EFFECTS OF INTERNAL CONTROLS ON FINANCIAL PERFOMANACE (A CASE STUDY OF TECHNICAL TRAINING INSTITUTIONS IN KENYA)

ABSTRACT

The study investigated and sought to establish the relationship between internal control systems and financial performance in Technical Training Institutions in Kenya. Internal controls were looked at from the perspective of Control Environment, Internal Audit and Control Activities whereas Financial performance focused on Liquidity, Accountability and Reporting as the measures of Financial performance. The Researcher set out to establish the causes of persistent poor financial performance from the perspective of internal controls.

The research was conducted using both quantitative and qualitative approaches using Survey, Correlation and Case study as Research Designs. Data was collected using Questionnaires as well as review of available documents and records targeting basically Finance Officers, Heads of Departments, Management Committee members and Finance and Accounts staff as respondents from a population of 37 Technical Training Institutions in Kenya. Data was analyzed using the Statistical Package for Social Scientists where conclusions were drawn from tables, figures from the Package.

The study found that management of the institutions is committed to the control systems, actively participates in monitoring and supervision of the activities of the Technical Training Institutions in Kenya, all the activities of the Institution are initiated by the top level management, that the internal audit department is not efficient, is understaffed, doesn’t conduct regular audit activities and doesn’t produce regular audit reports although the few reports produced by the internal audit department address weaknesses in the system. It was further revealed that there is a clear separation of roles, weaknesses in the system are addressed, and there is a training program for capacity building in the institutions. However, the study also found out that there is lack of information sharing and inadequate security measures to safeguard the assets of the Technical Training Institutions in Kenya. It was also noted that there isn’t enough cash to meet intended obligations effectively as and when they fall due, that the fees charged to students are not appropriate to cover costs, that all fees meant to be remitted to the Technical Training Institutions in Kenya are not collected. It was however, revealed that all revenues and expenditures are properly classified, and that assets of the Technical Training Institutions in Kenya have generally increased.

The study established a significant relationship between internal control system and financial performance. The investigation recommends competence profiling in the Internal Audit department which should be based on what the Technical Training Institutions in Kenya expects the internal audit department to do and what appropriate number staff would be required to do this job. It also recommends that the institutions establishes and manages knowledge/information management system to enable all parties within the institution to freely access and utilize the official information. There should be a strategy to improve the generation of additional finances for the Technical Training Institutions in Kenya. The Study therefore concludes that internal control systems do function although with hiccups and that there is a significant relationship between internal control systems and financial performance of Technical Training Institutions in Kenya.

TABLE OF CONTENTS

Declaration................................................................................................ ii

Acknowledgement.................................................................................................... iii

Dedication........................................................................................................... iv

Abbreviations and Acronyms.......................................................................... v

List of Tables.................................................................................................. vii

Abstract........................................................................................................................ ix

CHAPTER ONE: INTRODUCTION...................................................... 1

1.1 Background of the Study....................................................................................... 1

1.1.1 Financial Control in Technical Training Institutions in Kenya........................... 2

1.1.2 Financial Performance....................................................................................... 3

1.1.3 Internal Control and Financial Performance of Technical Training Institutions in

Kenya.................................................................................................... 4

1.1.4 Technical Training Institutions in Kenya..................................................................... 6

1.2 Problem Statement..................................................................................... 8

1.3 Research Objective....................................................................................... 10

1.4 Value of the Study....................................................................................................................... 10

CHAPTER TWO: LITERATURE REVIEW...................................................................... 11

2.1 Introduction...................................................................................... 11

2.2 Theoretical Framework.............................................................................................................. 11

2.3 Internal Audit and Financial performance........................................................................ 12

2.4 Control Activities........................................................................................... 17

2.5 Financial Performance....................................................................... 18

2.6 Measures of Financial performance............................................... 19

2.6.1 Survival........................................................................ 20

2.6.2 Liquidity.............................................................................. 21

2.6.3 Accountability........................................................................... 21

2.6.4 Reporting............................................................................... 21

2.7 Control Environment........................................................................................... 22

2.8 Value of internal control and risk management.............................................................. 24

2.9 Empirical Studies.......................................................................................................................... 25

