CHAPTER ONE

INTRODUCTION

1.1. Background of the Study

Current business trends have made it imperative for almost all MFI to maintain effective internal control systems. Internal control has attracted intense debate and scholarly attention across industries in control environment and activities, information and communication, accountancy and auditing literature over the past decades.

Internal control is a process effected by the entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the categories; reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (Ray and Kurt, 2001). There are many controls that a MFI can institute to protect it resources against loss to improve performance. An internal control is a topic that cuts across a number of disciplines including financial accounting and auditing. It can be traced back to ancient times. In Hellenistic Egypt there was dual administration where one side was involved in collation of taxes while the other supervising them. Sacking of Troy was one of the examples of weaknesses of internal controls. Internal controls became apparent at the beginning of 21st century following major corporate scandals (PABC 2006).

The internal control system is the major part in any organisation. Internal control is the process designed and affected by those charged with governance, management and other personnel to provide reasonable assurance about achievement of entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. (COSO, 1992)

Every organisation, both profit and non-profit making organisation has its objectives and goals in mind to achieve. For an organisation to carry out its business, there must be some factors put in place for the smooth running of the business operations. These factors of production are material, machine, money of which they need to be well managed (Kratz, 2008). Inside controls comprise of the considerable number of measures taken by the organization with the end goal of; securing its assets against waste, extortion and wastefulness; guaranteeing precision and unwavering quality of bookkeeping and working information; guaranteeing consistency with the strategies of the organization; assessing the level of execution Enwelum, (2013). In addition, a sound of internal control systems can help the organization to prevent frauds, errors and minimize wastage Uket and Joseph, (2012) and Eniola & Akinselure, (2016).

It obvious when employees feel safe and function stable whenever his mistakes and the organization’s mistakes decrease Ge et al, (2014); this shows that internal control plays an active role in achieving the positive performance of the employees and limiting the negative aspects that may be exposed to employees such as thefts and protect them at the same time from mistakes that may expose them to legal accountability or loss of functionality.

Micro finance institutions (MFIs) are financial institutions that provide mode of finance designed to provide low-income individuals with the means to become self-sufficient. A microfinance institution issues small loans to those marginalized from normal modes of finance with the intention of helping the poor prosper by allowing them to save or borrow money (Campbell R. Harvey 2012). They earn financial revenue from loans and other financial services in form of interest, fees, penalties and commissions. Financial revenue also includes income from other financial assets, such as investment income. MFI’s financial activities also generate various expenses, from general operating expenses and the cost of borrowing to provisioning for the potential loss from defaulted loans.

Poor internal control or lack of internal control has been posted as one of the main causes of failure of MFIs Eniola and Akinselure, (2016). John, (2016) observes that internal control is one significant area companies should give attention in order to enhance their financial performance. Business management also entails having effective internal control of the business transactions. In essence, internal control is one thing an entrepreneur cannot afford to ignore. A strong internal control system is thus paramount to efficiently manage the resources available to these tertiary institutions (MFIs). Eniola and Akinselure (2016) noted that the survival of an organization depends on the effective and efficient utilization of resources at its disposal. The importance of internal control cannot be undermined given its vast benefits to the organization Ejoh &Ejom, (2014).

Internal controls therefore are measures instituted by an organization so as to ensure attainment of the entity’s objectives, goals and missions (Ogneva et al, 2007). In some instances, internal controls are check mechanisms to avoiding wastages, theft and mismanagement of the organization’s assets. In pursuit of organizational objectives regarding reliable financial reporting, effective and efficient operations, managers and boards of organizations resort to establishing internal control systems in ensuring effective outcomes Crawford (2011).

It is believed that properly designed and enforced internal control systems will normally lead to better financial reporting procedures as well as giving rise to a reliable report that improves management accountability function of an institution (Doyle, et al. 2007).

However, the prospect of achievement is determined by limitations inherent in all internal control systems. In this respect, Emasu (2007) explains that internal control systems can only ensure reasonable rather than complete guarantee to the achievement of the organization’s objectives which are instituted by an institution’s management and board of directors.

In this study, internal controls refer to procedures outlined by an institution to give reasonable assurance with respect to attaining efficient and effective operations, reliable financial reporting, and compliance with appropriate rules, regulations and laws (Ray & Kurt, 2001). Financial performance on the other hand in is explained in terms of measures like profitability (using gross profit ratio, net profit ratio), liquidity (i.e. liquidity ratios like current ratios) and Accountability (in the form of financial accountability) (ACCA- Managerial Finance Paper 8; 1998; and Panday;1996).

In the past decade, internal control failures were the reason for the most explosive accounting scandals of the world. The Enron is the best example in the United States. Before Enron collapse in 2001, the company stated earnings of $200 million and according to the stock market was worth billions of dollars. Conversely, the stock price of Enron was driven up by fraudulent accounting practices and earnings management (Kratz, 2008).

