Internal Control Systems Effect on Financial Performance

Introduction

A business organization should engage in practices that foster the realization of financial goals and objectives. The attainment of desirable financial performance is usually a depiction of competitiveness in the industry in which an organization operates. Thus, the effective management of the accounts and finances of a business organization is necessary for enabling the attainment of impressive financial performance.

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Particularly, engaging in practices that enhance the effectiveness of internal control systems is identified as essential in facilitating the improvement of an organization’s financial performance (Gordon & Wilford, 2012). For this reason, the need for engaging proper accounting and bookkeeping practices is underlined as crucial in bolstering the reliability of financial reports. Besides, ensuring that the organization complies with the established regulations, laws, and policies in the industry plays a considerable role in promoting its financial success. Therefore, as this study concludes, exploring the extent to which the effectiveness of internal control system affects the financial performance of an organization is relevant.

Literature Review

In an inquiry, Nyakundi, Nyamita, and Tinega (2014) sought to investigate the degree to which internal control systems influenced the financial performance of small and medium enterprises in Kisumu, Kenya. The researchers took note of the declining survival of such enterprises in the region since most startups closed business even before reaching their third anniversary. In this concern, Nyakundi et al. (2014) identified the need for internal control systems in a business organization based on their observed positive effect on the financial performance of startups.

This inquiry reveals that internal control systems play an important role in triggering significant changes in companies’ financial performance. As such, there is the need for business organizations to offer continued training to their staff members on the importance of internal control systems towards promoting their financial performance, thus enhancing their sustainability in the industry.

The implementation of internal control tasks by employees is identified as a significant determinant of an organization’s financial success. In a study, Guo, Huang, Zhang, and Zhou (2015) investigated the impact of the policies enforced by the human resource department on the effectiveness of internal control systems. The studies particularly focused on understanding the relationship between poor employee treatment and ineffective internal controls, as well as financial restatements.

This study uncovers that the offering of employee benefits creates a considerable sense of motivation that influences how employees undertake their internal control tasks. In this respect, cases of financial restatements that mainly arise from unintentional accounting and auditing errors lessen as an outcome of providing employment benefits (Guo et al., 2015). In this regard, the establishment of proper employee treatment policies is relevant in bolstering integrity in the areas of internal control and financial reporting.

Besides offering training and employee benefits, the integration of technology into internal control systems has a considerable effect on financial performance. In this perspective, Maiga, Nilsson, and Jacobs (2014) saw the relevance of integrating technological innovations into an organization’s internal control systems, including the outcomes of such a move on the financial performance of a manufacturing company. Important to note, contemporary businesses require stakeholders to incorporate technology into their systems as an approach to bolstering competitiveness.

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Chen, Smith, Cao, and Xia (2014) hold that managers who integrate information technology systems into the execution of activity-based and volume-based costing processes realize greater efficiency in the management of their financial accounts. In particular, as Maiga et al. (2014) underline, the combination of information technology and cost control systems goes a long way in positively influencing the financial performance of a manufacturing company. Therefore, improving the efficiency of internal control systems through the integration of technological advancements into an organization plays a considerable role in promoting the financial success of a business organization.

The weakness of internal control systems is identified as a threat to the financial success of an organization. In this respect, key stakeholders such as shareholders and auditors need to have a strong tone concerning the importance of effective internal control systems to boost the financial performance of their enterprises. In this concern, Skaife, Veenman, and Wangerin (2013) assert that insider-trading activities that result in a greater realization of profitability among the parties involved depict weaknesses in an organization’s internal control systems. The weakness of such systems is also identified as one of the major factors that contribute to the ineffective reporting of financial statements.

The scenario exposes the investments of stakeholders to significant financial risks that can result in devastating losses (Skaife et al., 2013). Therefore, auditors need to embrace a strong tone that underlines the importance of engaging in open trades that promote the financial prosperity of organizations.

The various forms of businesses operating in diverse industries need to observe the essence of internal control systems in bolstering financial performance. Globally, family firms constitute a majority of enterprises that seek to reach specific financial goals. Bardhan, Lin, and Wu (2014) investigate the degree to which family attributes affect the internal control systems regarding financial reporting compared to the case of non-family firms.