CHAPTER THREE: RESEARCH METHODOLOGY................................................. 26

3.1 Introduction................................................................................................... 26

3.2 Research Design................................................................................................. 26

3.4 Sampling Procedure..................................................................................................... 26

3.5 Data Collection.................................................................................................... 27

3.6 Validity and Reliabi1ity of Research Instrument........................................................... 27

3.7 Data Analysis and Presentation.............................................................................................. 28

CHAPTER FOUR: DATA PRESENTATION AND DISCUSSION OF FINDINGS... 29

4.1 Introduction..................................................................................................................................... 29

4.2 Description of the Positions of respondents in the Institution................................. 29

4.3 Descriptive statistics on Internal Control systems......................................................... 30

4.4 Descriptive statistics on Internal Audit................................................................. 36

4.5 Descriptive statistics on Control activities......................................................................... 41

4.6 Descriptive statistics on Financial Performance............................................................. 45

4.7 Relationship between Internal Control systems and financial performance..... 47

4.7.1 Control environment is related with financial performance.............................. 48

4.7.2 Internal audit and financial performance.................................................................. 49

4.7.3 Internal Control activities and financial performance......................................... 49

CHAPTER FIVE: SUMMARY FINDINGS, CONCLUSION AND RECOMMENDATION... 50

5.1 Introduction..................................................................................................................................... 50

5.2 Summary findings........................................................................................................................ 50

5.2.1 Functionality of the internal control system............................................................. 50

5.2.2 The Financial Performance of the Institution........................................................... 51

5.2.3 Internal Control System and Financial Performance............................................ 51

5.3 Conclusions..................................................................................................................................... 52

5.4 Recommendations.................................................................................................... 53

5.5 Suggestions for further research......................................... 54

REFERENCES............................................................................................... 55

APPENDICES..................................................................................................... i

Appendix I: Introductory Letter.......................................................................................... i

Appendix II: Questionnaire................................................................................................................ ii

Appendix III: List of Technical Training Institutions in Kenya...................................... vii

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Internal controls refer to the measures instituted by an organization so as to ensure attainment of the entity’s objectives, goals and missions (Brennan & Soloman, 2008). They are systems of policies and procedures that protect the assets of an organization, create reliable financial reporting, promote compliance with laws and regulations and achieve effective and efficient operations. These systems are not only related to accounting and reporting but also relate to the organizations communication processes, internally and externally, and include procedures for:- handling funds received and expended by the organization, preparing appropriate and timely financial reporting to board members and officers, conducting the annual audit of the organization’s financial statements, maintaining inventory records of real and other properties and their whereabouts Internal Controls are processes designed and affected by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of the financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations (David, 2001). Increasingly, reliability of financial reporting in accounting context is very important for the investors who use the information for decision management (Jenning et al., 2008).

The reliability of financial reporting is effective to internal control efficiency to ensure that the transactions and bookkeeping are appropriate and properly authorized, valid, correctly recorded, complete, and on time. Moreover, it is very important that organizations have fairly summarized accounting information data disclosure (Sebbowa, 2009). However, in general, a quality reporting is affected by internal control mechanism. There is a general perception that institution and enforcement of proper internal control systems will always lead to improved financial performance. It is also a general belief that properly instituted systems of internal control improve the reporting process and also give rise to reliable reports which enhances the accountability function of management of an entity. According to Dixon et al (1990), appropriate performance measures are those which enable organizations to direct their actions towards achieving their strategic objectives.

