CHAPTER ONE

GENERAL INTRODUCTION

1.     Background to the study

Internal auditing reviews and analyses the attributes of an organization, provides counsel and recommendation to the members of the organization to perform their duties effectively. It is an independent function which evaluates and appraises the functioning of the organization. Meckling (2000) identified auditing as one of the methods for monitoring and controlling the activities in the agency theory, where both the parties try to maximize their utilities. Raja (2002) argued that the increase of internal audit normally adds value and improves on an organization’s operation because of its objectivity and the consultative forums with other departments in the same Organization. Internal auditing is an independent, objective assurance and consulting activity designed to add value to and improve an organization operation. It helps the organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes (Wikipedia.org).

The function of internal audit extends beyond the books of accounts and it primarily concentrates on reviewing the operations of the organization and giving recommendations to improve the efficiency of the performance.  The main objective of internal auditing is to evaluate the systems, procedures and controls in the functional areas of the organization by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance. Internal auditing achieves this by providing insight and recommendations based on analyses and assessments of data and business processes. Increase in the size of the organization and expansion of its operations require more control. Therefore, it is necessary to verify that the procedures are complied with correctness and inefficiency. This function can be done only by internal auditing.

The internal auditors are professionals who employed by the organizations to perform the internal auditing activity. The auditor is expected to guide the management on the best accounting practices and at the same time assist in the formulation and updating of policies (Anderson, V., 2003).  The internal auditor could be engaged either as a full time employee or on contract basis by the management of the company. These individuals are called upon to be independent both in fact and appearance. Internal audit services are deemed as a monitoring mechanism because of the potential conflicts of interest between employees as well as owners and managers and other different categories of stakeholders in an organization (De Angelo, 1981). According to Harrison Mwinzi 2015 “This monitoring role means that auditors are used as a mechanism to enhance credibility of the financial statements so that the public who are not involved in the day to day running of the organization can have some level of confidence in the reported financial position.  The willingness of internal auditors to report a discovered breach depends on a number of factors including; the level of independency accorded by the management”. Audit independence must be viewed within the totality of corporate governance and the accountability of organizations to their stakeholders (Raja, 2002). Auditor’s independence in an organization has been termed as the cornerstone of the auditing profession since the opinion of the auditor shades light to the management whether the financial statements for a given period depicts a fair and true position of the financial status of an organization (Caswell& Allen 2001). Harrison Mwinzi 2015 states “The management as the users of the financial statements usually rely on the internal audit reports for quality audits especially where independence was accorded to the auditors in the organization.  Independence permits internal auditors to render the impartial and unbiased judgments essential to the proper conduct of engagements”.  Over the years, several major instances of misstated earnings have been reported of Small and medium size enterprises. The definition of small and medium enterprises varies between one country and another.  However, generally small and medium enterprises (SMEs) are companies which deal with various industries in an economic sector with personnel numbers which fall below certain limits (Harrison Mwinzi 2015). Small and medium enterprises exceed large companies by a wide margin and also employ many more people and are involved in developing innovations and competition in different economic sectors (Bo, R.1992). Small and medium sized enterprises(SMEs), this is, companies with up to 250 employees, constitute the engine of most of the world’s economies. The OECD (organization for economic co-operation and development) estimates that SMEs account for 90% of firms and employ 63% of the workforce in the world.  In the enlarged Europe, some 23 million SMEs represent 99% of all enterprises and provides about 75 million jobs (EC 2008).

In Cameroon, SMEs constitute a bulk of the country’s enterprises. In fact, law No 2010/010 of 13 April 2010 on the promotion of SMEs in Cameroon paved the way for the sector with many enterprises being created. With other accompanying measures for a level playing ground created, the SMEs, according to annual statistics of the year 2016 from the ministry of small and medium-sized enterprises, social economy and handicraft (MINPMEESA), constitute 95% of Cameroon’s enterprises and 36% of the gross domestic product. Recent statistic shows that, SMEs in Cameroon represent 96% of firms and employ 50% of the workforce but represent barely 36% of the GDP (gross domestic product).

