internal controls and financial reporting quality in privitized companies in uganda: a case of...
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INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN PRIVITIZED
COMPANIES IN UGANDA:
A CASE OF CENTRAL PURCHASING COMPANY LIMITED (CPCL)
ABAS JASPER OLWOL
DBS, Bsc Accts/Finance (Hons)
11/2/501/E/428
SUPERVISOR: Dr Henry Buwule Musoke
PhD, Msc, BBA (Hons)
A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS
ADMINISTRATION DEGREE OF NDEJJE UNIVERSITY
SEPTEMBER, 2013
i
DECLARATION
I Abas Jasper Olwol do hereby declare that this dissertation is my own original work and
has not been presented to any institution/University for academic award or otherwise by
any person.
Signature ………………………… Date………………….
Abas Jasper Olwol
Reg No: 11/2/501/E/428
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APPROVAL
This dissertation has been submitted for examination with my approval as a University Supervisor
Signature……………………………… Date…………………………………
DR. Henry Buwule Musoke
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DEDICATION
I dedicate this research dissertation to the almighty God, my late Father Benjamin Okwenye, my Mother
Ms Leah Okwenye, my Wife Ms Deborah Olwol and Children (Glad, Gloria and Gabriel), brothers and
sisters, my friend Opio Amed Sunday and all those whose desire has seen me where I am now. May God
bless you all
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ACKNOWLEDGEMENT
Most of all I thank the Almighty God for being a source of inspiration and for providing me
wisdom and the Grace to complete this research. I am greatly indebted to my Supervisor, Dr. Henry
Buwule Musoke for his guidance, encouragement and patience even when I seemed not to
understand. I also extend my profound appreciation and thanks to family and most especially my
parents the late Benjamin Okwenye and Ms. Leah Okwenye, my wife Deborah and Children,
brothers and sisters Robinson, Dianah, Janet, Night and Gift for having been understanding,
tolerant, supportive for along time. My gratitude also goes to my colleagues especially Opio, Filder,
Nicho, Wanyana, Harriet, Olive, Maureen, Kamukama, Cissy and Linda who assisted and offered
me the academic company I needed during the MBA program, my pastor Moses Kakembo together
with the family of Luzira Healing Springs Church. Special thanks go to the Central Purchasing
Company management for allowing me carry out this research; I also thank all staff especially those
who participated in this research by responding to questionnaires. For all the above various groups
and individuals and many others that I may not have mentioned, in this acknowledgement, I owe
this achievement to you all and I will always remain indebted to you.
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TABLE OF CONTENTS
DECLARATION………………………………………………………...…..…...Error!
Bookmark not defined.
APPROVAL……………………………………………………………….....…..Error!
Bookmark not defined.
DEDICATION………………………………………………………………...…iii
ACKOWLEDGEMENT…………………………………………………… .….iv
TABLE OF CONTENT……………………………………………………..…..v
LIST OF TABLES…………………..………………………………………....viii
LIST OF FIGURES……………………………………………………………..ix
ABBREVIATIONS AND ACRYOMNS..... …………………………………….x
ABSTRACT........................................................................................................... xi
1.0 INTRODUCTION .......................................................................................... 1
1.1 Background to the study ................................................................................. 1
1.2 Statement of the problem................................................................................ 6
1.3 Objectives of the study...................................................................................... 7
1.3.1 General objective ........................................................................................... 7
1.3.2 Specific objectives ......................................................................................... 7
1.4 Research Questions ......................................................................................... 7
1.4.1 Hypothesis.................................................................................................... 7
1.5 Significance of the study................................................................................. 7
1.6 Conceptual frame work..................................................................................... 8
1.7 Scope of the Study ............................................................................................ 9
1.7.1 Geographical Scope ....................................................................................... 9
1.7.2 Content Scope ................................................................................................ 9
1.7.3 Time scope ..................................................................................................... 9
1.8 Definition of Key Concepts used in this Study................................................ 9
1.9 Organization of the study................................................................................ 11
CHAPTER TWO…………………...…………………………..………………12
LITERATURE REVIEW .................................................................................. 13
2.1 The nature of Internal Controls....................................................................... 13
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2.1.1 Preventive Internal controls: ........................................................................ 14
2.2 Financial Reporting Quality.......................................................................... 26
2.3 Internal Controls and Financial Reporting Quality......................................... 33
2.4 Preventive Controls and Financial Reporting Quality .................................... 35
2.4.1 Detective Controls and Financial Reporting Quality................................... 36
2.5. Conclusion .................................................................................................... 38
CHAPTER THREE…………………………………………………………….38
METHODOLOGY ............................................................................................. 39
3.1 Research Design.............................................................................................. 39
3.2 Study Area and Population ............................................................................. 39
3.2.1 Study Area ................................................................................................... 39
3.2.2 Study Population.......................................................................................... 39
3.3 Sampling Design and Sample Size ................................................................. 40
3.3.1 Sampling Design.......................................................................................... 40
3.3.2 Sample Size.................................................................................................. 40
3.4 Data Collection Sources, Methods and Instruments ....................................... 40
3.4.1 Data Sources ................................................................................................ 40
3.4.2 Data collection methods............................................................................... 41
3.4.3 Data collection instruments.......................................................................... 42
3.5 Data Processing and Analysis ......................................................................... 43
3.5.1 Data Processing............................................................................................ 43
3.5.2 Data analysis ................................................................................................ 43
3.6 Ethical Considerations .................................................................................... 43
3.7 Limitation of the Study ................................................................................... 44
CHAPTER FOUR............................................................................................... 45
FINDINGS OF THE STUDY ............................................................................ 45
4.1 Demographic Characteristics .......................................................................... 45
4.1.1 Gender and departments of respondents ...................................................... 45
4.1.2 Length of Service in the Organization ......................................................... 46
4.3. Preventive and Detective Internal Controls ................................................... 48
4.4. Financial Reporting Quality........................................................................... 52
4.5. Relationship Between Internal Controls and FRQ......................................... 55
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4.6. Regression Analysis....................................................................................... 58
4.6.1 Qualitative Data Presentation ...................................................................... 59
4.6.3 Internal controls ........................................................................................... 59
4.6.4. Effectiveness of internal controls................................................................ 60
4.6.5 Accountability procedure............................................................................. 61
4.6.6 Reporting procedure..................................................................................... 61
CHAPTER FIVE…………………...……………………………………....……61
5.0 SUMMARY,CONCLUSIONS AND RECOMMENDATIONS…………62
5.1 Summary of Major Findings ........................................................................... 62
5.1.1. Objective One. ............................................................................................ 62
5.1.2. Objective two .............................................................................................. 62
5.1.3. Objective Three........................................................................................... 63
5.2 Conclusions.................................................................................................... 63
5.3 General Recommendations ............................................................................. 64
5.3.1 Objective one ............................................................................................... 64
5.3.2 Objective Two.............................................................................................. 65
5.3.3 Objective Three............................................................................................ 65
5.5 Recommendation for further research ............................................................ 65
REFERENCES…………………………………………………………………..65
APPENDIX I SELF – ADMINISTERED QUESTIONNAIRE...................... 69
APPENDIX II INTERVIEW GUIDE:.............................................................. 73
APPENDIX III :( NATURE OF INTERNAL CONTROLS) ......................... 74
APPENDIX IV (NATURE OF FINANCIAL REPORTING QUALITY)..... 75
APPENDIX V KREJICE AND MORGAN (1970) .......................................... 76
APPENDIX VI INTRODUCTORY LETTER…………………………………..76
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LIST OF TABLES
Table 3.1: Sample Size ......................................................................................... 40
Table 3.2: The Content Validity Index ................................................................. 42
Table 3.3 Reliability Test Table............................................................................ 43
Table 4.1 Respondents and their departments ...................................................... 45
Table 4.2: Length of Service in the Organization................................................ 46
Table 4.3. Age of Respondents ............................................................................. 46
Table 4.4 Level of Education of the Respondents ................................................ 47
Table 4.5.Likert Scale ........................................................................................... 48
Table 4.6.showing Descriptive statistics controls................................................. 48
Table 4.7 showing Descriptive Statistic of FRQ…………………………...……51
Table 4.8 Relationship between Internal Controls and FRQ……….……....……54
Table 4.9 Relationship between preventive control and Compliance……...….…55
Table 4.9.1 Relationship between preventive control and Reliability……...……55
Table 4.9.2 Relationship between detective control and Compliance……...……56
Table 4.9.3 Relationship between detective control and Reliability...……...……56
Table 4.9.4 Model summary………………………………………....……...……57
Table 4.9.5 Analysis of Variables (ANOVA)……………………………………57
Table 4.9.6 Standardised Coefficient………...………...…………....……...……58
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LIST OF FIGURES
Figure 1.1: Conceptual frame work of ICs and FRQ in Privitised Companies in Uganda…...........7
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ABBREVIATIONS AND ACRYNOMS
ACCA Association of Chartered Certified Accountants
AICPA American Institute of Certified Public Accountants
COBIT Control Objectives for Information and Related Technology
COSO Committee of Sponsoring Organizations
CPCL Central Purchasing Company Limited
CPD Continuing Professional Development
CVI Content Validity Index
FCPA Foreign Corruption Practices Act
FRO Financial Reporting Organizations
GCPC Government Central Purchasing Corporation
HRO Human Resource Organizations
ICPAU Institute of Certified Public Accountants of Uganda
ICS Internal Control System
IFRS International Financial Reporting Standards
IIA-UK Institute of Internal Auditors- United Kingdom
SAC System Audit ability and Control
SAIGA The South African institute of government auditor
SD Standard Deviation
SOX Sarbanes- Oxley Act
SSA Sub Saharan Africa
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ABSTRACT
Whereas extensive studies have been carried out to explore and explain internalcontrols and financial reporting quality in Privatized Companies worldwide, very fewof these have focused on Developing Africa and Uganda as a whole. This study assessedinternal controls and financial reporting quality in privatized companies focusing oncentral purchasing company limited (CPCL). A conceptual framework was developedon the internal controls and financial reporting quality of Central PurchasingCompany. The specific objectives were (i) To access the nature of internal controlsused by Central Purchasing Company Limited. (ii) To examine the nature of financialreporting quality at (Central Purchasing Company Limited). (iii) To establish arelationship between Internal Controls and Financial Reporting Quality. Aquantitative correlational cross-section survey and a case study research design wereused to collect data. Stratified and purposive sampling techniques were used to selectthe respondents. Microsoft Excel and SPSS were used to analyze the data and topresent the findings. Findings indicates that, the company had average internalcontrols and most of them were functioning properly .The correlation coefficient ofr=0.914 indicated that there is a strong positive relationship between internal controlsand financial reporting quality. It’s thus recommended that Central purchasingcompany management should ensure that all its internal controls that are implementedare properly functioning and are not undermined by its staff as a way of attainingfinancial reporting quality (B.K. Sebbowa, 2009), .(Gerrit and Mohammad J. 2010). Inconclusion, given the correlation coefficient above it’s evident that there is a strongpositive relationship between internal controls and the financial reporting quality ofthe company. Recommendations were made focusing mainly on the need to improvethe weak areas such as verification of documents an aspect internal control so as toachieve sustainable financial reporting quality.
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CHAPTER ONE
1.0 INTRODUCTION
This study presents internal controls and financial reporting quality in privatized companies with
Central Purchasing Company as a case study. This Chapter covers the background to the study,
statement of the problem, objectives of the study, research questions, hypotheses, significance of
the study, scope of the study, the conceptual frame work and definition of key terms, and
organization of the study.
1.1 Background to the study
An internal control is a process implemented by an organization structure work and authority
flows, people and management information systems, designed to help the organization
accomplish specific goals or objectives with means of directing, monitoring and measuring of
organization resources. (COSO, 2005).
Internal control activities have been established by practitioners, primarily auditors. Rather than
investigate to control activities themselves, academics focused their research efforts on issues
surrounding the controls using an explicit, or implied, assumption that the properties of the
control activities are known. (Barra & Roberta 2010; Ashton1974; Bodner 1975; Cushing1974;
Doty et al1989; Hornik and Ruf 1997 Simon 1974 and Curtis1998) Aldridge and Colbert (1994)
define internal control as the process designed and effected by those charged with governance,
management and other personnel to provide reasonable assurance about the achievement of the
entity’s objectives with regard to the reliability of financial reporting, effectiveness and
efficiency of operation and compliance with applicable laws and regulations.(Gerrit and
Mohammad J. 2010),
Also internal control is defined as a process designed to provide reasonable assurance regarding
the achievement of financial reporting quality through reliability of financial reporting and
compliance with applicable laws and regulations. (Schaefer& James 2010; Peluchett & Joy
2009).
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 objectives in
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the following categories: reliability of financial reporting, effectiveness and efficiency of
operations, compliance with applicable laws and regulations.( Stephen H, 2003), Internal
controls have existed from ancient times. It is common knowledge among practicing
accountants, managers and business scholars that good internal controls prevent errors and frauds
leading to unqualified auditors opinion. External auditors may test the effectiveness of internal
controls and place reliance on the underlying records as a basis for the preparation of financial
reports. (ACCA- Managerial Finance Paper 8; 2010; and Panday;2008) .
In the United States many organizations have adopted the internal control concepts presented in
the report of the Committee of Sponsoring Organizations of the Tread way Commission
(COSO). Published in 1992.COSO describes internal control as consisting of five essential
components. These components, which are subdivided into seventeen factors, include:The
control environment
Risk assessment
Control activities
Information and communication
Monitoring
The COSO model is depicted as a pyramid, with control environment forming a base for control
activities, risk assessment, and monitoring. Information and communication link the different
levels of the pyramid. As the base of the pyramid, the control environment is arguably the most
important component because it sets the tone for the organization. Factors of the control
environment include employees' integrity, the organization's commitment to competence,
management's philosophy and operating style, and the attention and direction of the board of
directors and its audit committee. The control environment provides discipline and structure for
the other components. (Gerrit & Mohammad J, 2010).
Risk assessment refers to the identification, analysis, and management of uncertainty facing the
organization. Risk assessment focuses on the uncertainties in meeting the organization's
financial, compliance, and operational objectives. Changes in personnel, new product lines, or
rapid expansion could affect an organization. Sebbowa , (2009),
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Control activities include the policies and procedures maintained by an organization to address
risk-prone areas. An example of a control activity is a policy requiring approval by the board of
directors for all purchases exceeding a predetermined amount. Control activities were once
thought to be the most important element of internal control, but COSO suggests that the control
environment is more critical since the control environment fosters the best actions, while control
activities provide safeguards to prevent wrong actions from occurring. Sarens, G. & De Beelde,
I. (2006b)
Information and communication encompasses the identification, capture, and exchange of
financial, operational, and compliance information in a timely manner. People within an
organization who have timely, reliable information are better able to conduct, manage, and
control the organization's operations.
Monitoring refers to the assessment of the quality of internal control. Monitoring activities
provide information about potential and actual breakdowns in a control system that could make it
difficult for an organization to accomplish its goals. Informal monitoring activities might include
management's checking with subordinates to see if objectives are being met.
A more formal monitoring activity would be an assessment of the internal control system by the
organization's internal auditors.In Hellenistic Egypt there was a dual administration, with one set
of bureaucrats charged with collecting taxes and another with supervising them. The sacking of
Troy was a classic example of the failure of internal controls. Mwindi (2008).
