DETERMINANT OF INTERNAL CONTROL SYSTEM EFFECTIVENESS IN A MANUFACTURING COMPANY

ABSTRACT

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.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Internal control as “Comprising the plan of an organization and all the coordinate 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 systems will 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 affected by people not merely policy manuals and forms, but people functioning at every level of the institution. Internal control only provides reasonable assurance 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).