On the other hand Sebbowa (2009) refers to performance as the ability to operate efficiently, profitability, survive, grow and react to the environmental opportunities and threats. For purposes of the study I will adopt Ray and Kurt’s definition of internal control systems. In as much as Internal control Systems are wide and numerous, for the sake of this study, Internal control systems will be limited to; the Control Environment, Internal Audit, and Control activities whereas Financial performance will be looked at basically from the three perspectives of Liquidity, Accountability and Reporting (Donald & Delno 2009).

1.1.1 Financial Control in Technical Training Institutions in Kenya

Financial control refers to means by which an organization's resources are directed, monitored, and measured. It plays an important role in preventing and detecting fraud and protecting the organization's resources, both physical (machinery and property) and intangible (reputation or intellectual property such as trademarks) (Jenning et al., 2008). 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. 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 (Donald & Delno 2009).

1.1.2 Financial Performance

Organizational performance encompasses accumulated end results of all the organization’s work processes and activities. Performance measures can be financial or non-financial. Both measures are used for competitive firms in the dynamic business environment. Financial measures of organizational performance include; return on assets, return on sales, return on equity, return on investment, return on capital employed and sales growth (Gerrit & Abdolmohammadi, 2010).

According to Donald & Delno (2009), appropriate performance measures are those which enable organizations to direct their actions towards achieving their strategic objectives. Gerrit and Abdolmohammadi (2010)contends that, performance is measured by either subjective or objective criteria; arguments for subjective measures include difficulties with collecting qualitative performance data from small firms and with reliability of such data arising from differences in accounting methods used by firms. Brennan & Soloman (2008) found out that, objective performance measures include indicators such as profit growth, revenue growth, return on capital employed. Financial consultants Stern Stewart & Co. created Market Value Added (MVA), a measure of the excess value a company has provided to its shareholders over the total amount of their investments. This ranking is based on eight more traditional aspects of financial performance including: total return for one and three years, sales growth for one and three years, profit growth for one and three years, net margin, and return on equity.

Brennan & Soloman (2008) however, mentions other financial measures to include value of long-term investment, financial soundness, and use of 30 corporate assets. He also talks of non financial performances measures to include; innovation, ability to attract, develop, and keep talented people, quality of management, quality of products or services, and community and environmental responsibility. Donald & Delno (2009) mention accounting-based performance using three indicators: return on assets (ROA), return on equity (ROE), and return on sales (ROS). Each measure was calculated by dividing net income by total assets, total common equity, and total net sales, respectively.

1.1.3 Internal Control and Financial Performance of Technical Training Institutions in Kenya

Internal control is broadly defined as a process, affected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories; effectiveness and efficiency of operations, reliability of financial reporting and compliance with applicable laws and regulations (Donald & Delno 2009). Internal control can help an entity achieve its performance and profitability targets, and prevent loss of resources. It can help ensure reliable financial reporting. And it can help ensure that the enterprise complies with laws and regulations, avoiding damage to its reputation and other consequences. In sum, it can help an entity get to where it wants to go, and avoid pitfalls and surprises along the way (Jenning et al., 2008).

Internal control is involves an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals. Organizational performance comprises the actual output or results of an organization as measured against its intended outputs (or goals and objectives). It involves the ability of an organization to fulfill its mission through sound management, strong governance and a persistent rededication to achieving results. Effective nonprofits are mission-driven, adaptable, customer-focused, entrepreneurial, outcomes oriented and sustainable. Creating flexible, high-performing, learning organizations is the secret to gaining competitive advantage in a world that won’t stand still. Performance measures can be financial or non-financial. Both measures are used for competitive firms in the dynamic business environment) (Jenning et al., 2008).

Financial measures of organizational performance include; return on assets, return on sales, return on equity, return on investment, return on capital employed and sales growth. Accounting measures have several strengths. They are widely available because governments require firms to publish accounting data and the fact that they are subject to internal controls within firms enhances their reliability (David, 2001). Non-financial organizational performance measures include; opportunities to maximizing returns on investment at minimal costs, promote stakeholder relations between customers, suppliers, investors, and competitors, increase profits, volume of sales, market share, development of new products, and communication within and outside the organization. But the foundation of long-term performance is lifetime customer value; the revenue customers generate over their lives, less the cost of acquiring, converting, and retaining them (David, 2001).