SMEs are a major source of entrepreneurial skills, innovation and employment, but they can be the companies most affected by the globalization process and are often confronted by certain difficulties and barriers; for example, SMEs frequently have difficulties in obtaining capital or credit, particularly in the early start-up phase, lack of qualified staff, and also, lack of technical production materials amongst other which impedes their performance (2016 statistical book of the tutelage ministry). Financial performance. Financial performance in an organization measures the results of a firm’s policies and operations in monetary terms.  These results are reflected in the firm’s Sales growth, increase in profit, losses, investment and share capital in the last four Years (Harrison Mwinzi Kiema 2012). It is a subjective measure of how well a firm can use assets from its return on assets, value added, etc.  It is also a subjective measure of how well a firm can use assets from its primary mode of business and generate revenues (Will Kenton 2019). There are many different ways to measure financial performance by small and medium enterprises in different industries, though all measures should be taken in aggregation.  Line items such as revenue from operations, operating income or cash flow from operations can be used, as well as total unit sales.  Furthermore, the analyst or investor may wish to look deeper into financial statements and seek out margin growth rates or any declining debt (MacDonald, 2000). Financial performance is normally derived from sound financial statements as determined by the auditors on independence basis (Johnsone, 2001).  I choose to carry out my study on SMEs because, it appears that most SMEs in the world at large neglect the use of internal auditing for efficiency and effectiveness of their operations. This is because, some of these firm are completely ignorant of the important of internal auditing while others complain of the costliness of maintaining a good internal auditing system. And also, SMEs constitute the highest percentage of Cameroon’s firms and employ most of her population. This study will help reduce this ignorance and if our SMEs starts to consider the internal audit function, they will grow and Cameroon will be a more developed country. Internal auditing is important to SMEs in that, it enables them to be more complaint with law because internal audit consultants are generally experts in these areas and the consequences of non-compliances are serious which often result in severe financial penalties and at times even imprisonment and can also jeopardize the very existence of the business itself (CA Rishabh Kumar).

1.2 Statement of the problem

Microfinance institutions (MFIs) are critical in providing financial services to low-income populations, fostering entrepreneurship, and reducing poverty. However, the effectiveness of MFIs largely depends on their internal auditing systems and the quality of their financial reporting. Weak internal audit practices can lead to financial mismanagement, fraud, and errors, which jeopardize the sustainability of these institutions. In Buea, many MFIs face challenges such as limited resources, inadequate training for audit staff, and lack of compliance with international financial reporting standards. These issues contribute to unreliable financial data, reducing stakeholders’ confidence in their operations and financial health (Moya & Kereta, 2021).

The lack of transparent and accurate financial reporting further complicates the ability of MFIs to attract funding and meet regulatory requirements. Internal auditing, as a key control mechanism, plays a vital role in ensuring operational efficiency and accountability. Without robust internal audit systems, MFIs in Buea are vulnerable to inefficiencies and financial risks, which can hinder their ability to achieve their goals of promoting financial inclusion and supporting community development. Addressing these gaps is crucial for building trust among clients, investors, and regulatory bodies, and for ensuring the long-term viability of MFIs in the region (Dorner & Gichira, 2022).

; Research Questions

1. How do internal auditing practices affect the financial reporting quality of microfinance institutions (MFIs) in Buea?
2. What are the challenges faced by MFIs in Buea in implementing effective internal auditing systems?
3. To what extent does the quality of financial reporting influence stakeholder confidence in MFIs in Buea?
4. How do internal auditing and financial reporting impact the financial performance and sustainability of MFIs in Buea?

Objectives

General Objective:
To investigate the effect of internal auditing practices on financial reporting quality and the overall performance of microfinance institutions in Buea.

Specific Objectives:

1. To examine the relationship between internal auditing practices and financial reporting quality in MFIs in Buea.
2. To identify the challenges faced by MFIs in Buea in implementing effective internal auditing systems.
3. To assess the impact of financial reporting quality on stakeholder confidence in MFIs in Buea.
4. To evaluate how internal auditing and financial reporting influence the financial sustainability of MFIs in Buea.