Internal Control System (ICS) is a very important function in the achievement of the
organizational success and successful management functions (The South African institute of
government auditor SAIGA 2003). It further pointed out that when administrative and financial
management decisions go wrong, reference is usually made to ICS to seek out possible reasons.
On the other hand, financial statement is a written report which quantitatively describes the
financial health of a company or an organization which usually includes the income statement,
balance sheet, cash flow statement and the statement of retained earnings. (Myojung; Kim and
Lim 2010).
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Financial report Quality on the other hand refers to statements prepared to the required
accounting financial reporting standards to show the financial position of the business at the end
of the financial/accounting year and these statements must meet the following characteristics
which include; understandability, comparability, relevance and fair presentation.(Aharony, J and
A. Dotan, 2004) According to Welsch and Chesley(1990) the notes of balance sheets, cash flows
statement, statements of changes in are integral part of financial statements and help users
interpret the statement, elaborated on accounting policies, major financial effects and certain non
quantifiable events that may contribute to the success or failure of the business. The objective of
financial statements is to provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders and other creditors in making decisions in their
capacity as capital providers. (Murray, 2010).
The Financial Accounting Standards Board and the International Accounting Standards Board
releases a joint exposure draft proposing significant changes to how businesses present their
financial statements. Two major objectives of the proposed financial statements are
‘’disaggregation’’ and "cohesiveness." Disaggregation means, simply, that information on the
financial statements will be broken into more detail than is currently done, Cohesiveness means
that financial information expenses on the statement of comprehensive income to specific assets
or liabilities on the balance sheet and to specific cash flows on the statement of cash flows.
(Wagoner, Joel, 2011).
According to Osborne and Gaebler 1992, privatization is the shift of functions, activities and
responsibilities from the public (government) sector to the private sector. It involves a process
where the government gradually and progressively eliminates their involvement in direct service
provision while maintaining responsibility and authority over key functions such as
standardization, certification and accreditation. According to Megginson and Netter 2001,
Privatization is the deliberate sale by a government of state-owned enterprises or assets to private
economic agents.Andrews and Dowling, 1998 describe Privatization as a process by which state
owned enterprises are sold to the private sector
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In 1991/92 financial year, Uganda had about 140 State-Owned Enterprises covering a diverse
range of activities from trade and commerce, agricultural production and processing,
manufacturing, hotel and tourism, banking, insurance and utility services. Over 85% of these
State-Owned Enterprises were commercial in nature and were considered unlikely to survive in
competition with the emerging private sector without significant continuing government subsidy
(Adam Smith Institute, 2005).
In 1993, privatisation and reform supporting legislature, the Public Enterprises Reform and
Divestiture Statute 1993, Statute No. 9, (thereafter referred to as the PERD 1993 Statute) was
then passed by parliament and enacted to give legal backing to the policy reform objectives. This
was a pre-reform set of activities and an enabling law formulation that legalized the Economic
Reform process. The law served to safe guard outcomes of the operations and future legal
consequences. However some of the enterprises such as Lake Victoria bottling company– a soft
drinks company and Nile Breweries had already been privatised before the law was passed!
The PERD 1993 Statute provided guidelines for the reform and divestiture. It categorized the
enterprises that were to be reformed or divested under the programme, laid down the
implementers and the modes of privatisation that would be used in the process. There were
subsequent amendments to the statute along the way.
Following continued criticism from the World Bank and International Monetary Fund (IMF)
regarding poor performance of public enterprises especially in Sub-Saharan Africa (SSA), many
governments have had to implement Structural Adjustment Reforms to try and improve their
economies and to gain access to financial credit facilities and so did Uganda (Tangri et al. 2001).
In May 1987, Uganda government took a stand to embrace a radical Economic Recovery
Programme (ERP) to improve the performance of the economy and ensure sustainable growth.
This programme introduced privatisation into the economy and this involved rationalization of
state ownership, liberalization, rehabilitation, divestiture, consolidation and liquidation. The
privatisation programme is part of the overall Economic Recovery Programme (ERP) and its
adoption was intended to invigorate the private sector so that it could make the private sector
play a leading role in the development of the economy (Privatisation Unit 2005).
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The Central Purchasing Company was formed following the divestiture of the Government
Central Purchasing Corporation (GCPC). GCPC had been set up by government to procure
common-user items in bulk and supply these materials to Government at lower prices taking
advantage of economies of scale. GCPC eventually started supplying to the private sector as
well. In June 2000, GCPC was privatized by way of a Management Employee Buyout under
which the former employees of GCPC forfeited their terminal benefits for stock in the company.
The company which was originally owned by eighty six (86) individuals now trades as the
Central Purchasing Company Ltd (CPCL) with its main business being procurement and trading
for both the public and private sector.
The company set up should be designed to realize the objective of the company. However an
evaluation of the company structure, management of staff, financial performance, decision
making structures and levels that procurement function did not portray alignment to the
objectives. For instance Company’s capacity assessment of 1999 conducted by private sector
foundation revealed that most private companies go down in business due to weakness and laxity
in control systems. B.K. Sebbowa, (2009)
1.2 Statement of the problem
Despite the availability of professional staff and their continued development, internal and
external auditor’s contribution in most Companies still experience difficulty in presenting
financial reports that reflect the financial condition and results of operations in rational and
meaningful manner. According to Blackbeard (2006), information is often delayed, inaccurate
and relayed from person to person rather than via reports; making it hard for Organizations to
achieve financial reporting quality .
However despite all the above efforts, the company still struggles with meeting acceptable
financial reporting quality, financial reports are not made timely, accountability for the financial
resources are still wanting, frauds and misuse of the Company’s resources have been unearthed (
Auditors Report,2011). If the Company continues in this direction, decisions made may not be
informed and this may lead to declined performance. While there are many factors that affect
Financial Reporting Quality of privatized Companies, particularly Central Purchasing Company
Limited, Internal Controls may be playing a significant role. It is for this reason that the
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researcher embarked on this study relating Financial Reporting Quality (Compliance and
Reliability) to Internal Controls, specifically preventive and detective controls in Central
Purchasing Company Limited.
1.3 Objectives of the study
This sub section spells out the general and specific objectives of the study
1.3.1 General objective
The general objective of the study was to find out the effect of internal controls on financial
reporting quality in privatized companies in Uganda, using CPCL as a case study.
1.3.2 Specific objectives
i) To assess the nature of Internal Controls used by CPCL.
ii) To examine the nature and Quality of Financial Reporting at CPCL.
iii) To establish a relationship between Internal Controls and Financial Reporting Quality in
CPCL.
1.4 Research Questions
i) What internal controls are being used by Central Purchasing Company?
ii) What is the nature and quality of financial reporting at CPCL?
iii) What relationship exists between the internal controls and the Financial Reporting Quality?
1.4.1 Hypothesis
There is no significant relationship between Internal Controls and Financial Reporting Quality.
1.5 Significance of the study.
(i) The study may help management of CPCL in setting policies that are relevant to company’s
performance in improving their financial reporting.
(ii) The study may provide information and knowledge to academicians and other researchers
and also the study findings can generate knowledge for the government about why privatized
companies fail to comply with financial reporting requirements. This can help the government to
identify what kind of technical support they should provide the privatized companies before
giving them any funding in order to ensure acceptable quality of financial reports.
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(iii) The study may provide information that will assist workers of CPCL and other stakeholders
to improve on the existing internal controls in the Company
(iv) The study findings can also help privatized companies in improving their compliance to
financial reporting requirements and thus improving their capability to attract more development
and ensure their company’s sustainability.
1.6 Conceptual frame work
Independent Variable Dependent Variables
Mediating Variables
Source: Conceptualized by Researcher
Figure 1.1 Relationship between internal controls and financial reporting quality.
Fig.1.1 provides a conceptual framework relating internal controls to financial reporting quality.
The independent variables are internal controls and the framework depict two elements of
internal controls, namely preventive controls and detective controls, all conceptualized to have
an effect on financial reporting quality. The dependent variable in this study is the financial
reporting quality which was measured in terms of compliance to International financial reporting
standards and reliability for its purpose. The framework further shows that there are moderating
variables such as company policies and systems, organizations efficiency through experience,
skills, knowledge and ethical behavior of staff ,For example, despite the expected relationship
between internal controls and Financial Reporting Quality, organizational inefficiency can have
an opposite effect.
Financial Reporting QualityInternal Controls
Compliance
Reliability
Preventive ControlsSegregation of Duties
Approvals, Authorizations,and Verifications:
Detective Controls
Reviews of Performance Reconciliations Internal Audit
Company policies andsystems
Organizational
Efficiency
Experience, skillsand knowledge ofStaff
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1.7 Scope of the Study
This sub section covers geographical scope, content scope and time scope.
1.7.1 Geographical Scope
The study was undertaken at the head office of Central Purchasing Company Ltd located on plot
56 Bell Avenue West, Jinja and two branches in Jinja District and Malaba in Busia District. The
researcher selected Central Purchasing Company Ltd because it was the first Government
Corporation to be sold to its own employees under the privatization unit and pioneer of takeover
by employees in Uganda. The locations were chosen because Jinja and Malaba office are the
only remaining operational offices of Central Purchasing Company Limited.
1.7.2 Content Scope
The study focused on accounting controls and was limited to two dimensions of accounting
controls ( preventive controls and detective controls) as independent variables and financial
reporting quality measured in terms of compliance and reliability of financial reporting as
standards of measurement under internal financial reporting .
1.7.3 Time scope
The study covered the period from 2002 to 2009 in order to review the significance of internal
controls on financial reporting quality so as to come up with the necessary conclusions and
recommendations which would be generalized and applicable to justify the study. The researcher
was interested in this period because it was the time Central Purchasing Company started selling
off its properties in Kampala and laying off employees.
1.8 Definition of Key Concepts used in this Study.
Internal controls: refers to a control environment and control procedures adopted by
management of an entity, to assist in achieving the practicable; the orderly and efficient conduct
of its business, adherence to management policies, safeguarding assets, prevention and detection
of fraud and error, accuracy and completeness of records and timely preparation of reliable
financial information. (ISA 400 Risk assessment and Internal control), Internal controls are those
measures which ensure the accuracy of financial statements through preventive and detective
control. Millichamp, (1996).
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These are measures which ensure the accuracy of financial statements. Once financial
statements are known to be accurate, there will be increased reliance on the underlying
accounting system as a basis for the preparation of accounting reports. Accounting control may
include authorization, management accounts (profit, loss account and balance sheet) produced
monthly, periodic stocktaking and valuation and reconciliation of bank statements with the cash
book. Millichamp (1996).
Detective Internal Controls: These controls are meant to expose those frauds and errors that
have not been prevented. An audit, both internal and external will serve to detect errors and
frauds, reconciliation of bank accounts, reconciliation of debtors ledgers to their controls
accounts, cash and stock accounts will detect anomalies that need to be investigated and decision
to correct them made by management. Supervision is also a detective control. (Institute of
Chartered Accountants of Britain and Wales, sept.1999).
Administrative Internal Controls are controls that are put in place by management to ensure
operational efficiency, effectiveness and compliance with management policies in all
departments or sections of an organization. Administrative control may include authorization to
use equipment or entry to certain offices, security of all the assets of the organization. Finance
Markets ‘Authority (AMF).January2007.
Financial Reporting. According to Frank wood and Sangster, (1998) financial reporting is
defined as a discipline concerned with the preparation and presentation of financial statements.
While ACCA, (Foulks Lynch, 2005), defines financial reporting as preparation of financial
statement in accordance to accounting standards.
It’s a statements prepared to the required accounting financial reporting standards to show the
financial position of the business at the end of time period and also the operating results by
which the business arrives at this financial position .It is of view that accountants rely on record
keeping systems particularly, double entry to produce meaningful financial reports that
summarize both the past and current financial positions of the organization. Also financial
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reporting show past and projected finances and these reports are both the sources of tax
information and the means of analyzing the business. Blake J (1999), Brookson (2001.
Financial reporting quality. Financial report is said to be of quality when it meets all its
characteristics like reliability, comparability, relevancy, understandability and also measures a
company's financial performance during a specific accounting period.
Compliance of financial reporting. Compliance refers to practical application of the existing
laws and regulations and internal policies in relations to IFRS framework. Coco indicates that
control comprises: those elements of an organization (including its resources, systems, processes,
culture, structure and tasks) that, taken together, support people in the achievement of the
organization's objectives.
Reliability of financial reporting is all about information being fit for purpose. Where people
have a clear responsibility to do something and they need to use information to do this, it brings
the whole issue of reliability into focus. The purpose for any financial information is aiding
management with clear decision concerning financial matters as reliability is seen as an
important concept in a number of other fields such as engineering and research we are keen to
see if the theory in these areas may help us to understand how reliability relates to audited
financial statements.
1.9 Organization of the study
The Study covered five chapters as follows Chapter one covers the background to the study,
statement of the problem, general objectives of the study, specific objective of the study,
research questions, hypothesis tested, significance of the study, the conceptual frame work, and
scope of the study, definition of key terms and organization of the study.
Chapter two presents a review of related literature on internal controls and financial reporting
quality.
Chapter three is the detailed descriptions of the research methods and instruments employed in
the study.
12
Chapter four is a presentation and discussion of the study findings based on the objectives
aiming at internal control system and financial reporting quality for the last seven years.
Chapter five presents the summary of the results, conclusion and recommendations from the
study.
13
CHAPTER TWO
LITERATURE REVIEW
This chapter comprises the concepts and views of authorities in this area of study that is internal
control and financial reporting quality and the relationship between the two variables of the
study.
2.1 The nature of Internal Controls
There are numerous definitions of internal control, most of them having been drafted by
professional accountants’ organizations.
This is the case for the definition of internal control provided in 1977 by the French Institute of
Chartered Accountants: “internal control is the set of security measures which contribute to the
control of a company. Its aim is to ensure, on the one hand, the security and safeguard of assets
and the quality of information, on the other hand, the application of instructions given by Senior
Management, and to encourage improvements in performance. It is evidenced through the
organization, methods and procedures for each of the company’s activities, so as to ensure the
continuity of that company”. Finance Markets ‘Authority (AMF).January2007.
Internal control is a company’s system, defined and implemented under its responsibility, which
aims to ensure that: Laws and regulations are complied with; the instructions and directional guidelines
fixed by Executive Management or the Management Board are applied, The Company’s internal
processes are functioning correctly, particularly those implicating the security of its assets.
In determining its policies with regard to internal control, and thereby assessing what constitutes
a sound system of internal control in the particular circumstances of the company, the board’s
deliberations should include consideration of the following factors: the nature and extent of the
risks facing the company; the extent and categories of risk which it regards as acceptable for the
company to bear; the likelihood of the risks concerned materializing; the company’s ability to
reduce the incidence and impact on the business of risks that do materialize; and the costs of
operating particular controls relative to the benefit thereby obtained in managing the related
risks. (Institute of Chartered Accountants of Britain and Wales, sept.1999).An internal control is
broadly classified into administrative and accounting controls.
14
Administrative internal controls are controls that are put in place by management to ensure
operational efficiency, effectiveness and compliance with management policies in all
departments or sections of an organization. Administrative control may include authorization to
use equipment or entry to certain offices, security of all the assets of the organization.
Accounting internal controls are those measures, which ensure the accuracy of financial
statements. Once financial statements are known to be accurate, there will be increased reliance
on the underlying accounting system as a basis for the preparation of accounting reports.