Internal control has various interconnected components including risk assessment, control activities, information and communication and monitoring. Control Environment considerably influences and determines organisational tone has a significant impact on the perception relating to control system and also serves as a foundation for effective functioning of the internal control system. Risk assessment as the procedure employed by the management of the firm to handle the risks that act as hurdles in accomplishing the objectives. Risk assessment is the identification, assessment and supervision of risks. These risks involve misstatement of financial data or even the inefficient utilization of assets. Control activities comprise a variety of tasks such as agreements, endorsements, certification, reconciliation, conducting reviews, providing security, and the development and maintenance of data which serve as proof of implementation of these activities along with suitable documentation. Information and communication as procedures adopted by a firm to gather, process and report authentic information within the appropriate time to ensure employees perform their duties punctually. (Channar, 2015) These components of internal control apply to all business entities though Micro Finance Institutions may apply them differently to large corporations.

‘Micro-finance Institutions’ internal control systems could be less formal and unstructured but at the same time be very effective. According to Ledger wood and White (2006), an internal control adopted by Micro Finance Institutions need to be orderly, practical and efficient enough to help them conduct business. Internal controls are most effective when they are directly incorporated in the process that support operations and enable quick response to changing economic conditions. Microfinance Institutions use internal control mechanisms to make sure the staffs are respecting its policies and procedures.

1.2. Statement of the Problem

The efficacy of internal control system on financial performance is paramount in every organization. This is because internal controls ensure prevention and detection of errors and frauds. The firm’s economic assets generate income which gives growth and sustainability. It is imperative for Micro Finance Institutions to establish water tight controls if at all it is to achieve improved financial performance.

Currently Micro finance Institutions are at par with other financial players in the industry in terms of human resource. The management of Micro Finance Institutions is of the highest qualifications, calibre and dedication. Management meets regularly to review and improve its processes to ensure that quality, efficiency, and customer satisfaction is consistently achieved. Micro-finance Institutions have overtime undergone positive transformations in all their departments. Internal controls are in place to safeguard Microfinance Institutions assets; to avoid misappropriation of its assets and to detect against probable frauds. However, despite all the above findings, Micro-finance Institutions struggle with liquidity problems, operating and financial expenses are relatively high for Micro finance Institutions and on average, revenues from Micro-Finance Institutions remain lower than in other global regions, generating income and providing a source of livelihood for the majority of low income households by financing the businesses that they run. The general perception is that enforcement of proper internal control systems always leads to improved financial performance. Nevertheless, available Literature still point out that in spite of elaborate system of controls in organizations, financial performance has been elusive in most of these organizations (OAG, 2010).

Commercial banks traditionally lend to medium and large enterprises which are judged to be creditworthy and tend to avoid doing business with the poor and the micro enterprises because the associated costs and risks are considered to be relatively high. There is still lack of proper and efficient internal control systems in most Local authority offices countrywide.

Financial performance was measured in terms of liquidity. According to Stoner (2003) financial performance is the ability to operate efficiently, profitably, survives, grow and react to the environmental opportunities and threats. Most Micro finance Institutions have not attained financial stability as a result of not putting in place sound financial cost control portfolios and are relying on subsidies as their source of funds. A small number of Micro finance Institutions are extending loans to individuals, at the same time most of the Micro-finance Institutions are taking deposits to cushion risks associated with non-repayment of loans.

Despite the fact that internal control is a vital factor affecting a firm regardless of its size, there is little evidence on the effect of internal controls on financial performance of financial institutions since most of the studies on internal controls globally and in Cameroon focus more on financial institutions, thus, a literature gap that this study intended to fill.

1.3. Research Questions

1.3.1. Main Question

What is the effect of Internal Control on the Financial Performance of Micro Finance Institutions in Bamenda II?

1.3.2. Specific Questions

1. What is the effect of internal audit on the Financial Performance of Micro Finance Institutions in Bamenda II?
2. What is the effect of internal check on the Financial Performance of Micro Finance Institutions in Bamenda II?

iii. What is the effect of monitoring on Financial Performance of Micro Finance Institutions in Bamenda II?

1.4. Objectives of the Study

1.4.1. Main Objective

To Assess the Effect of Internal Control on the Financial Performance of Micro Finance Institutions in Bamenda II?

1.4.2. Specific Objectives

1. To Investigate the Effect of “Internal Audit” on the Financial Performance of Micro Finance Institutions in Bamenda II.
2. To Evaluate the Effect of “Internal Check” on the Financial Performance of Micro Finance Institutions in Bamenda II.

iii. To Evaluate the Effect of “Monitoring” on the Financial Performance of Micro Finance Institutions in Bamenda II.

1.5. Research Hypotheses

The study was guided by the following null hypotheses:

H0₁: “Internal Audit” has no significant Effect on the Financial Performance of Micro  Finance Institutions in Bamenda II.

H0₂: “Internal Check” has no significant Effect on the Financial Performance of Micro Finance Institutions in Bamenda II.

H0₃: ‘Monitoring” has no significant Effect on the Financial Performance of Micro Finance Institutions in Bamenda II.