the financial performance of commercial banks.
Chepkorir (2010) established that internal audit 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. The internal audit activity evaluates risk exposures relating to the organization's governance, operations and information systems. The internal auditors are expected to provide recommendations for improvement in those areas where opportunities or deficiencies are identified.
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Musili (2012) researched on factors affecting performance of commercial banks in Kenya, Agung (2011) studied about Benchmarking and performance in commercial banks, Ruto (2011) researched on Relationship between internal audit independence and co-operative governance in commercial banks in Kenya and Wanyoike (2007) studied about Internal audit departments role in enterprise risk management.
This research will be different from all the above mentioned as it will specifically look at internal audit as a factor affecting financial performance of commercial banks. The above researchers concentrated on management of risks and corporate governance .This study will have a look at the internal audit function in banks, the role they play in the organisation, internal audit and asset management and how the effect on financial performance.


1.3 Research Objective
The objective of this study will be to establish the effect of internal audit on financial performance of commercial banks in Kenya.


1.4 Value of the Study
This study will help in increasing the role and image of internal audit in commercial banks to make it more effective and professional. It will help the shareholders appreciate the role of the internal audit as one of the most important managerial control systems in an organization required to safeguard their interests.
The management of banks will be able to look for ways of making Internal Audit a completely independent function from the management thus making it more effective. By
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implementing recommendations given on the internal audit reports management will be able to enhance performance of the bank.
For scholars it will help them to appreciate and enhance their knowledge of internal audit so as to adhere to the professional ethics as required by the IAS.





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