Accounting control may include authorization, management accounts (profit, loss account and
balance sheet) produced monthly, periodic stocktaking and valuation and reconciliation of bank
statements with the cash book. Mill champ (1996).This control is further classified into;
Preventive, Detective and Corrective internal controls.
2.1.1 Preventive Internal controls: These are controls that are put in place by management to
prevent the accuracy of errors and frauds in the financial statements. These controls include
internal audit, recruitment of the right people with adequate training and experience in the right
places, segregation of duties, authorization and approval of transactions and surprise cash
accounts in the cash office among many more. Coe, Charles K, Ellis, Curtis (2010)
Separating Approval and Payment. A requirement that an employee who is authorized to
initiate a payment to a vendor is not also authorized to sign vendor payment checks would be a
preventive control. Among other things, such a control is designed to reduce the risk of
unauthorized payments,( Krishnan, J. 2005).
Limiting Access to IT Systems. Controlling access to software programs related to accounting
or payment functions through the use of passwords and access codes is another type of
preventive control. Limiting the persons who can change IT programs reduces the risk of
unauthorized transactions. (Conor, Errol &Divesh, 2006).
Segregation of Duties: One of the building blocks of internal control is segregation of duties.
This concept involves assigning responsibility for different parts of a process to different people
so that no one person can control the entire process. The importance of segregation of duties
stems in part from the fact that collusion between two individuals is less likely than misconduct
15
by a single individual. Segregation also reflects the lower probability that two persons will make
the same error with respect to the accounting for a transaction. Assigning responsibility for
physical access to a supply room to a different person than the individual who is responsible for
maintaining the records of the supplies inventory is an example of segregation of duties. (COSO,
2010).
Approval, verification, and authorization
The first step towards controlling financial reporting is to ensure that all transactions are properly
authorized in accordance with management’s policies. Management authorizes employees to
perform certain activities and execute certain transactions within limited parameters. In addition
management specifies those activities or a transaction that needs supervisory approval before
they are performed or executed by employees. A supervisor’s approval (manual or electronic)
implies that he or she has verified and validated that the activity or transaction conform to
established policies and procedure (Rezaee, I&Zabihellah.B, 2002).
Authorization is the delegation of authority and it may be general or specific. Giving a
department permission to expend funds from an approved budget is an example of general
authorization, specific authorization relates to individual transactions; it requires the signature or
electronic approval by a person with approval authority. Approval of a transaction means that the
approver has reviewed the supporting documentation and is satisfied that the transactions is
appropriate, accurate and comply with the applicable laws, regulations, policies and procedures.
Generally approvers review supporting documents, question usual items and make sure that
necessary information is present to justify the transactions before they sign off on the transaction.
As a general rule, authorizations do both of the following (COSO, 2010).Require advance
approval, require written documentation of approval, Dittenhofer, M. (2001).
2.1.2 Detective internal controls:
These controls are meant to expose those frauds and errors that have not been prevented. An
audit, both internal and external will serve to detect errors and frauds, reconciliation of bank
accounts, reconciliation of debtors ledgers to their controls accounts, cash and stock accounts
will detect anomalies that need to be investigated and decision to correct them made by
management. Supervision is also a detective control, (Hayes et al. 2005).
16
Review of performance : While business firms require ongoing changes in organizations'
activities (Alles et al, 2006), they also provide internal control effectiveness thoroughly
understanding in the way continuous monitoring adequacy is because continuous monitoring
ensures that firms are subject to operational effectiveness, reliability of financial reporting, and
regulatory compliance. Therefore, continuous monitoring adequacy is a component of internal
controls that it serves preventive and detective control, for example, when staff members who
know their work as well, they always perform their duties. In this research, continuous
monitoring adequacy is defined as the sufficient and appropriate process of methodology for
issuing the extent of firm to monitor and evaluate internal control system, involvement of long
and short term action plan that the organization uses to assess their plan on strategic objectives.
The appropriate and sufficient monitoring control includes of a performance by firm's evaluators
who respect, trust, and believe the operational control system. The monitors such as internal
auditors or to whom a company assigns their duty to be continuous or ongoing monitoring by
using a highly a control skills, knowledge, and ability that they can evaluate, summarize, and
control effectively. Hence, continuous monitoring leads to preventive and corrective firms'
control system before all members have gotten an effect on organization's goals. The continuous
monitoring adequacy will provide the strongest support for company reporting, particularly, a
reliance of financial reporting (Shapiro and Matson, 2008)
Communication: Within organization, communication is very important baseline in business
firms for both inside and outside the firms (Duxbury and Neufeld, 1999). However, particular
intra organization communications want more links from the staff members and college to
encourage information and knowledge (Zhang et al, 2005). When firm acquires new information
or company rules of internal control, the senior management will make connections with the
target groups and might be aware of information and consciousness within the firm (Yang and
Maxwell, 2011). Therefore, the role of intra organization communication needs a clear
communication skills, or communication in practice. Effective communications within
organization allows employees to recommend and suggest internal control guidance on practical
performance which is used in the day to day operations of a business (Harvey et al., 2000).
Organization communication has been defined as a comprehensive and thorough of firm
members who are receiving or addressing on particular internal control topics and issues
17
completely, clearly, reliability and timeliness. The potential of intra origination communication
may address or stress on the awareness between organization staffs regarding how a quickly was
relation with internal control information it is. If firm members felt that their behavior had
received incomplete or not clear information that firm sends from the firm particular internal
control policies announcement, they perhaps feel most dissatisfied consequently internal control
doesn't effectiveness (Oberg and Walgenbach, 2008). The control of channel communication
distribution information can help build effectiveness of internal control mechanism (Nunlee,
2005).
Firm must be quickly expanding internal control information to all employees' levels. Moreover,
firm policies should show that its reliability can be assisted by providing internal control actually
happening at the intra communication level within organization (Carlsson et al 2010; Hogard et
al, 2005).) Intra-firm communication possess is sharing information, a potential adapter collect
information before making a decision impact on innovation in finance (Everdingen and Wiernga
2002). On the other hand, intra organization communication should be designed to help both
users and contributors to communicate and share information within organization easily (Yang
and Maxwell, 2011; Bardir et al 2009; Russo and Harrission, 2005; Millson and Wilemon, 2002).
The wide domain of potential intra organization communication related to internal control
effectiveness has a significant criterion such as task performance and respect (Driskill and
Downs, 1995) especially accounting policy and firm member belief or behavior respectively.
(COSO). 2007
Risk assessments: At present, every business firms requires risk assessment to avoid and mitigate
firm risk purposes. Risk management system consists of manager's style and his philosophy,
linked with business strategy, and objective setting in operating (Arena et al., 2010). The risk
management today has moved from the entity area of the firm to the corporate cover the firm
(Arena et al., 2010, Power, 2009). The sufficient and appropriated risk management procedure
may present internal control effectiveness by senior executive management and board of director
policies. Hence, the senior management and board of director must understand risk appetite more
as the consequence organizational process (Power, 2009). The clear and sufficient accounting
policies can make appropriate internal control effectiveness (COSO, 2004). Therefore, risk
management efficiency is intended to reflect that firm has been updated rules, standard of work,
18
guidance, and especially a quality of compliance. However, organizations using a weaker risk
management process focused on control compliance and experience are with more difficulty
(Arnold et al., 2011). The outcome of risk management efficiency on the internal effectiveness is
reliability of financial reporting. Hence, risk management efficiency is a part of the internal
control effectiveness. Therefore, internal control system is stemmed from the attitude and
behavior of senior executive management and Board of Directors' behavior that must
transparency, integrity, accountability, and competiveness, (B.K. Sebbowa, 2009).
Reconciliations. Independently comparing two sets of records that relate to the same transaction
and analyzing any differences is a detective control. Reconciling the cash account balance on the
company’s books to its bank records could identify whether any payments recorded by the com-
pany were not received by its bank, or whether any withdrawals reported by the bank were not
accounted for by the company, (B.K. Sebbowa, 2009).
Internal Audit, Whittington & Pany (2001) suggest that internal auditing is performed as part of
the monitoring activity of an organization. It involves investigating and appraising internal
controls and the efficiency with which the various units of the organization are performing their
assigned functions. An Internal Auditor is normally interested in determining whether a
department has a clear understanding of its assignment, is adequately staffed, maintains good
records, properly safeguarding cash, inventory & other assets and cooperates harmoniously with
other departments. The internal auditor normally reports to the top management. (Gupta, 2001)
on the other hand asserts that “Internal audit is an independent appraisal function established
within an Organization to examine and evaluate its activities as a service to the organization”.
The objective of internal audit is to assist members of the organization in the effective discharge
of their responsibilities. According to Gupta “the scope of internal audit is determined by
management”. This may however, impair the internal auditor’s objectivity and hampers his
independence, it is quite hard to report negatively on someone who determines the scope your
work. Although at a Seminar organized by the Institute of Certified Public Accountants of
Uganda (ICPAU), Sebbowa, 2009 in his presentation “The role of Internal Audit function in
Organizations”, states that “Independence is established by organizational and reporting
structure” and that “Objectivity is achieved by an appropriate mindset”. Sebbowa, 2009 also
19
defines “Internal auditing is an independent, objective assurance and consulting activity designed
to add value and improve an organization’s operations.ICPAU,(2009).
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”. He further mentions the principles of Internal audit to include; Integrity, Objectivity,
Confidentiality and Competency. However, given that Internal Auditors are appointed by
management, report to management, and are employees of an organizations, their objectivity is
usually highly compromised Adams, M. B. (2006).
In accordance to Institute of Internal Auditors (IIA-UK; 1997), independence is applicable to all
categories of auditors. This means the opportunity granted to the auditors to report directly to the
top authority. Woolf (1986), says, although an internal auditor is an employee of the enterprise
and cannot therefore be independent of it, he should be able to plan and carryout his work as he
wishes and have access to the highest level of management. However, Millichamp (1993) says,
effective internal audit should be carried out by an independent personnel though they are
employees appointed by management, for them to work efficiently, they should have scope to
arrange priorities and activities have un restricted access to records, assets and personnel.
Adams, M. B. (1994)
According to Bhatia (2003), Internal Auditing is the review of operations and records sometimes
undertaken within the business by especially assigned staff. It’s also an independent appraisal
function established within an organization to examine and evaluate the effectiveness, efficiency
and economy of managements control system (Subramaniam, 2006). Its objective is to provide
management with re-assurance that their internal control systems are adequate for the need of the
organization and are operating satisfactorily (Reid & Ashelby, 2002). It is a component of the
internal controls set-up by management of an enterprise to examine, evaluate and report
operations of accounting and other controls. The quality and effectiveness of internal audit
procedures in practice are necessary since internal auditors cover a wide variety of assignments,
not all of which will relate to accounting areas in which the external auditor is interested. For
example, it’s common these days for internal audit to undertake the extensive and continuous
task of setting management goals and monitoring its performance (Woolf, 1996).
20
Emasu (2010) notes that “The effectiveness of internal audit function partly depends on; legal
and regulatory framework, placement of the function and its independence, existence of audit
committees, resources allocated to the function and professionalism of internal audit staff”. It is
however a bitter reality that internal audit departments are rarely adequately facilitated.
Regarding the size and facilitation of the Internal Audit Function, Gerrit and Mohammad (2010),
found evidence in support of the monitoring role of the Internal Audit Function. They
specifically, found evidence that management ownership is positively related to the relative size
of the Internal Audit Function, which is inconsistent with traditional agency theory arguments
that predict a negative relationship, but more in line with recent studies on earnings management.
This finding suggests that increased management ownership may influence the board of directors
to support larger Internal Audit Functions to allow them to closely monitor managers’
performance. It is also plausible that management with higher share ownership is motivated to
invest in larger Internal Audit Function for better monitoring of earnings and for signaling to the
board of directors that, despite their high stake in earnings, they are convinced that appropriate
use of resources has to be assessed on a regular basis. Gerrit and Mohammad also believe that
the proportion of independent board members to have a negative effect on Internal Audit
Function size. This finding may indicate a substitution effect, which means that independent
board members may be considered as an alternative monitoring mechanism to the Internal Audit
Function. They further assert that the control environment has a significant effect on the relative
size of the Internal Audit Function. Specifically, a supportive control environment characterized
by formalized integrity and clear ethical values, a high level of risk and control awareness, the
perception that risk management is important and the fact that responsibilities with respect to risk
management and internal control are clearly defined is associated with a relatively larger Internal
Audit Function. ACCA (2010)
Using a US sample, Wallace & Kreutzfeldt (1991) found that companies with internal audit
departments are observed to be significantly larger, more highly regulated, more competitive,
more profitable, more liquid, more conservative in their accounting policies, more competent in
their management and accounting personnel, and subject to better management controls. Carey et
al. (2000) found that agency variables do not explain the voluntary use of internal audit by
21
Australian family firms. More recently, a study by Goodwin-Stewart & Kent (2006), using a
sample of Australian listed companies, shows that the existence of an Internal Audit Function is
positively associated with firm size and commitment to risk management. Sarens & De Beelde
(2006) also show that the risk and control awareness have an influence on the scope of the
Internal Audit Function. These results suggest that when management is aware of risks and
control activities, they are more likely to understand the role of the Internal Audit Function in
monitoring risk and control activities, thus it is more likely that they will support a relatively
larger Internal Audit Function (Sarens & De Beelde, 2006a; Selim & McNamee, 1999). Meigs et
al (1988) holds that there must be a strong internal control system and the internal auditor must
verify the operations of the system in much the same way, as the external auditor. It involves the
investigation, recording, identification and review of compliance tests of control, they also
argued that effective internal audit procedures provide sufficient relevant and reliable evidence in
order to detect and prevent fraud. ACCA (2009/2010)
Kochan (1993), considers auditing procedures in one company and describes steps taken in
implementing a quality assurance system, she discusses the use of internal audits as an essential
part of ISO 9000 certification process. Boakye-Bonsu (1999) asserts that internal audit
procedures are seen as ends in themselves rather than a means towards a specific objective, with
such an approach our rambler would undoubtedly get lost. Internal audit procedure is a form and
content manual that includes audits notes and responsibilities, documentation standards, local
reporting standards and targets, training requirements and expectations and performance
measures and indicators (Watts, 1999). Effectiveness is the achievement of goals and objectives
using factor measures provided for in determining such achievement. However, it has been
traditional in internal auditing that determination of internal auditing effectiveness can be
accomplished by evaluating the quality and effectiveness of internal auditing procedures that
result in determination by the internal auditors of the character and the quality of effectiveness of
the auditee’s control operations and if the auditing procedures are effectively carried out, then
the evaluative results are positive (Dittenhofer, 2001). Maitin (1994) says efficiency and
effectiveness of internal audit procedures is not a simple task, successful operation is governed
by the extent to which the element of internal audit procedures receive attention which include;
expertise, independence, objectivity and totality. Effectiveness of internal audit procedures is a
measure of the ability of the programme to produce a desired effect or results that can be
22
qualitatively measured (Harvey, 2004). Zabihollah (2001) argues that, there should be effective
internal audit procedures to ensure reliability of financial statements, operational reports
safeguarding corporate assets and effective organizational controls. Benston (2003) further
supplements that perception and ownership, organization and governance framework, legislation,
improved professionalism and resources were identified as functions in the public sector derived
from the effectiveness of the internal audit procedures. How far internal audit procedures
succeed in their effort of effectiveness is mainly judged by three factors that include; frequency
of irregularities committed by the staff in the organization in form of errors or fraud, the
promptness with which such irregularities are detected by the authorities and the planning which
makes possible repetition of such irregularities in future more difficult (Reid & Ashelby, 2002).
