Critical Evaluation of the Role of Internal Control Mechanisms in Corporate Governance and Firm Performance

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Introduction

Over recent years, corporate governance has become a mandatory center in practice and academic literature (Kim, Nofsinger and Mohr, 2009). The essential pillars of good corporate governance are: discipline, transparency, independence of board members and committees, fairness, accountability and social responsibility (King Report, 2002). Moreover, the most simplified definition of corporate governance is a system through which companies are directed and controlled (Cadbury Report, 2002). Corporate governance is made up of several mechanisms which include: Non-executive directors, executive incentives, institutional investors and internal control. However, Wearing (2005) stated that, a good corporate governance in a firm cannot exist without an internal control mechanism and companies can undergo financial substantial losses without an Internal control. Internal control is defined as “an executive process of board of directors, authorities and other employees to achieve purposes in these of the categories: efficiency and effectiveness of operations, reliability of financial accountability, obeying laws and legal act” (Shim, 2011). This essay will therefore emphasize on the importance of internal control using different related theories, the background to the creation of the mechanism and finally the role and effectiveness of internal control with the various reports that have come up.

Theoretical framework

There are various fundamental theories which have been brought up on the literature of corporate governance and these are as follows: agency theory, stewardship theory, resource dependence theory, stakeholder theory (Norton and Joseph, 2000). The most relevant theory regarding the internal control in corporate governance is the agency theory. Agency theory is basically the relationship between principals and the agents. The principals which are the shareholders and the agents which are the executive managers in a company (Safieddine, 2009).

In this theory, the shareholders who are the owners of the firm, appoint the agents or managers to deliver the work respectively and expect the managers to make decisions in the shareholders’ interests (Collins, 2007). However, on the contrary, this might not be the case, as the agents may be succumbed to self-interest and this was a highlighted aspect due to the problems arising from separation of ownership and control according to the Blake and Mouton Paradigm which was enforced in 1985 (Coyle, 2003). The first argument made by Bhimani (2008) was that the agents might be embedded with opportunistic behaviour and thus falling short of the correspondence between the aspirations of the principals’ pursuits. In addition, Harvey and Brown (1998) concluded that the uttermost focus of corporate governance should be to maximise shareholders’ wealth while ensuring that wealth maximization conflict does not arise with the interests of other stakeholders. Kulik (2005) argued that if there is conflict of interest, the management should take interests into account on legal terms instead of acting in their best interest. In other words, there should be an alignment of the goals and strategies between the management and the owners (Collier and Zaman, 2005). Nonetheless, McVay (2007) argued that agents will concentrate on works with a higher return and a fixed wage instead of providing fluctuating incentive payment. Thus, not eradicating any corporate misconduct regarding internal control.

Moreover, Jensen and Meckling (1976) are of the view that the agency problem can be reduced by control mechanism which has arisen from the separation between ownership and management. Control mechanism is the basic of internal control and they are employed to ensure that the managers act in the interest of the owners (Healy and Palepu, 2001). Two drawbacks factors that can be deduced from the agency perspective are different risk appetite and agency costs (Borad, 2019). One way to improve the agency problems is to establish explicit contracts which incorporate the disclosure of relevant information by the management and the shareholders who are the provider of finance (Healy and Palepu, 2001). By this means, the mechanism of transparency is of better use by evaluating to which extent the management is using the resources of the firm in the interests of the shareholders thus, attracting more institutional investors.

The second theory that has made an impact on the mechanism of corporate governance is the stakeholder theory. The stakeholder theory can be defined as any group of individuals in a firm who can affect or is affected when the objectives or goals of an organization have been encountered (Solomon, 2013). Unlike the agency theory, where the managers are working in order to meet the criteria of the shareholders, the stakeholder theory emphasises on the fact that the managers have to maintain the relationship between its stakeholders such as suppliers, employees and business partners (Arnold, 2012). Broadbent and Guthrie (2008) view the firm as a system of stakeholders operating within a larger system of a host of society that provide necessary legal and market infrastructure for the firm’s activities. Khan (2014) supported this view by stating that the goal of directors and management should be maximizing total wealth creation by the firm.

In addition, one mandatory issue concerning the stakeholder theory is the existence of problem asymmetry between the managers and the potential investors (Freeman, 2002). Besides, it would be difficult for stakeholders to obtain reliable information on their investee company if there is not a structured system of disclosure (Hill and Jones 1992). However, these problems in information asymmetry can lead to moral hazard and adverse selection problem (Solomon, 2013). Furthermore, this issue can be eradicated by ensuring a relevant and corporate disclosure in firms and also the second essential aspect is the accounting function which links the auditors and the investors in better decision-making purposes (Bushman and Smith, 2001).