The scholars uncover that family businesses portray material weaknesses that affect the internal control systems negatively as evidenced by their inaccurate financial reporting. Important to note, the individual interest of some of the family members in such businesses prompts them to overlook the relevance of maintaining strong internal control systems. For this reason, it is common to find some relatives possessing dual-class shares that protect their self-interest over the overall financial performance of the family firm (Bardhan et al., 2014). In this regard, the need for upholding the efficiency of internal control systems is critical since it fosters effective financial reporting, thus denoting the actual financial position of the firm.

The standard of financial reporting influences the effectiveness of an organization’s investments. In the assessment of the relationship between the quality of financial reporting and investment efficiency, Cheng, Dhaliwal, and Zhang (2013) uncover that the existence of material weaknesses in an organization affects financial reporting negatively to the extent of leading to investment inefficiencies.

Thus, the material weaknesses undermining the effectiveness of internal control systems contribute to the establishment of ineffective investment decisions. As a result, financial constraints influence organizations to under-invest, hence further affecting the financial performance of the organization considerably (Gordon & Wilford, 2012). As such, there is the need for organizations to disclose their material weaknesses that undermine their financial reporting processes to realize investment efficiency.

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Internal Controls

Internal controls infer to the approaches established by a business organization to facilitate the reliability of financial and accounting information, the smooth accomplishment of operations and profitability goals, and the transmission of management policies in the entire organization. In other words, internal controls infer to the procedures and policies that an organization establishes to secure an asset, offer dependable financial information, bolster efficient and effective operations, and/or guarantee policy compliance (Moeller, 2014).

As such, businesses need to integrate various internal controls into the different departments to foster a collaborative approach to improving financial performance. The documentation of internal controls in the various units of business organizations is crucial since it facilitates the creation of an audit trial. Therefore, the management of an enterprise is responsible for the creation and preservation of internal controls.

Internal controls consist of key components that need to be integrated to facilitate the realization of effective financial reporting, streamlined operations, and policy compliance. In this respect, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) outlines the necessary components that facilitate the assessment of internal controls (Pett, Blomster, & Wallace, 2015). The five notable components of internal controls as provided by COSO include the control environment, risk assessment, control activities, information and communication, as well as monitoring (Gordon & Wilford, 2012). The integration of all components is crucial since it reinforces the effectiveness of internal controls in an entity.

The control environmental component of the COSO model of internal controls integrates the functions of governance and management in creating a surrounding that upholds accountability in financial reporting, the effectiveness of processes, and the observance of relevant regulations and policies (Pett et al., 2015). In this case, management and governance need to concentrate on the awareness, attitude, and actions of the parties mandated with the task of creating, implementing, and monitoring internal controls.

For example, the auditor in an entity needs to communicate and enforce integrity, as well as ethical practices in the organization as a way of creating a control environment. Therefore, there is the need for the management and employees to embrace a serious attitude towards internal systems since the approach goes a long way in bolstering the robustness of the internal control systems incorporated into the organization.

The risk assessment component of internal controls concentrates on the approaches the management of an organization embraces to administer threats that influence the performance of an organization. The need for mitigating material misstatements prompts the demand for risk assessments that detect or prevent errors in accounting processes. For this reason, large business organizations institute internal audit departments that concentrate on the identification and assessment of risks (Gordon & Wilford, 2012). For example, the internal audit unit of a business entity can identify and assess the risks associated with unrecorded expense transactions or revenue.

The information and communication component of internal controls requires the management to streamline the effectiveness of information technologies and the systems of accounting and communication. Undoubtedly, the incorporation of technology in the accounting and communication processes is identified as a crucial step towards promoting the desirable maintenance and management of assets, financial records, as well as backup data (Moeller, 2014). For example, a business organization can enhance the functionality of the information and communication component of internal controls. Furthermore, ensuring that the information required for disclosure is appropriately reported fosters the efficiency of internal controls.

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Furthermore, the control activities element of internal controls constitutes the procedures and policies created to facilitate the implementation of management directives in the entire organization. The notable control activities include authorization, performance review, information processing, and the segregation of duties (Moeller, 2014). For example, ensuring that checks of above $5,000 require more than two signatures may be regarded as a control activity that seeks to guarantee the efficiency of internal controls.