The work of the internal auditor should appear to be properly planned, controlled, recorded and
reviewed. Examples of the due professional care by the internal auditor are the existence of an
adequate audit manual, general internal audit plans, procedures for controlling individual
assignments and satisfactory arrangements for reporting and following up. Earnest and Young
(1995),
The need for an internal audit function will vary depending on company-specific factors
including the scale, diversity and complexity of the company’s activities and the number of
employees, as well as cost/benefit considerations. Senior Management and the board may desire
objective assurance and advice on risk and control. An adequately resourced internal audit
function (or its equivalent where, for example, a third party is contracted to perform some or all
of the work concerned) may provide such assurance and advice. There may be other functions
within the company that also provide assurance and advice covering specialist areas such as
health and safety, regulatory and legal compliance and environmental issues.
In the absence of an internal audit function, management needs to apply other monitoring
processes in order to assure itself and the board that the system of internal control is functioning
as intended. In these circumstances, the board will need to assess whether such processes provide
sufficient and objective assurance. Kombo & Tromp (2009)
Assurance. When undertaking its assessment of the need for an internal audit function, the board
should also consider whether there are any trends or current factors relevant to the company’s
23
activities, markets or other aspects of its external environment that have increased, or are
expected to increase, the risks faced by the company. Such an increase in risk may also arise
from internal factors such as organizational restructuring or from changes in reporting processes
or underlying information systems. Other matters to be taken into account may include adverse
trends evident from the monitoring of internal control systems or an increased incidence of
unexpected occurrences. http://audit.unlv.edu/InternalControls.htm
The importance of internal controls
A company’s system of internal control has a key role in the management of risks that are
significant to the fulfillment of its business objectives. A sound system of internal control
contributes to safeguarding the shareholders’ investment and the company’s assets.
Internal control (as referred to in paragraph 20) facilitates the effectiveness and efficiency of
operations, helps ensure the reliability of internal and external reporting and assists compliance
with laws and regulations. Kochan, A. (1993).
Effective financial controls, including the maintenance of proper accounting records, are an
important element of internal control. They help ensure that the company is not unnecessarily
exposed to avoidable financial risks and that financial information used within the business and
for publication is reliable. They also contribute to the safeguarding of assets, including the
prevention and detection of fraud. I. M. Pandey (2010).
A company’s objectives, its internal organization and the environment in which it operates are
continually evolving and, as a result, the risks it faces are continually changing. A sound system
of internal control therefore depends on a thorough and regular evaluation of the nature and
extent of the risks to which the company is exposed. Since profits are, in part, the reward for
successful risk taking in business, the purpose of internal control is to help manage and control
risk appropriately rather than to eliminate it. (Institute of Chartered Accountants of Britain and
Wales, sept.1999)
Does the company have clear objectives and have they been communicated. So as to provide
effective direction to employees on risk assessment and Control issues? For example, do
objectives and related plans include? Measurable performance targets and indicators? Are the
24
significant internal and external operational, financial, compliance and other risks identified and
assessed on an ongoing basis?
Significant risks may, for example, include those related to market, credit, liquidity,
technological, legal, health, safety and environmental, reputation, and business probity issues. Is
there a clear understanding by management and others within the company of what risks are
acceptable to the board?
Internal control will also be evaluated by the external auditors. External auditors assess the
effectiveness of internal control within an organization to plan the financial statement audit. In
contrast to internal auditors, external auditors focus primarily on controls that affect financial
reporting. External auditors have a responsibility to report internal control weaknesses (as well as
reportable conditions about internal control) to the audit committee of the board of directors.
(Nigel Turnbull, Rank Group Plc)
Internal control must be evaluated in order to provide management with some assurance
regarding its effectiveness. Internal control evaluation involves everything management does to
control the organization in the effort to achieve its objectives. Internal control would be judged
as effective if its components are present and function effectively for operations, financial
reporting, and compliance. The boards of directors and its audit committee have responsibility
for making sure the internal control system within the organization is adequate. This
responsibility includes determining the extent to which internal controls are evaluated. Two
parties involved in the evaluation of internal control are the organization's internal auditors and
their external auditors. (Tim Row bury Internal, Audit Consultant)
At the specific transaction level, internal control refers to the actions taken to achieve a specific
objective (e.g., how to ensure the organization's payments to third parties are for valid services
rendered.) Internal control procedures reduce process variation, leading to more predictable
outcomes. Internal control is a key element of the Foreign Corrupt Practices Act (FCPA) of 1977
and the Sarbanes–Oxley Act of 2002, which required improvements in internal control in United
States public corporations. Internal controls within business entities are also referred to
as operational controls.
25
Limitations of internal controls
Internal controls are procedures and policies to be followed when carrying out financial
transactions. Policies are mere guides to action to ensure consistency in treatment of similar item
at different times; being guides they are subject to personal error of judgment. It is in the interest
of the organization that set procedures are followed when handling financial transactions.
Internal controls can offer only reasonable assurance that management objectives are reached,
this is because of certain inherent limitations as follows;- Menon, K. & Williams, J. D. (1994),
Due attention is devoted to day to day operational matters, but at the finalization stage of
financial reports, major adjustments are passed which may contain errors and fraud.
Internal controls can lead to internal rigidities that delay decisions and financial reports. Internal
controls already in use may prevent creativity because procedures were set and must be followed
without deviation. Collusion among staff can be used to undermine the internal control
procedures leading to loss of assets.
Management resistance to controls. In a situation where management does not support internal
control procedures, it may override controls to its own advantage. Internal controls work well
where management support is evident.
Management support could arise in form of staff recruitment policies, reviews of financial
information and taking corrective action where deviation from control procedures is reported,
Sarens, G. & De Beelde, I. (2006b).
Some internal control procedures are not cost effective; the cost of a control is disproportionate
to the cost of potential loss due to errors and fraud.
The effectiveness of internal control system is always affected due to carelessness, distraction
and misunderstanding of instructions. Human weaknesses tone down the effectiveness of internal
control systems, Emasu (2007).
Changing business environment may cause inadequacy in procedural conduct of business and
thereby compliance with procedures becomes difficult. (M.S. Ramaswamy, 1997).
In the control activities, Authority usually flows from the Board of Director to general
management.
26
General management therefore exercises delegated authority to ensure that all transactions both
financial and non financial are authorized.
Separation of duties is implemented to prevent intentional and unintentional errors and
misstatements. Duties such as custody of assets should be separate from authorization; posting
of ledgers should be separate from payments and receipting of cash, ( Subramanian, N. 2006)..
Documentation and record keeping provide proof for the accuracy of transactions. Transactions
must be supported by third party invoices, receipts and claim forms. Every transaction has to be
recorded permanently in the books of the organization, Ogneva, M., K. R. Subramanyam, and K.
Raghunandan. 2007.
Unauthorized access to some offices like cash, computer and stores is implemented to avoid loss
of portable assets and also to avoid deliberate damage to say computer programs. (KPMG Audit
Manual, 1988)
2.2 Financial Reporting Quality.
According to Collins and Collins (1978), a financial report is a means of portraying financial
accountability. In order for an organization to review the financial activities of the past year and
make plans for the future it prepares and publishes annual accounts or financial reports.
According to Samuel (1991), these are outputs of an accounting system and they are prepared at
the end of the year, hence the name final accounts. According to Horne (1998), the financial
reports should include a narrative description of the organization’s activities and audited
financial statements. He argues that these enable the stakeholders to see the organization’s
performance and the overall financial situation of the organization. Samuel (1991), states that
managers and accountants are usually required to defend the results shown in the financial
reports as part of the accountability process. According to Gale (2003), financial reports must
exhibit certain qualities that make them useful to the stakeholders and these include relevance,
reliability, understandability and timeliness. Australian Accounting Research Foundation (1990),
stated that it is important for financial reports to be relevant. They must have value in terms in
making and evaluating decisions about the allocation of scarce resources and in assessing the
rendering of accountability by the providers. The reports must also be reliable because users use
them for decision making. Reliability means that information is reasonably free from error and
27
bias and faithfully represents what it purports to represent. Understandability is the ability of
users to understand the financial reports. This will depend in part on their own capabilities and in
part on the way in which the information is displayed. Timeliness of financial reports is very
crucial because reports which are relevant and reliable may be rendered irrelevant if there is
undue delay in presenting them, (ACCA- Managerial Finance Paper 8; 2010; and Panday; 2008).
.
According to Gale (2003), poor quality of financial reports greatly diminishes the quality of
NGOs. Quality information is one that is readable, reliable, comparable, consistent, complete,
timely, decision-useful, accessible and cost effective. The integrity of the nonprofit sector is
served best if NGOs are accountable (Gale, 2003).
Financial reporting quality can be associated with investment efficiency in at least two ways.
First, it is commonly argued that financial reporting mitigates adverse selection costs by reducing
the information asymmetry between the firm and investors, and among investors (Verrecchia,
2001). For instance, Leuz and Verrecchia (2000) find that a commitment to more disclosure
reduces such information asymmetries and increases firm liquidity. On the other hand, the
existence of information asymmetry between the firm and investors could lead suppliers of
capital to discount the stock price and to increase the cost of raising capital because investors
would infer that firms raising money is of a bad type (Myers and Majluf, 1984). Thus, if
financial reporting quality reduces adverse selection costs, it can improve investment efficiency
by reducing the costs of external financing and, as discussed in more detail below, the potential
for financial reporting quality to improve investment efficiency is greatest in firms facing
financing constraints, (Gale, 2003)..
Second, a large literature in accounting suggests that financial reporting plays a critical role in
mitigating agency problems. For instance, financial accounting information is commonly used as
a direct input into compensation contracts (Lambert,2001) and is an important source of
information used by shareholders to monitor managers (Bushman and Smith, 2001). Further,
financial accounting information contributes to the monitoring role of stock markets as an
important source of firm specific information (e.g., Holmstrom and Tirole, 1993; Bushman and
Indjejikian, 1993; Kanodia and Lee, 1998). Thus, if financial reporting quality reduces agency
28
problems, it can then improve investment efficiency by increasing shareholder ability to monitor
managers and thus improve project selection and reduce financing costs,( Reid, K. &Ashelby, D.
2002).
Based on the discussion above that financial reporting affects both adverse selection and agency
conflicts, I predict an average negative relation between financial reporting quality and both
underinvestment and overinvestment. These links complement research in Bushman, Piotroski,
and Smith (2005), which studies the relation between country measures of timely loss
recognition and the country propensity to liquidate bad projects (i.e., mitigate overinvestment),
and in Wang (2003) which explores the relation between capital allocation efficiency and
accounting information quality for a sample of US firms, without making a distinction between
under- and overinvestment, Piotroski, and Smith (2005).
2.2.1 Compliance of financial reporting
Compliance refers to practical application of the existing laws and regulations and internal
policies in relations IFRS framework. Coco indicates that control comprises: those elements of
an organization (including its resources, systems, processes, culture, structure and tasks) that,
taken together, support people in the achievement of the organization's objectives,( Boubakri et al
2004).
Currently, many business firms have adhered to compliance financial reporting quality which is a
mechanism tool for the financial reporting procedure. Due to business, firms that senior
management use internal controls allow them to review and teach all staff how to achieve
companies' goals via policies. Firms that have staffs member activities with compliance qualities
also influence reliability of financial reporting. The compliance quality, particularly all firms
accept compliance of financial control practice that it is very important in every part of the
business (COSO, 2004). The ultimate aim must appear on financial reporting that firm has to
consider how compliance quality can be achieved with regard to the company performance
goals. For one reason, at least, the company requirement is to appoint stakeholders to implement
and monitor systems for achieving quality of financial reporting through internal control
effectiveness. Firm should be appropriate and complete an internal control system and the quality
of compliance monitored by manager. Including of all staff members of audit committee,
29
stakeholders, external auditor, and also internal auditor should be encouraged to comment upon
any matters which could improve the compliance quality on the internal control effectiveness,
Sarens, G. & De Beelde, I. (2006b).
Guidelines and procedures, Financial reporting process must relate with the agency rules and
procedures significantly to determine whether firm financial practices are in accordance with the
statutory regulatory principles set by the financial reporting standard board. For example, if a
firm has implemented a corporate financial management approach, its effectiveness will be
significantly determined by user rules and procedures which prescribe use of financial
information’s. Where client server e-mail is in use, e-mail specific guidelines will be in use
which account for the greater control exercised by users and the decreased irretrievability of
information (Adolph, 1998).
Regulators and accounting standard-setters establish laws, rules, and standards relating to the
preparation of financial statements for external purposes. These financial reporting rules and
standards form the basis upon which management specifies suitable objectives for the entity and
its subunits.
When specifying suitable external reporting objectives relating to the preparation of financial
statements, management considers the accounting standards that are applicable
to that entity and its subunits. Management also specifies the accounting principles that are
appropriate in the circumstances. For example, management may set an entity-level external
financial reporting objective as follows: “Our Company prepares reliable financial statements
reflecting activities in accordance with generally accepted accounting principles.”Management
specifies suitable sub-objectives for divisions, subsidiaries, operating units, and functions with
sufficient clarity to support entity-level objectives. For example, a US company applies
accounting principles generally accepted in the United States of America (US GAAP) to all
subunits in preparing its consolidated financial statements, and it applies International Financial
Reporting Standards (IFRS) to those subunits that submit subsidiary financial statements in
statutory filings in non-United States jurisdictions, O. Ray Whittington & Kurt Pany (2001).
30
Further, management specifies appropriate accounting principles (e.g., US GAAP, IFRS) to
apply to transactions and events of the entity. For example, management specifies that FASB
Accounting Standard Codification No. 605 Revenue Recognition and SAB 101A Revenue
Recognition in Financial Statements (US GAAP) or IAS 18 Revenue Recognition (IFRS) apply
to all sales transactions as applicable to the entity or subunits ‘respective external financial
reporting objective,IFRS,(2010).
2.2.2 Reliability of financial reporting
Increasingly, reliability of financial reporting in accounting context is very important for the
investors who used the information for decision management (Jenning et al., 2008). The
reliability of financial reporting is effective to internal control efficiency to insure that the
transactions of account bookkeeping are appropriate and properly authorized, valid, correctly
record, complete, and on time. Moreover, it is very important that companies are fairly
summarized of accounting information data disclosure. However, in general, a quality reporting
is affected by internal control mechanism. The internal control is essential corporate governance
mechanism of the firm based on internal control statement quality that it should be to control
effectiveness and also influences the reliability of financial reporting both in internal and
external's firm (Skaife et al, 2007) .
This research project is intended to promote original thinking to bring to life the concept of
‘reliability’ as applied to financial reporting. In particular, it will consider how auditors could
enhance users' confidence that information contained in audited financial statements is reliable
for the purposes for which they want to use it.
Reliability is all about information being fit for purpose. Where people have a clear
responsibility to do something and they need to use information to do this, it brings the whole
issue of reliability into focus. As reliability is seen as an important concept in a number of other
fields such as engineering and research we are keen to see if the theory in these areas may help
us to understand how reliability relates to audited financial statements, Maitin, T.P. (2004)..
Reliability and audited financial statements
31
We are starting from a strange set of circumstances. On the one hand, financial reporting
standard setters have taken steps to move away from the concept of ‘reliability’, to the extent that
it no longer exists in the IASB/FASB Joint Conceptual Framework. At this report, we also saw
auditing standard setter, IAASB, is inclined to accept the IASB/FASB view of reliability as well.