Hence, coming into contrast with both the agency and the stakeholder theory, the most essential one regarding internal control will be the agency theory because it is the vital theoretical framework that can help with the transparency, disclosure, risk remuneration and control in companies. Also, the BP (2005) report implies that the priority will be accountable to shareholders’ needs as they will enhance in the better profitability and goals of the company.

Background of Internal Control Mechanism

Internal Corporate governance control became an important phenomenon in the rise of the major accounting scandals that took place in both Europe and the USA (Donaldson, 2005). Some of the examples are as follows: The collapse of Barings Bank in 1995 which happened because of Nick Leeson, a trader in the bank who was taking huge amount of risks and even created a secretive account that covered for the losses he encountered in the bank which was unknown because of lack of control (PennState, 2018). Furthermore, the second major financial humiliation that awaken the public’s attention was the Enron scandal which happened in 2001 (CNN, 2018). So, because of these scandals, various reports emerged on the basis of handling better internal control. The USA government carried out the first steps to regulate the internal control systems in public listed companies by introducing the Sarbanes-Oxley’s Act (SOX) in 2002 under section of 404 to enhance the transparency and accuracy of financial reporting (Nofsinger, 2009). Secondly, the guidance that came up for the UK companies listed on the London stock exchange was the Turnbull Report which was introduced in (1999) by Nigel Turnbull and got updated in October 2005 to the Financial Reporting Council (FRC). The Turnbull guidance views internal control as a system that encompasses the policies, processes, tasks, behaviours and other aspects of a firm while keeping its focus on risks management (Hills, 2011). Finally, there was the Turner Review (2009) which came into practice because of the aftermath of the disastrous banks scandals.

The roles and the effectiveness of the Internal Control mechanism

As a benchmark with the Turnbull report the roles that the Internal control mechanism is supposed to play are as follows:

To encourage the board of directors by initiating that the internal control framework can help in better communication with the shareholders and how the risks are going to be managed.
To aid companies in complying with the internal requirements of the combined code.
Disclosure of Financial risks
Increasing Transparency
Monitoring and control

The Cadbury report in 1992 informed that the importance of an effective system of internal control should be comprised of the audit committee, internal audit function and the external audit linked together effectively.

The Audit committee has been identified as the foundation of effective corporate governance and it states that they should be interconnected to the board of directors regarding risk management (Solomon, 2013). Deloitte and Touche (2005) presumed that the larger the boards are, the less effective they are in monitoring and controlling the financial reporting process. One evidence was derived that the economic crunch in Europe represented a radical redefinition of the nature of internal control as a feature of corporate governance, explicitly aligning internal control with risk management (Brandon, 2004). In addition, bankers, regulatory bodies and financial system acquired most of the criticism (Gupta and Nayar, 2007). Moreover, internal checks are compulsory processes which define day to day administrative controls routine while ensuring that the work of one person is independently proved by that of another person in the normal course of work (Coram, 2008). One study piloted by Tunji (2013) stated that many banks did not have an adequate board to have access to the risk-relevant information to ensure that the risk management system were in motion. This happened because there were irregular meetings between the risk management committees and board of the banks. One example to backup this argument will be the scandal that happened in 2008 by the Lehman Brothers. Sraders (2018) stated that they Hid over $50 billion in loans disguised as sales and this was done by selling toxic assets to Cayman Island banks with the understanding that they would be bought back eventually. Lehman brothers created the impression that they had $50 billion in cash and $50 billion less in toxic assets. New York Times (2018) discussed that the public would never doubt that they were doing illegal transactions since they were ranked the first ‘Most Admired Securities Firm’ by Fortune Magazine.

Ebaid (2011) proposed that the second tool of internal control is the internal audit function. This was traditionally designed so as the firms’ assets are safely safeguarded and mainly assisted in the production of reliable accounting information for decision-making. The internal audit’s perspective is to have an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations (IIA, 2009). Dichev (2011) stated that to evaluate and improve the effectiveness of risk management, control and governance process an internal audit fits more accurately. For example, it has been assessed that six percent of US companies’ that did not have an internal audit, lost revenues in 2002 through fraud committed by employees (Holtfreter, 2004) and of the 491 Australian and New Zealand companies who responded to the KPMG survey in 2004, almost half had experienced a fraud costing them $457 million (KPMG, 2015) resulting in the malfunctioning of internal control.