1.1.4 Technical Training Institutions in Kenya

Technical, Vocational and Entrepreneurship Training (TVET) is a comprehensive term referring to the educational process. It involves, in addition to general education, the study of technologies and related sciences and the acquisition of practice, skills and knowledge relating to an occupation in various sectors of economic and social life. With regard to skills training, there are 2 National polytechnics, 18 Technical training institutions, one Technical Teacher Training college and 12 Institutes of Science and Technology. In addition, there are 600 youth polytechnics distributed throughout the country with only 350 receiving Government assistance. The private sector operates close to 1,000 Technical and Commercial colleges (MOEST, 2002).

In addition to the above institutions that fall under the auspices of the Ministry of Education Science and Technology (MOES &T), other Government Ministries operate institutions that provide specialized technical training. These include institutions run by the Ministries of Home Affairs, Office of the President, Ministry of Health, Ministry of Water Development, Ministry of Roads and Public Works and Ministry of Labour and Human Resource Development, among others. Overall, the management of Technical, Industrial, Vocational and Entrepreneurship Training (TIVET) institutions is spread over several ministries, which makes co-ordination of their activities and maintenance of training standards difficult. The supervision of most of these institutions is left to individual ministries and private sector that often lack the capacity to assure quality and high standards of training and management (MOEST, 2002).

Due to the limited places available in TVET institutions and the apathy towards technical education in the country, only a small proportion of eligible school leavers are absorbed. Every year, 55% of those graduating from the primary and secondary school level join technical institutions while the balance join the labour market directly. There is need to target this group for skills development through TVET institutions as these have the potential to create the critical human resource needed for technological transformation of the country.

It is imperative therefore that the existing education structure is reviewed in order to establish opportunities that link TVET programmes with programmes at higher levels of education and training. This will have the potential of enhancing training and the attractiveness of the TVET programmes to learners, and parents who consider TVET as sub-standard. Non-Formal Education (NFE) in Kenya is mainly provided and managed by communities and Non Governmental Organizations (NGOs). The main challenges relate to the low quality of education provided and the lack of linkages with the formal education system. The sub-sector also suffers from the lack of adequate teaching and learning resources, poor physical facilities and low prioritization by Government in terms of budgetary allocations (MOEST, 2002).

Performance of Technical Training Institutions in Kenya has remained a big challenge in the modern competitive business environment. Regardless of the internal control practices, it is evident that Technical Training Institutions in Kenya are inefficient and ineffective based on their practices. However, the motive behind this study is to investigate the effect of internal controls in performance of technical institutions in Kenya thus coming up with appropriate measures to reduce the felt difficulty among Technical Training Institutions in Kenya.

1.2 Problem Statement

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). It is worth noting that internal controls only provide reasonable but not absolute assurance to an entity’s management and board of directors that the organization’s objectives will be achieved. “The likelihood of achievement is affected by limitations inherent in all systems of internal control” (Gerrit and Abdolmohammadi 2010). Organizations establish systems of internal control to help them achieve performance and organizational goals, prevent loss of resources, enable production of reliable reports and ensure compliance with laws and regulations (Emasu, 2010). The continued involvement of Technical Training Institutions management in the affairs of supervisory capacity has ensured continuity and faster rise, growth and prosperity.

However, related studies that have been conducted in Kenya on Technical Training Institutions internal control systems clearly indicate that organizational internal control and financial performance is understudied area. Some of the challenges experienced with regard to internal control include; struggles with Liquidity problems, financial reports are not made timely, accountability for the financial resources is still wanting, frauds and misuse of institutional resources have been unearthed and a number of decisions made have not yielded the expected results.