And so from the perspective of standards we are not supposed to talk about reliability. Yet on the
other hand, in reality, people (including regulators) still refer to the need for reliability of
financial statements. There are a number of credible sources for this. For instance, Hans
Hoogervorst, the incoming Chair of the IASB, said in a speech to a European Commission
conference on 9 February 2011 that 'Financial statements should contain information that is as
unbiased and reliable as possible.'
Also, the recent FRC paper on effective company stewardship refers to the importance of reliable
information and that ‘Investors and capital markets require reliable in-depth information about
the business of a company … and …that Directors should describe in more detail the steps that
they take to ensure the reliability of the information on which the management of a company,
and therefore the directors’ stewardship is based.’ The FRC paper goes on to say that the
reliability of financial statements is dependent on, among other things the quality of the external
audit.
Short summaries of some of the relevant fields and issues they raise are set out below. These are
presented in a way that introduces the idea of various levels to how we may think about
reliability, for example, from the starting point of reliability of individual numbers through to
audited financial statements as a whole and all the way up to reliability of organization’s whole
financial reporting processes. Such a way of looking at reliability might help us to resolve some
of the mixed messages received from users, ACCA (2009/2010).
Applying the concept of reliability to financial reporting quality
The intention is to come up with some different approaches that might help to connect with how
people are talking about reliability in practice in relation to financial reporting quality. It might
also provide a far better understanding of the role the auditors play in helping to enhance
reliability in audited financial statements.
32
We have been looking at research on how investors rely on financial reporting information and
talking to investors about what information is being used and how relevant and reliable it is for
their purposes. It exposes a mix of perspectives and objectives of investment professionals. The
problem is that investors are not necessarily clear about what they need and why and that parties
in the financial reporting process (including standard setters, companies and auditors) do not
fully understand how they use and rely on this information.
We think that by mapping investors different views on reliability to the different types of
reliability identified through looking at other fields it might help our understanding of them and
help piece together the different types of reliability that investors look for in audited financial
statements. This will be the next phase of our work.
Materiality of financial reporting, a material weakness is a deficiency, or a combination of
deficiencies, in internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of the company’s annual or interim financial statements
will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a
combination of deficiencies, in internal control over financial reporting that is less severe than a
material weakness; yet important enough to merit attention by those responsible for oversight of
the company’s financial reporting. A deficiency exists when the design or operation of a control
does not allow management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely basis. PCAOB Auditing Standard No.5
Understandability of financial reports, Madison (2010) was of the view that the objective of
financial statements is to provide about the financial position of an organization that is useful to
wide range of users in making economic decisions. Financial statements should be
understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are
directly related to an organization’s financial position. Financial statements are intended to be
understandable by readers who have a reasonable knowledge of business and economic activities
and accounting and who are willing to study the information diligently. Financial statements may
be used by users for different purposes. Owners and manager require statements to make
important business decisions that affect its continued operations. Financial analysis is then
performed on these statements to provide management with more detailed understanding of the
33
figures. (KPMG). These statements are also used as part of management’s annual report to the
stakeholders. Employees also need these reports in making decisions with management, in the
case of labour unions or for individual in discussing their compensation, promotion and rankings.
Prospective investors make use of financial to assess the viability of investing in a business.
Financial statement analysis are often used by investors are prepared by professionals (financial
analyst), thus providing them with the basis for making investment decisions. Financial
institutions (banks and other lending companies) use them to decide whether to grant a company
with fresh working capital or extend debt securities (such as a long term bank loan or debentures)
to finance expansion and other significant expenditures. (Groppelli, 2000).
Accuracy of financial reporting, Government entities (tax authorities) need financial statements
to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
Vendors who extend credit to a business require financial statements to extend credit to a
business require financial statements to assess the creditworthiness of the business. Media and
the general public are also interested in financial statements for a variety of reasons. Income
statement also known as profit and loss account (P&L), earnings statement, operating statement
or statement of operations is company’s financial statement that indicates how the revenue is
transformed into the net income (The purpose of the income statement is to show managers and
investors whether the company made or lost money during the period being reported.(Angelico
& Nikbakht).
2.3 Internal Controls and Financial Reporting Quality.
Effective internal control over financial reporting should provide reasonable assurance regarding
the reliability of financial reporting and preparation of financial statements for external purposes.
This exercise provides reasonable assurance, both to management and shareholders, about the
financial status of the company. Sovereign governments also publish their financial statements
and these have far implications. The financial statements of sovereign governments have an
impact on their international quality and are quite significant in the current context of global
business. (PCAOB, 2002) Poor internal control is regarded as the primary reason why fraud
occurs (KPMG, 1994). The federal government tries to emphasize the importance of internal
controls to organization through Chapter 8 of the federal sentencing Guidelines for organizations
(1991). Internal control and financial reporting have received increased attention especially since
34
the Tread way commission (1987) identified the tone set by senior management as the most
important factor contributing to the integrity of financial reporting process, B.K. Sebbowa
Bamweyana, (2009).
Brief (1996) and Rich (1990) concluded that ethical environment are more important than codes
of conduct in influencing accountants when resolving ethical problems. Basu (1992) found that
management’s attitude towards internal control was significant when public accountants were
asked to evaluate the control environment of an organization. Amore important issue however is
whether these internal control factors are actually related to misrepresented information. Fraud
and internal control; Internal control system plays an important role in the prevention and
detection of fraud. Under the Sarbanes-Oxley Act (2008), companies are required to perform a
fraud risk assessment and assess related controls. This typically involves identifying scenarios in
which theft or loss could occur and determining if the existing controls procedures effectively
manages the risk to an acceptable level. Financial reporting is also a key area of focus in fraud
risk assessment. (PCAOB, 2002) Internal controls and improvements; If the control system is
implemented only to prevent fraud and comply with laws and regulations, then an important
opportunity is missed. The same internal controls can also be used to systemically improve
businesses, particularly in regard to effectiveness and efficiency. (Trend way commission 1994)
Continuous controls monitoring; Advances in technology and data analysis have led to the
development of numerous tolls which can automatically evaluate the effectiveness of internal
controls. Used in conjunction with continuous auditing, continuous controls monitoring provides
assurance on financial information flowing through the business processes. (PCAOB, 2002)
At the organizational level, internal control objectives relate to the reliability of financial
reporting, timely feedback on the achievement of operational or strategic goals, and compliance
with laws and regulations.
Some users of the COSO report have found it difficult to read and understand. A model that
some believe overcomes this difficulty is found in a report from the Canadian Institute of
Chartered Accountants, which was issued in 1995. The report, Guidance on Control, presents a
control model referred to as Criteria of Control (CoCo). The CoCo model, which builds on
COSO, is thought to be more concrete and user-friendly. Coco describes internal control as
actions that foster the best result for an organization. These actions, which contribute to the
achievement of the organization's objectives, center around:
35
No system of ICFR can provide absolute assurance. Internal control systems are operated by
individuals, and individuals inevitably make mistakes. Further, while effective ICFR is a legal
requirement for some public companies, cost considerations may affect the design of control
systems. For these reasons, it is impossible to create a practical control system that will detect or
prevent all potential errors. In addition, intentional misconduct, such as fraud, collusion, or
management override, may prevent controls from operating as intended, regardless of how well
they are designed.
Accordingly, control systems can provide reasonable, but not absolute, assurance that financial
statements are reliable and prepared in accordance with GAAP. What is reasonable depends on
the facts and circumstances of each particular situation. The securities laws define reasonable
assurance as the degree of assurance that would satisfy prudent officials in the conduct of their
own affairs, Brennan, N. M., and J. Solomon. 2008.
2.4 Preventive Controls and Financial Reporting Quality
Preparing reliable financial information is a key responsibility of the management of every
company. The ability to effectively manage the company’s business requires access to timely and
accurate information. Moreover, investors must be able to place confidence in a company’s
financial reports if the company wants to raise capital in the public securities markets, Ettredge,
M. L., L. Sun, and C. Li. 2006.
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.
36
Over time, effective preventive controls over financial reporting have become a legal obligation.
Since 1977, federal law has required public companies to establish and maintain a system of
internal control that provides reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements in accordance with generally accepted accounting
principles (“GAAP”). The Sarbanes-Oxley Act of 2002 added a requirement, applicable to most
public companies, that management annually assess the effectiveness of the company’s ICFR
and report the results to the public. In addition, the Act requires most large public companies to
engage their independent auditor to audit the effectiveness of the company’s ICFR. John J.
Morris .2011).
2.4.1 Detective Controls and Financial Reporting Quality.
Sector (2002) also agrees with Eyong (2001) and reported that there is a strong connection for
organizations being perceived as honest and ethical in using funds and having high levels of
public confidence in the organizations’ governance. This usually results in increased funding to
the organization. Keating and Frumkin (2003) argue that the not-for-profit community’s future
economic success depends not only on the quality of its social economic activities, but also on
improving its internal accounting and external financial reporting systems. Hughes (2003) agrees
with this argument by stating that it is governance, through organizational capacity, not
accountability that challenges not-for-profit organizations most. To supplement this argument
Light (2002), said that improving governance through developing organizational capacity should
be the first step, for without it even plans cannot be implemented. Telling an organization that it
should publish financial reports is one thing, and having the organization produce timely and
acceptable reports is another. The organization may not have the required technology or staff to
produce the reports, Mwindi (2008).
The process for reviewing effectiveness. Effective monitoring on a continuous basis is an
essential component of a sound System of internal control. The board cannot, however, rely
solely. On the embedded monitoring processes within the company to discharge its
responsibilities. It should regularly receive and review reports on internal control. In addition, the
board should undertake an annual assessment for the purposes of making its public statement on
internal control to ensure that it has considered all significant aspects of internal control for the
company for the year under review and up to the date of approval of the annual report and
37
accounts. A financial reporting system that is devoid of errors will produce financial reports on
time for management use. Where internal controls are operational to the satisfaction of external
auditors, the company’s financial reports will be unqualified. Brennan, N. M., and J. Solomon.
2008
It pointed out that when administrative and financial management decisions go wrong, reference
is usually made to detective Internal Control System to seek out possible reasons. .There are very
many cases of financial fraud in Central Purchasing Cooperation (CPC).In the 2004 management
report, Central has accumulated un collected revenue since its inception “ The Judgment
Creditor served the Judgment Debtor with a Bankruptcy Notice on the 12/8/04, requiring
payment of Shs.169,456,500- within seven days. This sum was the decretal sum in HCCS No.
627/2003, plus taxed costs and interest. The Notice contained as the rules demand a statement
that: “You must secure and compound for the said sum to the satisfaction of counsel for the
Petitioner (Creditor) or the Court that you have a counterclaim, set off or cross demand against
the Petitioner (Creditor) which equals or exceeds the sum claimed by the Petitioner (Creditor)
and which you could not set up in the action or other proceedings in the Judgment and decree
obtained.”
The Notice ended with an Endorsement of Notice clearly stating that: “You are specifically to
note that the consequences of not complying with the requisitions of this Notice are that you will
have committed an Act of Bankruptcy, on which Bankruptcy proceedings may be taken against
you. If however you have a counterclaim, set off or cross demand which equals or exceeds the
amount claimed by Central Purchasing Company Limited in respect of the Judgment/Decree
obtained and which you could not set up in the High Court Civil suit in which the said Judgment
or Decree was obtained you must within seven (7) days apply to this Court to set aside this
NOTICE by filing with the Registrar of the High Court of Uganda at Kampala an affidavit to that
effect” (Bankruptcy Cause No. 23 of 2004) .
There are also several cases of theft of cash “collection from advertising orders are at times
misappropriated by the marketing staff, forgery of staff bank account and collection at up-
country bureaus are not banked intact among many other control related problems” reported by
the internal auditor (Mr. Francis Opoi),
38
The likelihood of meeting these objectives does not depend solely on the will of the company.
There are in fact limitations which are inherent in any internal control system. These limitations
are due to several factors, notably to the uncertainties in the outside world, to the exercise of
people’s judgment or to problem areas that can arise as a result of human failure or of a simple
error. Curtis C. (1999)
In addition, when implementing controls, it is important to bear in mind the cost / benefit
relationship and not to develop internal control systems which are unnecessarily costly, even if it
means accepting a certain degree of risk. (Institute of Chartered Accountants of Britain and
Wales, sept.1999).
2.5. Conclusion
From the related studies presented above there is evidence that internal controls significantly
affects the financial reporting quality of an Organization depending on how it has been carried
out. Adequate internal controls can thus negatively affect the overall financial reporting of the
firm. This as seen in the discussion, calls for commitment and input from both the top and
middle management. The effectiveness of internal controls depends initially on the setting phase
and therefore on the planning and coordinating objectives. Secondly, it rests on an efficient
accounting system that reflects a true and fair view of financial position.
39
CHAPTER THREE
METHODOLOGY
This chapter contains the description of how the research was conducted. It includes the research
design, study population, sample design and size, data collection sources, methods and
instruments, data quality control, data processing and analysis, ethical considerations and
limitations of the study.
3.1 Research Design
Both quantitative and qualitative approaches were adopted in this study; Cross-sectional design
was used so as to take a random sample across participants at one point of time and on account
of its rapid turnaround in data collection. Survey design was chosen because it enabled the
researcher to collect data from a large number of respondents and a case study research design
was chosen because it enables the researcher to understand the variables in more details
(Saunder, Lewis & Thornhill, 2003). A quantitative correlation was chosen because variables
were measured in numbers and analyzed with Statistical procedures, in order to determine the
relationship between Internal Controls and Financial Reporting Qualitity,Cres well (2003).
3.2 Study Area and Population
3.2.1 Study Area
The area of study was Jinja district and specifically in the town centre covering Central
purchasing Head office and Central purchasing company freight services Located on plot 56 Bell
Avenue West, Jinja and its branch in Malaba.These areas were chosen because they are key to
Central Purchasing operations network.
3.2.2 Study Population
A total of 55 employees of Central Purchasing Company, in Administrations, Human resource,
finance and accounting, other departments were chosen to form the study population. But
however due to time, cost and convenience, the study covered only employees at head office in
Kampala and one branch in Malaba, Busia district.
40
3.3 Sampling Design and Sample Size
3.3.1 Sampling Design
Stratified, random sampling and purposive methods were employed in selecting the sample.
Stratified Sampling method was used to break the population into different categories to ensure
that all employees were involved in the study; Random sampling was employed to select
participants from each category. This method which ensured that each participant had equal
chance of being selected. All Heads of departments were purposively selected on account of their
knowledge concerning the variables in the study.
3.3.2 Sample Size
Using Krejcie and Morgan (1970) in appendix V attached, a representative sample of 48
respondents were selected systematically from 55 staff members of CPCL. In all, a total of 55
respondents participated in the general study. The second category of respondents consisted of
the key informants who participated in the interviews. Purposive sampling was also used in
selecting the key informants who were interviewed by virtue of their in-depth knowledge in the
area of study at CPCL.
Table 3.1: Respondents distribution/breakdown
Category Population Sample size Sampling methods
Administration 15 14 Purposive sampling
Human resource 10 10 Random sampling
Finance and accounting 15 14 Random sampling
Other stakeholders 15 10 Purposive sampling
Total 55 48
Source: Human resource record (2013)
3.4 Data Collection Sources, Methods and Instruments
3.4.1 Data Sources
The sources of data were both primary and secondary.