Moreover, the external audit represents one of the most vital paradigm in a firm’s system of internal control because it helps in monitoring the corporate governance checks and balances, henceforth increasing transparency (Solomon, 2013). The audit function from the view of an agency theory is helping shareholders in the monitoring and control of a firm’s management area. The external audit mainly emphasizes on the area of fraud in a company and make financial statements more credible to disclosure (Obosi, 2006). Indeed, the auditing is an important department in the company and one example to prove that is the fall of Enron which occurred due to the failure of the external audit function (Hermanson, 2000) and because of that the Smith report came into occurrence to tackle this incident. The smith report (2003) denotes that there should be a certain amount of information disclosure between the appointing auditors and the shareholders. Furthermore, to maintain the effectiveness of external auditors, the Cadbury report imposed the idea of rotation of auditors as this could be a means of avoiding cosy auditor-client relationship resulting in better auditor independency (Cadbury, 1992). In awareness with the agency theory, there is evidence that shareholders considered that the external auditors’ actions in accounting information are credible because the share prices react to earnings announcements (Abott and Peter, 2003).

Academic researchers such as Intosai (2008), Sullivan & Cromwell (2007) argued that credit ratings may be affected by internal governance mechanisms instituted by firms and that the quality of internal controls is interconnected with cost of equity capital. In July 2005, ﬁrms that had a lower internal control quality were more likely to have lower credit ratings which results in speculative-grade rating, lower proﬁtability and lower cash flows from operating activities (PCAOB, 2007). Studies showed that there were net losses in the current and prior ﬁscal year compared to ﬁrms with high-quality controls (Strawser, 2017).

A survey was conducted by Alkhafaji (2007) and 92% agreed that effective internal controls are an essential ingredient of good corporate governance. However, the remaining 8% was of a different opinion, saying corporate governance does not have any relationship with effective internal controls since some banks can outsource the services of control department. Coffee (2006) argued that the firm should adopt sound and effective internal controls and avoid the risks of poor board oversight and issues of directors who sit on the board just to selfishly enrich themselves. For example: In the United Kingdom in 1991, the Bank of Credit and Commerce International (BCCI) collapsed due to fraud by top executives costing depositors and investors large sums of money amounting to 6 billion pounds nearly half the bank’s assets (GlobalTimes, 2018). Additionally, Larcker, Richardson and Tuna (2007) deduced that to have a good and efficient internal control, there should be more non-executive directors to acquire independency on the firm thus, reducing the risk of frauds.

In addition, some of more real life examples are as followed: Mensah et al, (2003) found empirical evidence in Ghana that effective internal control improves good governance practices and decreases the corruptions in various firms among the shareholders and the agents. Another real life example on the effectiveness of internal control is the 2012 report from Mark Spencer stating that they disclosed information about their board of directors. Studies have shown that the company has improved in the communication between the agents and the shareholders, their risk profile has developed in a positive manner and they have made huge progress on acknowledging risks and taken up the necessary actions to handle the strategy (Mark & Spencer, 2012).

Recommendations and conclusion

To conclude, the results obtained clearly supported the assertion that the effectiveness of internal control systems contributed to a good corporate governance in financial institutions. Also, the success of the system is proportional to positive internal control culture as mentioned in the literature review. Also, auditors play a major role in the effectiveness of good internal control.

In addition, Banks should have an inclusive internal control management process to identify, measure, monitor and control internal control system effectively and with great compliance. Furthermore, financial institutions need to cultivate an ethical culture of doing business from the top management escalating down to the most junior employee in the organization so as to promote adherence to internal controls in a competitive environment. Additionally, ﬁrm credit rating is a function of internal control quality and ﬁnancial reporting is mandatory for the proper preparation of the reliability of financial statements, the quality of which impacts information risk and credit rating. Regulators should be interested in this implication to the relatively recent SOX legislation. However, no system of internal control can guarantee the prevention and detection of all control deficiencies that result in the inability to achieve organizational objectives. Changes in the external environment may result in conflict or in the manner in which internal control systems operate, create risks to the organization’s objectives that the internal control system may fail to manage. Besides, Economic crunch exposed the weaknesses of the financial sector and the fragility of the internal control. Thus, Internal Control Standards for the Public Sector must to be revised. Finally, the regression analysis emphasized the significance of corporate governance components in reducing the level of fraud in which the Internal audit plays the major role.

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Critical Evaluation of the Role of Internal Control Mechanisms in Corporate Governance and Firm Performance

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