Moreover, the monitoring component focuses on assessing the effectiveness of internal controls, as well as integrating the relevant remedial actions. Engagement in regular monitoring is important since it curbs the possibility of misstatements that pass unnoticed into the financial statements (Boland, Bronson, & Hogan, 2015). For this reason, monitoring internal controls are among the crucial roles of internal auditors.

The Benefits of Effective Internal Control System on Financial Performance

The observance of proper financial reporting, efficient operations, and policy compliance goes a long way in fostering the financial performance of an organization. Notably, the various components of internal control systems guarantee the realization of accountability in the management of finances, the engagement in appropriate business processes, and operating within the stipulated provisions.

Effective internal control systems seek to foster the creation of a control environment that favors the accurate recording of transactions, as well as the revenue collected during a particular period. The control environment plays an integral part in enforcing integrity and ethical values, especially among accountants, auditors, and financial managers. As such, the control environment curtails cases of financial fraud in the organization, thus fostering the financial performance of the organization. Studies reveal that the absence of a control environment can give room for insider dealings that expose the investments of stakeholders to considerable risks (Boland et al., 2015).

Since integrity and ethical practices lead to the financial excellence of an entity, the creation of a control environment as an aspect of the internal control system is important in boosting the financial performance of a business organization.

Besides preventing the occurrence of financial malpractices such as fraud, internal control systems facilitate the development of appropriate investment strategies that augment the financial success of an organization. Internal control systems benefit the organization since accurate financial statements reveal the actual economic position of the business in the industry. Thus, the accurate reporting of financial statements prevents governance and management units from engaging in underinvestment, owing to the understated financial figures.

Instead, accurate figures ensure that governance and management segments establish reasonable investment strategies that seek to realize particular organizational goals and objectives (Moeller, 2014). By so doing, the organization enhances its chances of realizing a desirable financial performance.

Internal control systems play a notable role in promoting the financial performance of an organization by facilitating the identification and assessment of risks that can interfere with the effective running of the business operations (Gordon & Wilford, 2012). Important to note, internal auditors engaging in the regular identification and assessment of risks reduce the chances of the occurrence of financial misstatements. As such, the effectiveness of financial reporting is important since it allows the governance and management body to establish and implement strategic financial decisions that end up fostering the attainment of the set objectives and goals.

The incorporation of an information system into internal controls enhances the efficiency of accounting and auditing processes in an organization. Notably, information systems improve the maintenance of accountability pertaining equity, assets, and liability (Boland et al., 2015). Additionally, information systems provided by internal controls have a positive influence on financial performance since they facilitate the resolution of incorrect processing and transactions.

Furthermore, information technologies integrated into the internal controls help in the processing and accounting of system overrides. Moreover, the information and communication structures offered by internal control systems streamline the transmission of information to the nominal ledger. Therefore, the technological innovations presented by internal control systems assist in fostering efficiency in the financial management of an organization.

The control activities adopted by an organization play a significant role in fostering financial performance. The organization benefits from control activities such as authorization, performance review, and physical controls since such measures guarantee financial accountability in an organization (Boland et al., 2015). For example, the authorization of financial transactions by more than one bank signatories is a considerable measure that guarantees accountability. Furthermore, performance reviews facilitated by control activities uncover the financial position of the organization besides identifying issues that need to be addressed to enhance financial performance.

Moreover, monitoring controls provide numerous benefits to an organization since they pave the way for the realization of unceasing efficiency and effectiveness in the recording of financial statements, the value of business operations, and the adherence to policies and procedures (Gordon & Wilford, 2012). By so doing, auditors among other professionals in the area of accounting allow the entire departments to engage in practices that improve the material strength of the entity, thus affecting financial performance positively.