Primary data source
Primary data were obtained from the respondents who included the above mentioned levels of
management representatives. Primary data were obtained from personal interviews and responses
41
from questionnaires administered to, managers and employees of Central Purchasing Company
Limited (CPCL).
Secondary data sources
Secondary data was obtained by reviewing selected interactive literatures from journal, published
annual audit reports, company’s financial reports, accounting and audit manuals; management
accounts, annual budgets, published materials, text books ,internet and websites .These were
selected because they were easily available and were having more current literature in the area of
study .(Sekaran, 2003,p.219).
3.4.2 Data collection methods
The study employed self Administering questionnaires and interviews.Bhattachharyya (2003), as
explained below
Semi Structured, Self-Administered Questionnaire
Self administered questionnaire was designed, pre-tested and distributed to selected respondents
(Bell, 1999) de Vaus (1996) Likert scale was used in the questionnaires to elicit responses from
the respondents. This was to enable accurate analysis and presentation of data.Questionaire was
chosen for this study because they cater for respondents who were not available in Office most of
the time and hence could fill it at their free time, encourage objectivity and confidentiality. In
addition since all respondents were elite class then it was easy for them to read and write making
it convenient for them.
Face –to face Personal Interviews
Unstructured interview used made it necessary to enable an overview of the control system to be
obtained. The interviewers were also able to highlight issues sensitive to the organization that do
required confidentiality. Spontaneous question were asked without any particular order, while
field notes were made to enable interpretation of results thereof. The researchers used this
method because it gives complete and accurate answers.
The interviews conducted were unstructured so as to enable the researchers obtain clarifications
of some variables which needed further in-depth investigation. An informal mode of interview
42
was carried out because of the sensitivity of some of the issues and also for the need to remove
bias on the part of the respondents who might present false information in order to put their
companies in better light just to earn some credibility.
3.4.3 Data collection instruments
A self· administered questionnaire was developed by the help of the supervisors using a 5- point
Likert Scale. An interview guide was developed so as to conduct key informant interviews with
some policy makers in CPCL.
3.4.4 Data Quality Control
Validity: For the validity, experts in the field were consulted about the content of the
instruments, ambiguity of question items and their relevancy. Thereafter, the instruments were
given to raters who rated the relevancy of each item and Content Validity Index (CVI) was
computed using the following formula:-
CVI = K = 14 = 1.00
N 14
Where CVI = Content Validity Index
K = Total Number of items rated as relevant
N = Total Number of items in the questionnaire
Table 3.2: The Content Validity Index
Variables Experts Opinions CVI
Preventive Controls 12 0.71
Detective Controls 13 0.85
Compliance 14 1.0
Reliability 13 0.85
Source: Researcher’s own construction (2013)
Table 3.2 shows that CVI for preventive controls was 0.71,for detective controls was
0.85,compliance of financial reporting was 1.0 and reliability of financial reporting was 0.85
which were all above 0.70 recommended for social sciences and Field (2005) suggesting that the
instrument was relevant in measuring what it was suppose to measure
Correlation Coefficient using a computer programme known as “Statistical Package for Social
Scientists”. Reliability analysis showed the following results for the respective variables. For
preventive control it was .9623, for detective controls was .9431, for compliance was .8626 and
reliability was .9431. (See table 3.3):-
43
Table 3.3 Reliability Test Table
Variable Alpha Number of Cases
Preventive Controls .9623 22
Detective Controls .9431 22
Compliance of Financial Reporting .8626 22
Reliability of Financial Reporting Quality .9431 22
Source: Primary
This instrument was found reliable because all the variables had values greater than 0.5.
3.5 Data Processing and Analysis
3.5.1 Data Processing
In order to ascertain the accuracy, consistency, uniformity, proper arrangement and completeness
of data, the researcher used computer for data entry, data editing (cleaning), and data coding
(categorization).Data presentation were mainly in forms of tables.
3.5.2 Data analysis
The SPSS programme was used for data analysis. Descriptive Statistics (means and standard
deviations), Pearson correlation and regression tests were used to establish existence and nature
of relationship between internal controls and financial reporting quality. ANOVA test was
carried out as well, to establish the influence of independent variables on dependent variable.
3.6 Ethical Considerations
Given that financial records are highly confidential and are meant for only permitted users, the
researcher promised the respondents that the information given was purely for academic
purposes and shall be held with utmost confidentiality .Secondly the researcher sought
permission from the University to give the introductory letter to the Organization. The
respondent’s names were not put in the questionnaire nor the section they are attached to.
However, once the report is submitted to the University it would be accessed by future
researchers for academic purposes.
44
3.7 Limitation of the Study
Some respondents especially Top executives did not give all the required information, because of
fear to expose it to the competitors. This likely caused a biased response. However, the
researcher solved this by spending time with the respondents to explain to them that the study
was basically for academic purposes.
One of the research designs was cross section, implying that it is short term in nature. It is
therefore likely not to capture an in-depth understanding of the situation. Data needed to be
analyzed using the SPSS package which is quite difficult to understand how it works.
Time and financial constraints also hindered the researcher from visiting Mombasa branch to
find out their views. The researcher therefore used only head office in Jinja.
Some respondents had no time to respond to the questions since they are busy at work and have
their own time tables for doing their work, which led to taking more time than earlier planned
45
CHAPTER FOUR
FINDINGS OF THE STUDY
This chapter presents the analysis and interpretation of data. It covers the analysis and
interpretation of background information on respondents, description of the independent,
dependent variables, objective by objective and the verification of the hypothesis.
4.1 Demographic Characteristics
This section presents the characteristics of the respondents such as age, the gender, job titles and
length of service in the Organization.
4.1.1 Gender and departments of respondents
Table 4.1 Respondents and their departments
Titles Male Female Total
Administration Count
% of Total
09
18.8%
06
12.5%
15
31.3%
Accounts/Finance Count
% of Total
10
20.8%
09
18.8%
19
39.6%
Human Resources Count
% of Total
03
6.3%
03
6.3%
06
12.6%
Others Count
% of Total
06
12.5%
02
4%
08
16.5%
Totals Count
% of Total
28
58.4%
20
41.6%
48
100%
Source: Primary Data.
From the Table 4.1 it’s indicated that most of the respondents were male (28), 58.4% compared
to the females (20), 41.6% and most of the respondents where under the department of
accounting and Finance as it’s indicated at (19), 39.6%.
46
4.1.2 Length of Service in the Organization
Table 4.2: Length of Service in the Organization
Years Frequency Percent
1 - 3 years 18 37.5
4 - 6 years 12 25
7 - 10 years 10 20.8
10+ years 8 16.7
Total 48 100.0
Source: Primary data
In Table 4.2, it can be revealed that majority of respondents have worked in the Institution
for the period 1-3 years (18), followed by 4-6 years (12), then 7-10 years (10), and lastly, over 10
years (8). These represent 37.5%, 25%, 20.8%, and 16.7% respectively. This could also show
that majority of the respondents have worked in the Institution for less than 10 years, as per the
Illustration.
4.1.3. Age of the Respondents
Table 4.3. Age of Respondents
Age group Frequency Percent Valid Percent Cumulative percent
Valid below 30
Between31 and 40
Between 41-50
50 and above
Total
21
15
7
05
48
43.7
31.3
14.6
10.4
100.0
43.7
31.3
14.6
10.4
100.0
43.7
75
89.6
100.0
Source: Primary data
47
From the table above most of the respondents were below 30 as they were (21), 43.7%, those
between 31-40 years were (15), 31.3% ,those between 41-50 years were (7), 14.6% and those
above 50 years were (5).10.4%. This implies that the respondents were old enough to understand
and answer the questions posted to them for the research.
4.1.4. Level of Education of Respondents
Table 4.4 Level of Education of the Respondents
Qualifications Population Percent Valid Percent Cumulative percent
PhD
Masters
Degree
Diploma
Certificate
Others
Total
02
07
20
8
6
05
48
4.2
14.6
41.7
16.6
12.5
10.4
100.0
4.2
14.6
41.7
16.6
12.5
10.4
100.0
4.2
18.8
60.5
77.1
89.6
100.0
Source: Primary data: Level of education of the respondents in percentage
From the above table, most of the respondents were of degree level as they constituted
(20),41.7% followed by diploma with (8), 16.6%,Masters (7),14.6%,Certificate (6),12.5%,others
(5),10.4%,and PhD (2),4.2% thus most of the respondents were undergraduates. This implies that
the respondents were educated enough to understand the questions and answer them to the best
of their knowledge therefore the respondents were professional enough to understand effectively
the accounting policies and standards.
48
4.2. The responses were interpreted using the 5 –Linkert Scale.
Internal Controls and Financial Reporting Quality were measured using Linkert scale of
measurement which can be seen in Table 4.5 below.
Table 4.5.Likert Scale
Description Scale Mean Range Interpretation
Strongly disagree 1 1.00-1.80 Very Low
Disagree 2 1.81-2.60 Low
Neutral, or sometimes 3 2.61-3.40 Moderate
Agree 4 3.41-4.20 High
Strongly Agree 5 4.21-5.00 Very high
Source: Primary data
These scales were applied to all the dimensions of internal controls and the Financial Reporting
Quality which can clearly be seen from the interpretation in Table 4.6 and 4.7 respectively.
4.3. Preventive and Detective Internal Controls
The sub-section addresses objective one, which was to assess the nature of internal controls in
place at CPCL and how they are implemented. Results are presented in Table 4.6. Descriptive
Statistics were used to analyze preventive and detective controls.
Table 4.6. Descriptive Statistics on Preventive Controls and Detective Controls
Propositions Mean Standard
deviation
Interpretation
Preventive Controls
Transaction are carried out with maximum ethics with
in Central Purchasing Company 4.041 1.336 High
Payments is authorized in Central Purchasing Company
3.833 1.342
High
There is a technical team that cross checks transactions 3.833 1.190 High
There is assignment of duties and responsibilities in the 3.354 1.480 Moderate
49
company.
There is segregations of duties at Central Purchasing
Company 3.25 1.495 Moderate
Documents are verified by officers in charge in
Central Purchasing Company 2.875 1.467 Moderate
Sub total 3.53 0.11 High
Detective Controls
There is review of performance and performance
appraisals in place 3.916 1.268 High
There is free flow of information in Central Purchasing
Company 3.895 1.33 High
Workers are properly monitored or supervised in
Central Purchasing Company
3.75 1.391 High
There is high level of communication within staff
members of the Company 3.531 1.213 High
Books are reconciled periodically in Central
Purchasing Company 3.437 1.236 High
Internal control system reviews the effectiveness of
other controls(Risk assessments) 3.354 1.480 Moderate
Sub total
3.65 0.10 High
Overall mean: The overall rating of the internal
control was high. 3.59 0.11 High
Source: Primary Data
4.3.1 Preventive Controls
Overall, respondents rated themselves high on the aspects of preventive Controls (mean=3.53,
S.D=0.11).Results in Table 4.6 further shows that preventive dimensions were rated as follows
In their descending means, Carrying out transactions with maximum ethics (mean=4.04,
S.D=.134)
50
These figures are further supported by percentage figures in appendix III where 36 or 75%
agreed that transaction are carried out with maximum ethics, compared to 7 or 14.6 % who
disagreed, Hence indicating that transactions are carried out with maximum ethics within CPCL.
It was further established that respondents rated themselves high on authorization of payment,
where (34) or 70.9 % agreed compared to (9) represented by 18.7 % who disagreed, as seen in
appendix III. Results from Table 4.6 shows (mean = 3.833, S.D=1.34) thus showing that
payments authorizations is being observed in Central Purchasing Company Limited.
From appendix III of percentage figures, (30) or 62.5 % of the respondents agreed, (10) or 20.8%
disagreed that technical team cross checks transactions in CPCL, more results in Table 4.6 shows
(mean = 3.83, S.D= 1.19). This shows that technical team cross checks transactions in the
company.
Further results from appendix III shows that (16) or 33.4 % of the respondents disagreed that
there is assignment of duties and responsibilities, while (27) or 56.2% agreed and this was
supported by evidence from table 4.6 which shows ( mean value = 3.25,S.D=1.494) implying
that respondents rated themselves moderately on assignment of duties .
The result indicated From appendix III of percentage figures shows that (18) or 37.5% of the
respondents disagreed that there is segregations of duties and responsibilities compared with (30)
or 62.5% of respondents who agreed with the proposition and this was further supported by
evidence from table 4.6 (mean value= 2.791, S.D= 1.543) implying that segregations of duties at
CPCL is moderate.
It was observed that verification of documents is a common practice in CPCL. However a greater
percentage of the respondents disagreed, from table 4.6 (mean value = 2.875, S.D= 1.467) and
were supported by (24) or 50 % of the respondents who strongly disagreed that there is
verification of document within the company while only (18), 37.5% agree, which indicates that
there is documents verification hence preventing error and forged information from being
processed in the final accounts.
51
4.3.2 Detective Controls
Overall, respondents rated themselves high on the aspects of detective Controls
(mean=3.65,S.D=0.10).Results in Table 4.6 further shows that detective dimensions were rated as
follows in their descending means, review of performance and performance appraisals(mean=4.0,
S.D=.11).These figures are further supported by percentage figures in appendix III where 36 or
75%agreed that review of performance and performance appraisals , compared to 16.6 % who
disagreed, Hence confirming that review of performance and performance appraisals works well in
Central Purchasing Company Limited.
Free flow of information on Table 4.6 were rated high (mean value=3.90, S.D=1.33).These
figures were further supported by percentage figures in appendix III where 32 or 66.7% of the
respondents who agreed , compared to 8 or 16.6 % who disagreed, Hence indicating that there is
free flow of information within Central Purchasing Company Limited.
The results indicated in table 4.6 observed (mean value=3.75, S.D=1.39), while results from
appendix III indicated that most of respondents 32 or 66.7%, agreed that there is monitoring and
supervision in the company 11 or 22.9% disagreed. Thus implying that management highly
considers monitoring and supervision of activities in Central Purchasing Company Limited.
Appendix III observed that most respondents 32 or 67.8% agreed, 10 or 20.8% disagreed, that
there is high level of communication in the company. This was further supported by (mean
value= 3.53, S.D=1.21) seen in the table 4.6. Thus there is a high level of communication in the
company. This implies that information is necessary for better financial reporting in the
company.
Table 4.6 observed (mean value =3.44, S.D=1.24) on reconciliation, while this finding was
supported in appendix III where (32) 66.6 % of the respondents agreed, (13) 27.1 % disagreed
that there is periodic reconciliation of books within the company. This implies that information
necessary for better financial reporting are most of the time reconciled in the company.
Appendix III observed that most respondents 27 or 56.2 % agreed, 16 or 33.4 % disagreed on
risk assessment. It was further observed in Table 4.6 where (mean value=3.354, S.D=1.48). This
implies that risk is assessed from time to time for better financial reporting in the company.
52
The overall dimensions of Internal Controls were rated high (mean value=3.59, S.D=0.11) which
were indications that Central Purchasing Company Limited internal controls are fully operational
at high rate.
4.4. Financial Reporting Quality
This sub-section addresses objective two, which was to identify the nature and quality of
financial reporting at CPCL and how it was implemented. Results are presented in Table 4.7.
Descriptive Statistics were used to analyzed compliance and reliability of financial reporting and
on these aspects of compliance of financial reporting.
Table 4.7 Descriptive Statistic on Financial Reporting Quality
Propositions
Mean
Standard
deviation
Interpretation
Compliance to International standards
Staff of Central purchasing company is highly
trained. 3.39 1.27 Moderate
Central purchasing company financial statements are
consistent. 3.38 1.44 Moderate
Financial statements leads to conformity 3.35 1.41 Moderate
Financial statements produced by the company
comply with the accounting standards. 3.27 1.18 Moderate
Central purchasing company financial statements are
complete. 2.58 1.40 Low
Financial statements released by Central purchasing
company are published in daily press. 2.13 0.94 Low
Sub total 3.02 0.19 Moderate
Reliability of financial reporting
Financial statements are audited annually 3.54 1.18 High
The accounting software produces quick report 3.52 1.19 High
Central purchasing company financial statements are 3.46 1.27
53
highly organized High
Central purchasing company staff is experienced and
their works shows high experience. 2.89 1.56 Moderate
Central purchasing company financial statements are
understandable. 2.21 1.20 Low
Central purchasing company financial statements are
highly relevant. 2.17 1.23 Low
Sub total 2.97 0.145 Moderate
Overall mean: The overall rating of the internal
control was moderate.
2.99 0.16 Moderate
Source: Primary Data
4.4.1 Compliance to International Reporting Standards
Overall, respondents rated themselves moderate on the aspects of compliance of financial
reporting where (mean value=3.02,S.D=0.19),Results from Table 4.7 shows compliance to
financial reporting standards were rated in their descending means; highly trained staff ( mean
value= 3.39,S.D=1.27).These figures were further supported by results from percentage figures
seen in appendix IV attached that indicates (24), 50% agreed whereas (14),33.2% disagreed
which implies that the company has experience staff which may lead to effective preparation of
quality financial reports.
Consistency of financial statements as seen from Table 4.7 (mean value= 3.38, S.D=1.44).Which
were further supported by results from percentage figures seen in appendix IV attached that
indicates (28), 58.3% agreed whereas (16), 33.4% disagreed which implies that the company has
moderate approach to consistency in preparation of financial statements which may lead to a
consistent preparation of financial reporting.
From the table 4.7 of nature of financial reporting quality in relations to whether financial
statement conforms with reporting standards (mean value= 3.35, S.D= 1.41) were recorded and
supported by analysis from appendix IV, (30) or 62.4% agreed, (15) or 31.3% disagreed and this
implies that respondents rated themselves moderately on the aspects of financial reporting
conformity .
54
Table 4.7 of nature of financial reporting quality in relations to whether financial statement
prepared comply with standards, (mean value= 3.27, S.D= 1.18) were recorded which
corresponded to the analysis from appendix IV, (20), 41.6% agreed, (10), 20.8%
disagreed,(18),37.6% were not sure and this implies that less than 50% of the respondents agreed
which shows that financial statements prepared in CPCL do not comply with the reporting
standards.
It was seen in this area that CPCL produces incomplete financial reporting evidenced by (mean
value= 2.58, S.D= 1.40) seen from Table 4.7. These were further explained in the findings
observed from appendix IV which indicated that (28), 58.3% of the respondents disagreed
whereas (12), 25% agreed.
Table 4.7 indicated (mean value= 2.13,S.D= 0.94), this was supported by result from appendix
IV which shows that financial statements are not published on the daily press (40), 83.3% of the
respondents disagreed compared with (8), 16.7% of the respondents who agreed and this implies
that most of the respondents disagreed.
4.4.2. Reliability of financial report
Table 4.7 indicated that respondents rating themselves high on the aspects of annual audit where
(mean value = 3.54,S.D=1.18).Further results from percentage figures in appendix IV showed
34 or 70.9% of the respondents agreed compared to 10 or 20.8% who disagreed. These confirms
annual audit.
The accounting software on produces quick reports was rated high by respondents where results
from Table 4.7 shows (mean value= 3.52,S.D= 1.19) and further results from appendix IV
revealed that 27 or 51.2% of the respondents agreed compared to 13 or,26.1% who disagreed
with the proposition.
Respondents rated themselves high on the aspects of organization’s financial statements being
highly organized, on Table 4.7(mean value=3.46, S.D=1.27) .These figures were further
supported by percentage figures from appendix IV where 26 or 54.2% of the respondents agreed
that financial statements are highly organized compared to 12 or 25% who disagreed which
implies that financial statements are highly organized.
55
On note whether staff of Central purchasing had enough experience to produce quality financial
reporting, Results from appendix IV indicated that 24 or 50% of the respondents disagreed
compared to 19 or 39.6% who agreed, Table 4.7 results showed (mean value= 2.90, S.D= 1.56)
which was relatively moderate implying that staff of CPCL may be experience enough to
produce good financial report.
In the appendix IV it was indicated that most respondents disagreed that financial statement are
understandable where results from percentage figures indicated that 32 or 85% of the
respondents disagreed while 8 or 16.6% agreed . This was further confirmed by results from
Table 4.7 where (mean value = 2.21, S.D=1.20). These implying low rating by respondents.
Table 4.7 indicated respondents rating themselves low on the aspects of relevancy of financial
statements where (mean value = 2.17,S.D=1.23).Further results from percentage figures in
appendix IV showed 36 or 75% of the respondents disagreed compared to 8 or 16.6 who agreed.
These indicated that the financial statements are lowly relevant.
The overall dimensions of Financial Reporting Quality were rated moderate (mean value=2.99,
S.D=0.16) which was indications that Central Purchasing Company Limited Financial Reporting
Quality may not be fully meeting the set standards.
4.5. Relationship Between Internal Controls and Financial Reporting Quality
The verification of hypothesis: The hypothesis which was set to be tested was that ‘There is no
significant relationship between Internal Controls and Financial Reporting Quality’’.
Table 4.8 Relationship between Internal Controls and Financial Reporting Quality
Internalcontrols
Financial ReportingQuality
Internal controls Pearson correlation. Sig.(2-tailed)
N
1.000.48
.914**.00048
Financial reporting quality Pearson correlationSig.(2-tailed)
N
.914**.00048
1.000.48
56
From the Table 4.8 there is a strong positive significant relationship between internal controls
and financial reporting quality using Pearson correlation coefficient which is (r= .914 and
sig=0.000). This implies that the more efforts that CPCL puts towards its internal controls the
more quality of its financial reports it will result. A directional change in Internal Controls lead
to the same directional change in Financial Reporting Quality.
4.5.1. Relationship between ICs (Preventive and Detective Controls) and FRQ (Compliance
and Reliability)
The hypothesis test: The hypothesis test was further extended to the dimension of internal
controls and financial reporting quality as seen in the tables below.
Table 4.9 Relationship between Preventive Controls and Compliance of FRQ
Preventive controls Compliance
Preventive controls Pearson correlation. Sig.(2-tailed)
N
1.000.48
.894**.00048
Compliance Pearson correlation. Sig.(2-tailed)
N
.894**.00048
1.000.48
From the Table 4.9 there is a strong positive significant relationship between preventive controls
and compliance of financial reporting using Pearson correlation coefficient (r= .894 and
sig=0.000). This implies that any further improvement on preventive controls would ensure
financial reporting quality. A directional change in preventive controls leads to a positive change
on financial reporting compliance.
Table 4.9.1 Relationship between Preventive Controls and Reliability of FRQ
Preventivecontrols
Reliability
Preventive controls Pearsoncorrelation. Sig.(2-tailed)
N
1.000.48
.945**.00048
Reliability Pearson correlation. Sig.(2-tailed)
N
.945**.00048
1.000.48
57
From the Table 4.9.1 there is a strong positive significant relationship between preventive
controls and Reliability of financial reporting, using Pearson correlation coefficient (r= .945 and
sig=0.000). This implies that any further improvement on preventive controls would ensure
reliability of financial reporting. A directional change in preventive Controls leads to a positive
change on financial reporting reliability.
Table 4.9.2 Relationship between Detective Controls and Compliance of FRQDetectivecontrols
Compliance
Detective controls Pearson correlation. Sig.(2-tailed)
N
1.000.48
.854**.00048
Compliance Pearson correlation. Sig.(2-tailed)
N
.854**.00048
1.000.48
Table 5.1 further confirms a very high significant positive relationship between detective
controls and Compliance of financial reporting, using Pearson correlation coefficient, (r= .854
and sig=0.000). This implies that any further improvement on detective controls would ensure
reliability of financial reporting. A directional change in preventive Controls leads to a positive
change on financial reporting reliability.
Table 4.9.3 Relationship between Detective Controls and Reliability of FRQ
Detectivecontrols
Reliability
Detective controls Pearsoncorrelation. Sig.(2-tailed)
N
1.000.48
.955**.00048
Reliability Pearson correlation. Sig.(2-tailed)
N
.955**.00048
1.000.48
Table 5.2 continued to confirm a very high significant positive relationship between detective
controls and reliability of financial reporting, using Pearson correlation coefficient, (r= .955 and
58
sig=0.000). This implies that any further improvement on detective controls would ensure
compliance of financial reporting. A directional change in preventive Controls leads to a positive
change on financial reporting compliance.
4.6. Regression Analysis
Table.4.9.4 Model Summary
Model R R Square Adjusted RSquare
Std. Error of theEstimate:
1 .831 .692 .658 .339
Predictors.(Constant), Internal Controls a.
Table 4.9.5 ANOVA
Model Sum of Squares df Mean square F Sig.
1Regression 2.316 1 2.316 20.2 .001a
Residual 1.032 9 .114
Total 3.348 10
a. Predictors: (Constant), Internal Controls
b .Dependent Variable: Quality Reporting Quality.
According to the model summary results, adjusted R square indicates that Internal Controls
predict 65.8% variations in Financial Reporting Quality, ANOVAs result indicates that Internal
Controls significantly predict Financial Reporting Quality as revealed by the (sig value .001 and
F value =20.2) which led to the rejection of the hypothesis to the effect that Internal Controls do
significantly influence Financial Reporting Quality. Further, results are supported by the
regression value which was (R=2.316 and Residual value which was 1.032).Which means that
Internal Controls very strongly predict Financial Reporting Quality.
59
Table.4.9.6 Standardized and Un standardized Coefficient
Model 1 Unstandardized
Coefficients
Standardized
Coefficient
t Sig.
B Std. Error Beta
1 (Constant) .143 0.864 165 0.000
Preventive Controls 1.759 .251 .501 7.007 .001
Detective Controls 2.859 .621 .793 9.233 0.0000
According to Coefficient in Table 4.9.6, Detective Controls according to beta weights and t –
values (Beta=793, t=9.233).Thus implying that Detective Controls have more influence on
Financial Reporting Quality compared to Preventive Controls where ( Beta=0.501,t=7.007).
4.6.1 Qualitative Data Presentation
Interview guide results
In trying to assess the effect of Internal Controls on financial reporting quality in Central
Purchasing Company Limited, the researcher conducted a number of interviews with key
informant members of the Company. These included both top level and middle level
management. Results of the Interview were summarized below.
4.6.2 The position of officers interviewed
This study conducted face-to-face interviews so as to strengthen the quantitative data collected
from questionnaires. Focus was put on the following positions; Internal auditor, Finance Officer,
Director Human Resources, Administration Manager, Heads of departments. The management
team constitutes both top level and middle level managers who are directly involved in
implementation of the organization’s policies.
4.6.3 Internal controls
The research examined and interviewed a number of key informants as to whether the company
operates systems of internal controls and as to whether the Internal Audit supports it. The
respondents seem to agree that the internal auditor role is supporting internal controls. They also
concur that the internal auditor advises management. He further gives assurance to management
that the internal controls put in place are functioning.
Similarly, they believe that the Company operates internal controls; implementing strategic plans
and measuring actual performance against budgets, stating priorities and implementing them on
an annual basis through the budgeting process, ensuring policies and procedures are followed in
60
all financial operations of the Company, safeguarding assets through the maintenance of a fixed
assets register and updating it regularly. They also note that they participate in the budgeting
process.
Additional support points that; the company appoints the right people for the right positions,
drafting policies, and enforcing policies through staff. Watching over and ensuring quality
control through spot check, performance appraisals, and transactions checks etc clearly guiding
staff, and evaluating activities, authorization of expenditure, sanctioning expenditures, and
supervision of other staff. However, they contend that although the Company has some internal
controls, there are gaps in those controls. For instance, there is lack of close monitoring of
project activities, overseeing and approving branch accountabilities and operation expenditure
(ensuring all expenditures were budgeted for and incurred for genuine budget line expenditure).
They also posit that they prepare budgets although they seem to feel that budgets are never
followed.
4.6.4. Effectiveness of internal controls
The respondents believe that some of the controls do function. They gave reasons for the
nonfunctioning areas of the controls to include; fewer staff in the departments meant to enforce
controls, such that the few staff available are overloaded with work, lack of monitoring of the
functioning of the controls of Internal controls, lack of adequate supervision. For instance, a
responsible officer only signs requisitions but without greatly getting involved in the monitoring
of the entire payment system, this seems to weaken the controls in the process. In addition, there
is a communication gap between managers and this consequently affects the process of reporting.
Further still, it is still possible for line managers to get their budgets approved by management
without the involvement of those charged with the responsibility of managing funds. They
further contend that this makes prioritizing activity expenditures difficult and thereby creating
more conflict in opinion.
They pointed out that there is laxity by top management in enforcing the controls. For instance;
the budgets are never adhered to. They believe that there is lack of commitment to the
effectiveness of the controls. This is evidenced by the laxity in scrutinizing expenses especially
society funds. Much scrutiny is done on the company’s expenses which is not the case with
society expenses. They further pointed out that there is lack of control over the income by the
61
departments and allot of unnecessary and wasteful expenditure as well as failure to have clear
priorities.
In a related concern, they pointed out that, lack of appropriate controls would lead to the
Company losing a lot of money. Other concerns relate to understaffing in some departments and
other employees lacking awareness of the need for internal controls. This however, can be
addressed by mentoring, short term training and guidance by senior managers.
4.6.5 Accountability procedure
The respondents gave their opinion on the effectiveness of the accountability procedure and
supported their position by citing some key examples which are presented below; they believe
that, the Accountability process is not adequate and their reason being that some staff takes the
process for granted. Some line managers noted that they have never been asked for
accountability for money .given to them especially after implementing the activities. They also
pointed out that the problem of accountability is related with lack of a comprehensive finance
manual that stipulates clearly what has to be done in regard to accountability. They also pointed
out lack of supervision and follow up of accountability related issues. However, they equally
support that other instances regarding accountability seem to be adequate and these include;
improving transparency in the system, and procurement process.
4.6.6 Reporting procedure
The respondents seem to have mixed opinions regarding the CPCL position on reporting. Others
believe that the Company has adequate reporting system (the reporting in the company is
gradually improving) while others think the reporting system is not any better (lack of regular
reports; senior managers do not ask for reports from their juniors, similarly, line managers also
fail to ask for regular reports and with sanctions in case this is not adhered to)
62
CHAPTER FIVE
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
This chapter summarizes the findings of the study and concludes on various aspects. It also puts
forward the recommendations on how the internal controls of CPCL can be strengthen in order to
achieve financial reporting quality.
5.1 Summary of Major Findings
The study was purposively carried out to evaluate the influence of internal controls on the
financial reporting quality in CPCL. Specifically, preventive and detective controls on
compliance and reliability of financial reporting.
5.1.1. Objective One.
According to the findings, CPCL had an average internal control (mean value=3.59, S.D=0.11).