The Consequences of Not Having and Implementing an Effective Internal Control System on Financial Performance

The absence of an effective internal control system can pose dire consequences that could undermine the financial performance of an organization. Important to note, poor internal control systems undermine an organization’s ability to trail performance against budgets, maintain the security of financial information, and curtail illegal transactions (Clinton, Pinello, & Skaife, 2014). Inefficiencies in the mentioned areas have the possibility of jeopardizing the performance of an organization financially. Thus, looking at the detrimental outcomes of the absence of effective internal control systems in an organization is relevant.

The absence or failure to implement an internal control system subjects an organization to difficulties in tracking the cost of activities against the noted budgets. In this concern, organizations that lack or poorly implement internal controls have higher risks of engaging in financial misstatements. Financial misstatements contribute to the unfair presentation of an organization’s financial statements since they fail to capture the actual financial figures (Clinton et al., 2014).

The accounting inconsistencies can arise from errors made by employees or because of fraudulent activities concealed by unfair financial reports. Since the avoidance of accounting errors is important towards enhancing the financial performance of an entity, the implementation of internal controls is necessary. Therefore, the exposure to financial management errors following the absence or ineffective implementation of an internal control subjects a company to financial constraints.

Besides, material misstatements can arise from the need to conceal fraudulent activities. The misappropriation of an organization’s funds has a negative influence on the financial performance since the move does not benefit the company but the self-interest of a few individuals (Gordon & Wilford, 2012). Undoubtedly, misstatements aimed at covering fraudulent activities in an organization denote a breach of the required financial reporting standards.

For instance, a family firm can consist of selfish individuals engaging in fraud to benefit themselves, thus jeopardizing the financial success of the firm in the end. Furthermore, fraudulent activities such as insider dealings can prompt the involved parties to fabricate financial report figures, thus presenting an unfair financial position of the organization. Such cases have a considerable adverse implication on the profitability of an enterprise.

The absence of internal controls in a business entity exposes it to information breaches that have the potential of undermining its financial performance. The integration of information technology in the internal controls can expose the organization’s financial information to security threats (Clinton et al., 2014). An organization with poor internal control systems can be an easy hacking target. Information breaches can influence the perceptions of key stakeholders in the environment in which the organization operates to the extent of leading to poor financial performance.

A company that fails to adequately implement the set laws and regulations exposes itself to considerable chances of making financial losses. Notably, a business organization that operates with the stipulated policies and regulations creates a positive image that enhances its competitiveness (Clinton et al., 2014). The lack of effective control systems put in place in a workplace environment can influence the engagement in operations that overlook the need to comply with policies and regulations. Such a scenario may damage the image of an organization, thus triggering the loss of customers. The reduced sales due to a smaller share in the market may result in the organization’s poor financial performance.

The Effect of Internal Control Systems at Fuji Electric on Financial Performance

Fuji Electric is one of the notable global players in the sector of electric power equipment. Over the years, Fuji Electric has been focusing on improving the efficiency of its process in a manner that facilitates the accomplishment of its goals and objectives. Particularly, the company has seen the increasing need for it to enhance the compliance to policies, management of loss-associated risks, the reliability of financial reporting, improved interactions between employees and auditors, and the introduction of systems that foster greater profitability (Fuji Electric, 2017). In this case, Fuji Electric sees the relevance of integrating internal control systems that have seen it realize impressive performance unlike in the past one decade.

In the recent past, Fuji Electric has faced cases of directors and employees failing to observe the stipulated laws and regulations. Since ensuring that employees observe the set policies and regulations is important towards fostering integrity and ethical standards, Fuji Electric identified the importance of enforcing policy compliance as an internal control in the company. Impressively, the system has played a considerable part in ensuring that directors and employees take responsibility and accountability in executing their tasks directed towards the realization of specific tasks.

For this reason, in 2015, Fuji Electric’s directors reported that the implementation of effective internal control systems contributed significantly to enhancing the integration of moral standards among employees (Fuji Electric, 2017). As such, integrity and ethical operations have become the core values of the organizational culture. The policy compliance internal control is also said to account for the increased profits realized by Fuji Electric in the 2015/16 fiscal year.