In that most of the internal controls were functioning properly as evidenced from the tables of
analysis. The internal controls of CPCL include authorization of payments, approval of payment
documents, segregation of duties, proper monitoring of workers, maintenance of high level of
communication, assignment of duties and verification of documents. While the weak internal
controls component was verification of documents. This was supported by Wananbwa (2008) as
he stated that CPCL has an internal control strategy that embeds the principles of integrated risk
management undertaken by the company’s board of directors, management and other personnel,
applied in strategy setting and across the company and is designed to identify potential hazards
and threats that may affect the company. It provides a framework to manage risk according to the
organization risk appetite and offers reasonable assurance regarding the achievement of the
organization’s objectives. It looks well beyond the set of traditional controls, seeking to address
the entire fund’s control within an organized and coherent framework.
5.1.2. Objective two
From the tables of analysis on the of financial reporting quality, it indicated that financial
reporting quality in CPCL are still poor (mean value=2.99, S.D=0.16). This may be because ,
some financial reporting measures in the company are being under looked or considered for
example a complete generation of financial informations,publication of financial statements on
daily press, employment of experience and qualified staff in finance section, relevancy and
understanbility of financial reports were rated low. Both quality and expertise are fundamentals
63
of financial reporting quality as was evidenced in chapter two that evaluating the quality of
financial statements involves making an assessment of both the quality and expertise in financial
statements published, being perceived as highly good involves having high levels of both
dimensions of quality which is particularly important for financial reports, (Flanagin &Metzger,
2008). Considering the above statement, CPCL financial statements are of poor quality since
they lack the element of quality.
5.1.3. Objective Three
The relationship between internal controls and financial reporting quality was a very strong
relationship considering correlation result (r=0.914) and are supported by the regression value of
(R=2.316 and Residual value=1.032),preventive controls and compliance (r=0.894),preventive
controls and reliability (r=0.945),detective controls and compliance (r=0.854) and detective
controls and reliability (r=0.955).Which means that Internal Controls very strongly predict
Financial Reporting Quality in all its dimensions. Internal control is one of the principal means
by which risk is managed (KPMG 2008). Also Altamura & Beatty (2009) stated the effective
internal control systems have long been advocated as a mechanism for establishing high quality
of financial reporting and have been used voluntarily by firms for this purpose. In response to
several high profile financial frauds, the committees of sponsoring organizations tread way
commission (COSO) issued its internal control integrated framework Report in September 2012,
providing a foundation for the assessment of the effectiveness of internal controls. Since several
waves of accounting scandals have led to regulatory requirement for management and auditors to
report on the effectiveness of internal controls since internal controls have a strong relationship
to financial reporting quality. The financial statements of sovereign governments have an impact
on their international quality and are quite significant in the current context of global business.
(PCAOB).
5.2 Conclusions
Effective internal control over financial reporting quality should provide reasonable assurance
regarding the reliability of financial reporting and preparation of financial statements for external
purposes. This exercise provides reasonable assurance both to management and stakeholders
about the financial reporting of the company. Internal controls are most effective when controls
are built into the financial entity’s infrastructure and are a part of the essence of the organization.
Controls support quality and empowerment initiatives, avoid unnecessary costs and enable quick
response to changing conditions thus ensuring financial reporting quality. Considering the results
64
of the study it is evident that some of the weakness of internal controls result mainly came from
management failure to appreciate the importance of internal controls which is the yard stick for
good performance and this is exhibited in CPCL as the organization assets are not secured and do
not belong to the company, there is no review and appraisal performance of employees and also
no clear information system. Therefore given the correlation coefficient (r=.914) it’s evident that
there is a strong relationship between internal controls and the financial reporting of the company
thus management should endeavor to eliminate the weaknesses in their internal controls so as to
achieve sustainable financial reporting quality.
5.3 General Recommendations
From the findings, since there is a positive relationship between internal controls and financial
reporting quality, I therefore recommend CPCL to ensure that all internal controls are
implemented and are not undermined by the staff. Also political interference in the activities of
the Company should be discouraged so as to create a smooth atmosphere for the proper
management of the company’s transactions. This will ensure that all transactions are carried out
without any favor thus ensuring good financial reporting in the company.
An internal audit committee should be put in place to carry out periodic and continuous audits so
as to observe early the loopholes that exist in the in the organization internal control system and
take corrective action where necessary. This committee will also ensure that transactions are
carried out in accordance with the International Accounting Standards which are guidelines for
bring out quality of financial statements. The company’s assets should be fully registered and
should posses the organization name when registered and should be monitored by the
organization asset committee to ensure that the assets fully belong to the organization. In order to
overcome malpractices such as embezzlement of funds and frauds, officials implicated in the
embezzlement of funds should be prosecuted and made to pay back the lost funds since this will
discourage other individuals from doing the same act.
5.3.1 Objective one
The nature of internal controls were rated moderate and these includes, assignment of duties and
responsibilities, segregation of duties, documents verifications and risk (overall mean =3.59
which is quite close to the average mean), Central Purchasing Company should improve on the
above mentioned areas in order to measure up in their Resulting targets.
65
5.3.2 Objective Two
Results from the findings on the objective two shows, most areas were rated moderate except
few areas which were rated low and these includes, completeness of financial statement,
publication of financial statements in the daily press, understandability of financial statements
and relevancy of financial reporting (overall mean 2.99), Central Purchasing Company should
ensure improving on the above mentioned areas in order to measure up in their financial
reporting quality.
5.3.3 Objective Three
Results from testing the third objective and hypothesis of the study revealed that there is a high
positive relationship between internal controls and financial reporting quality where (r=0.914)
and the regression results showing that internal controls significantly predict in to financial
reporting quality. This study therefore recommends that Central Purchasing Company should
ensure up grading the internal controls so as to achieve financial reporting quality.
5.4 New Knowledge Created
Theoretically the study identified Internal Controls (Preventive and Detective) that enhance
Financial Reporting Quality in privatized Companies in addition to contributing to their
operational definitions. Contextually internal controls that enhance Financial Reporting Quality
CPCL were unearthed.
5.5 Recommendation for further research
This particular study focused on internal controls and financial reporting quality. Further
research is recommended on risk management and financial reporting quality. The control
environment should further be studied to show the extent it contributes to financial reporting
quality.
66
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69
APPENDIX I
SELF – ADMINISTERED QUESTIONNAIRE
Dear respondent,
This is designed to aid an academic research on internal controls and quality of financial
reporting in privatized Companies in Uganda, a case of Central Purchasing Company. The study
is part of the requirement for the award of Master of Business Administration of Ndejje
University. All information will be treated confidential and for academic purpose not with the
intention of disguising Central Purchasing Company but credit its work and also find a way of
how to improve. Answer the questions below as correctly as possible following instructions
given at the beginning of each section.
Your response will be highly appreciated.
Yours,
ABAS JASPER OLWOL, MBA (ACCOUNTING AND FINANCE)
SECTION A
Demographic characteristics
Dear respondents, please only select one item from each category by inserting a tick in the box
provided.
1 a) Sex
Please tick in the box provided to select your sex
Male Female
b) Age
Please tick in the box provided to select the age group
below 30 between 31-40 above 41-50 51 and above
70
c) Level of education
Please tick in the box provided to select the level of education
PhD Diploma
Master Certificate
Degree Others/Specify
d) Departments
Please tick in the box provided to select your department of work
Administration
Human resource
Finance and accounting
Others/Specify
Dear respondent, I would like you to answer the following questions using figures of 1 to 5 as
they are credited below
Strongly agree Agree Not Sure Disagree Strongly Disagree
5 4 3 2 1
Answer according to want you think is right or what you have seen or experienced at Central
Purchasing Company simply by ticking.
SECTION B: INDEPENDENT VARIABLES
INTERNAL CONTROLS
The nature of internal control
B1 Preventive Control 1 2 3 4 5
1.1 Transaction are carried out with maximum ethics with in
Central purchasing company
1.2 There is a technical team that cross checks transactions
71
1.3 Payments is authorized in Central purchasing company
1.4 There is segregations of duties at Central purchasing
company
1.5 Documents are verified by officers in charge in Central
purchasing company
1.6 There is assignment of duties and responsibilities in the
company.
B2 Detective Controls
2.1 Workers are properly monitored or supervised in
Central purchasing company
2.2 There is free flow of information in Central purchasing
company
2.3 There is high level of communication within staff
members of the company
2.4 Internal control system reviews the effectiveness of
other controls(Risk assessments)
2.5 Books are reconciled periodically in Central purchasing
company
2.6 There is review of performance and performance
appraisals in place
SECTION C: DEPENDENT VARIABLES
FINANCIAL REPORTING QUALITY
Strongly Agree Agree Not Sure Disagree Strongly Disagree
5 4 3 2 1
Answer according to want you think is right or what you have seen or experienced at Central
Purchasing Company simply by ticking.
C1 Compliance to International standards 1 2 3 4 5
1.1 Financial statements released by Central purchasing
company are published in daily press.
72
1.2 Staff of Central purchasing company is highly trained.
1.3 Financial statements produced by the company comply with
the accounting standards.
1.4 Central purchasing company financial statements are
complete.
1.5 Central purchasing company financial statements are
consistent.
1.6 Financial reports conforms to reporting principles
C2 Reliability of financial information
2.1 Financial reporting are highly organized
2.2 Workers are competent and experience in Central
purchasing company
2.3 Central purchasing company financial statements are
understandable.
2.4 Central purchasing company financial statements are highly
relevant.
2.5 The systems produces a quick report
2.6 Central purchasing company carries risk assessments
73
APPENDIX II:
INTERVIEW GUIDE
Internal controls and Financial Reporting Quality in non-governmental organizations
Interview Guide:
Dear Respondent:
My name is Abas Jasper Olwol. I am currently carrying out a study for the purpose of writing a
dissertation as a requirement for the award of Master of Business Administration of Ndejje
University. You have been selected to participate in this study due to the importance of your
position in the Organization. The information you provide will only be used for the purpose of
this study and will be treated with utmost confidentiality. Kindly help me generate solutions to
the following Questions:
1. What is your position in the Organization?
2. What management level do you occupy by virtue of your position in the Organization?
3. In your opinion, does the Organization operate systems of internal controls? If so how does
your role supports it?
4. Are the systems of internal controls referred to in 3 above functioning as they are intended to?
5. In your opinion, what would you consider to be the main measures of financial reporting in
Non-governmental Organizations?
6. In your opinion is having too many controls the best measure of financial reporting quality?
What would be the other measures you would consider appropriate?
7. In your opinion, do you think your organization has adequate staff to meet its Obligations as
and when they fall due? Any reasons to explain the situation.
8. In your opinion, is the Assignment of duties process adequate in your organization? Give
reasons.
9. How would you rate the reporting process in your organization?
Thanking you for your participation.
74
APPENDIX III :( NATURE OF INTERNAL CONTROLS)
Propositions N 1 2 3 4 5 Total
Preventive Controls
Transactions are carried out with maximum
ethic.
Count
%
5
10.4
2
4.2
5
10.4
10
20.8
26
54.2
48
100
The technical teams cross checks transaction. Count
%
-
-
10
20.8
8
16.7
10
20.8
20
41.7
48
100
Payments are authorized and approved within
the company.
Count
%
5
10.4
4
8.3
5
10.4
14
29.2
20
41.7
48
100.0
There is segregation of duties within the
organization
Count
%
10
20.8
8
16.7
-
-
20
41.7
10
20.8
48
100.0
Documents are verified by officers in charge in
Central purchasing company
Count
%
14
29.2
10
20.8
6
12.5
8
16.7
10
20.8
48
100.0
There is assignment of duties and responsibilities
in the company.
Count
%
8
16.7
8
16.7
5
10.4
13
27
14
29.2
48
100.0
Detective Controls
Workers are properly monitored or supervised in
CPCL.
Count
%
5
10.4
6
12.5
5
10.4
12
25
20
41.7
48
100.0
There is free flow of information in Central
purchasing company.
Count
%
4
8.3
4
8.3
8
16.7
9
18.8
23
47.9
48
100.0
There is high level of communication within
staff members of the company
Count
%
5
10.4
5
10.4
5
10.4
24
52.1
8
16.7
47
100.0
There is a periodic risk assessment. Count
%
8
16.7
8
16.7
5
10.4
13
27
14
29.2
48
100.0
Books are reconciled periodically. Count
%
5
10.4
8
16.7
3
6.3
25
52.1
7
14.5
48
100.0
There is review of performance and
performance appraisals in place.
Count
%
4
8.3
4
8.3
4
8.3
16
33.3
20
41.7
48
100.0
75
APPENDIX IV (NATURE OF FINANCIAL REPORTING QUALITY)
Propositions 1 2 3 4 5 Total
Compliance
Financial statements released by Central
purchasing company are published in daily
press.
Count
%
10
20.8
30
62.5
-
-
8
16.7
-
5.3
48
100
Financial statements produced by the company
comply with the accounting standards.
Count
%
5
10.4
5
10.4
18
37.6
12
25
8
16.6
48
100
Completeness of financial statements Count
%
12
25
16
33.3
8
16.7
4
8.3
8
16.7
48
100
CPCL financial statements are consistency Count
%
7
14.6
9
18.8
4
8.3
15
31.2
13
27.1
48
100
The company encourages high level
professionalism
Count
%
3
10.3
11
22.9
8
16.7
13
27.1
11
22.9
48
100
Financial reporting conforms to various
accounting concepts
Count
%
8
16.7
7
14.6
3
6.3
20
41.6
10
20.8
48
100
Reliability
Financial statement are highly organized Count
%
4
8.3
8
16.7
10
20.8
14
29.2
12
25
48
100
Central purchasing company finance teams are
experienced and their works shows high
experience.
Count
%
12
25
12
25
5
10.4
7
14.6
12
25
48
100
Understandability of the financial statements. Count
%
14
29.2
22
45.8
4
8.3
4
8.3
4
8.3
48
100
Central purchasing company financial
statements are highly relevant.
Count
%
16
33.3
20
41.7
4
8.3
4
8.3
4
8.3
48
100.
Financial quick and easy to access Count
%
1
2.1
12
25
8
16.7
15
31.2
12
25
48
100
The company has annual audit Count
%
5
10.4
5
10.4
4
8.3
27
56.3
7
14.6
48
100.
76
APPENDIX V
Krejcie& Morgan’s (1970) Table for determining samples sizes (S) for finite population (N)
N S N S N S N S N S
10 10 100 80 280 162 800 260 2800 338
15 14 110 86 290 165 850 265 3000 341
20 19 120 92 300 169 900 269 3500 346
25 24 130 97 320 175 950 274 4000 351
30 28 140 103 340 181 1000 278 4500 354
35 32 150 108 360 186 1100 285 5000 357
40 36 160 113 380 191 1200 291 6000 361
45 40 170 118 400 196 1300 297 7000 364
50 44 180 123 420 201 1400 302 8000 367
55 48 190 127 440 205 1500 306 9000 368
60 52 200 132 460 210 1600 310 10000 370
65 56 210 136 480 214 1700 313 15000 375
70 59 220 140 500 217 1800 317 20000 377
75 63 230 144 550 226 1900 320 30000 379
80 66 240 148 600 234 2000 322 40000 380
85 70 250 152 650 242 2200 327 50000 381
90 73 260 155 700 248 2400 331 75000 382
95 76 270 159 750 254 2600 335 100000 384
(From Gay &Airasian, 2003: 113)
77