In the past 5 years, cases of material misstatements undermined the reliability of financial reports presented by Fuji Electric. The concern triggered the necessity of introducing a system that would mitigate the occurrence of material weaknesses. Fuji Electric saw the importance of improving the company’s financial performance through the formulation of regulations that guaranteed the correctness of documents, as well as other information regarding financial statements as underlined in the Financial Instruments and Exchange Law (Fuji Electric, 2017). Therefore, every Fuji Electric constituent company is required to design internal controls for streamlining financial reporting.

The internal control systems also improve the company’s financial performance by conducting the appropriate evaluations and reporting. Additionally, as a measure of enhancing the correctness of financial reporting, accountants and auditors need to present the financial figures to the Board of Directors for crosschecking concerning accountability and fairness. As a result, reliable financial reports help directors to make investment decisions that have seen Fuji Electric expand its operations in various markets, thus improving its financial position.

Moreover, Fuji Electric identifies the need for enhancing the relationship between employees and auditors besides maintaining the independence of the latter from the instructions or orders from directors (Fuji Electric, 2017). By so doing, employees at Fuji Electric assist auditors in ascertaining the accountability aspect of processes, as well as fostering their independence in the workplace setting. The positive interactions and independence of auditors are seen as one of the factors that contribute to the impressive financial performance of Fuji Electric.

Conclusion

Effective internal control systems affect an entity’s financial performance positively. Importantly, internal controls facilitate the efficiency of financial reporting, improvement of business operations, as well as fostering policy compliance. The components that allow internal controls to influence financial performance positively include the control environment, risk assessment, control activities, information and communication, and monitoring.

These components foster the mitigation of material misstatements that lead to the presentation of unreliable financial statements. Furthermore, effective internal controls play a major part in the mitigation of fraudulent transactions that can result in poor financial achievements of the business organization. Besides, streamlining the efficiency of operations such as observing the required accounting practice standards goes a long way in fostering the profitability of a company.

References

Bardhan, I., Lin, S., & Wu, S. L. (2014). The quality of internal control over financial reporting in family firms. Accounting Horizons, 29(1), 41-60.

Boland, M., Bronson, S. N., & Hogan, C. E. (2015). Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements. Accounting Horizons, 29(3), 551-575.

Chen, Y., Smith, A. L., Cao, J., & Xia, W. (2014). Information technology capability, internal control effectiveness, and audit fees and delays. Journal of Information Systems, 28(2), 149-180.

Cheng, M., Dhaliwal, D., & Zhang, Y. (2013). Does investment efficiency improve after the disclosure of material weaknesses in internal control over financial reporting? Journal of Accounting and Economics, 56(1), 1-18.

Clinton, S. B., Pinello, A. S., & Skaife, H. A. (2014). The implications of ineffective internal control and SOX 404 reporting for financial analysts. Journal of Accounting and Public Policy, 33(4), 303-327.

Fuji Electric. (2017). Internal control system. Web.

Gordon, L. A., & Wilford, A. L. (2012). An analysis of multiple consecutive years of material weaknesses in internal control. The Accounting Review, 87(6), 2027-2060.

Guo, J., Huang, P., Zhang, Y., & Zhou, N. (2015). The effect of employee treatment policies on internal control weaknesses and financial restatements. The Accounting Review, 91(4), 1167-1194.

Maiga, A. S., Nilsson, A., & Jacobs, F. A. (2014). Assessing the interaction effect of cost control systems and information technology integration on manufacturing plant financial performance. The British Accounting Review, 46(1), 77-90.

Moeller, R. R. (2014). Executive’s guide to COSO internal controls: Understanding and implementing the new framework. Hoboken, NJ: John Wiley & Sons.

Nyakundi, D. O., Nyamita, M. O., & Tinega, T. M. (2014). Effect of internal control systems on financial performance of small and medium scale business enterprises in Kisumu city, Kenya. International Journal of Social Sciences and Entrepreneurship, 1(11), 719-734.

Pett, J., Blomster, K., & Wallace, A. (2015). A well-oiled machine: organizations can fine-tune their internal controls over financial reporting using the COSO framework update. Internal Auditor, 72(1), 31-36.

Skaife, H. A., Veenman, D., & Wangerin, D. (2013). Internal control over financial reporting and managerial rent extraction: Evidence from the profitability of insider trading. Journal of Accounting and Economics, 55(1), 91-110.

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