THE INFLUENCING MECHANISM OF INTERNAL CONTROL:

ITS IMPACT ON THE FINANCIAL PERFORMANCE OF

SMALL AND MEDIUM SIZED ENTERPRISES IN
TUGUEGARAO CITY

In Partial Fulfillment of the Requirement for the Degree

Bachelor of Science in Accountancy

by

AGCAOILI, ERICA
CAC, JESSA MAE
DELA CRUZ, SHUNKY MAE
Introduction
This chapter focuses on the background to the study, putting the idea of internal control
system (ICSs) into perspective, and highlighting the general perception that the implementation
of internal control system will result in improved financial performance. The chapter deals with
the study's purpose, which is to determine the connection between ICSs and financial
performance. It also relates to the study's clear objectives, which included assessing the
effectiveness of ICSs in Small and Medium-Sized Enterprises (SMEs) and examining the
connection between ICSs and SMEs' financial performance. The chapter also brings into focus
the scope of the study as covering Tuguegarao City. It tackles the justification of the research
and brings out a diagrammatical representation linking internal controls and financial
performance.
Internal controls are the measures put in place by an organization to guarantee that its
objectives, goals, and missions are met. They are a set of policies and procedures that an
organization adopts to make sure that its transactions are handled properly in order to prevent
fraud, waste, and abuse of its resources. Internal Controls are processes designed and effected 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 (Mwindi, 2008). It is important to keep in mind that internal controls only
provide a company's management and board of directors a reasonable but not absolute assurance
that the organization's goals will be achieved. “The likelihood of achievement is affected by
limitations inherent in all systems of internal control” (Hayes et al., 2005). Systems of internal
control are put in place by organizations to help them achieve organizational and performance
goals, preventing resource loss, enabling the production of reliable reports, and ensuring
compliance with laws and regulations. An organization's entire network of systems designed to
provide a reasonable level of assurance that its goals will be met together form an internal
control system.
An internal control system has benefits such as improving operational effectiveness and
efficiency, ensuring the reliability of financial reporting, and compliance with laws and
regulations. Small and medium-sized enterprises, which are part of the informal sector, have
been acknowledged as playing an important role in Tuguegarao's economy and as a source of
many of the city's much needed job opportunities. Studies have shown that the sector has the
necessary ability of alleviating poverty through the creation of employment opportunities and
generation of income (Webster, 1991).
Within the business population, small and medium-sized businesses are the predominant
form of business organization (Corbetta and Montemerlo 1999), a factor that has contributed to
the urgent need for ICSs. They provide extensive contributions to Gross National Products
(GNP), job generation and wealth creation (Kelly, Athanassiou and Crittenden, 2000).
Nevertheless, in ICS, this form of business group is largely underrepresented (Steier, Chrisman
and Chua, 2004). SMEs have focused on making financial resources available, accessible, and
cost-effective to use. The important role internal control systems play in a company's
performance has gotten little attention. Small and medium scale enterprises have operated in
total disregard of internal control systems leading to the mass failure of these business
organizations (Lydia Were, 2011). Studies show that 90% of the business start-ups do not
operate beyond the third anniversary due to lack of sound internal control systems (Katuntu,
2005). Therefore, the study sought to contribute to the existing literature by empirically
investigating the role of internal control systems on financial performance and its importance in
small and medium-sized enterprises.

Literature Review
A number of academic publications have outlined the theoretical basis for establishing a
connection between financial performance and internal control systems. Internal control systems
that have been confirmed to have a relationship with business organization financial performance
include: organization, segregation of duties, physical authorization and approval, arithmetical
and accounting, personnel, supervision, management, acknowledgement of performance and
budgeting (Weber, 1998).
Internal control has shown to be crucial to the business's operations of SMEs (Kamau,
2016). An organization's internal control system is created to offer a realistic assurance tool to
achieve SME goals. According to COSO (2012), SMEs must also be reliable in their reporting
and compliant with legal requirements. Internal control has a significant impact on SMEs'
performance. Internal control has therefore been a reliable and useful technique that has assisted
in enhancing company governance, achieving goals, and reducing risks (Kamau, 2016).
Internal control produced competitive advantages, as demonstrated by IFAC (2012).
Benefits of having an effective internal control system for a business would be better equipped to
handle commercial risks. Monitoring activities, information and communication systems, and
control activities are all components of internal control in general (COSO, 2012), although the
performance of small and medium-sized enterprises (SMEs) was primarily impacted by these
components (Kamau, 2016). Internal control elements undoubtedly have an influence on both
financial and operational performance. The study supported the idea that internal controls have a
major impact on performance at tertiary institutions (Akinleye & Kolawole, 2019). The
effectiveness of the organization was positively impacted by a number of internal control factors
(Abiodun,2020).
Due to their size and organizational structure, smaller businesses are more likely to have
internal control problems. Hardesty (2008) points up two problems. Managers of smaller
organizations tend to be more hands-on than managers of bigger organizations. Due to SMEs'
lower levels of management, they are also more likely to have access to higher levels of control.
This is a problem since there would be fewer tiers of management, which would allow one
manager to have access to all systems and essentially overrule any internal control procedures
that were previously in place. Ju (2014) concurs with this and continues by pointing out that
managers of SMEs may not have had the necessary training to keep their post. This is frequently
the case since SME are family enterprises and it is practical to have a close relative working for
the organization. Although it is done for convenience, it doesn't seem like much attention has
been given to potential long-term commercial repercussions.
The risks that organizations face expand along with them. According to studies, a
growing organization will have increasing control issues. To be aware of possible risks and
understand how to lower the possibility that any risks would harm the firm, management must
continually improve their skills. A lack of training is frequently to blame for this, and it is well
known that owners of smaller businesses are not always ready to pay for their employees'
additional education (Soobaroyen & Sannassee, 2007). There are certain SMEs that do have a
board of directors. Even if they do establish a board, it is typical for its members to lack
professional qualifications.
Small scale enterprises are mostly managed by family members and close relatives who
show less interest in following internal control systems they have to the latter. Internal controls
are a function of internal audit function (Messier, 1997). Small entities have disregarded this
important function whose benefits may prove to be more than the costs of having none. Messier
(1997) points out that a firm’s performance depends heavily on a sound internal audit function.
Small and medium sized businesses are not too small for effective internal controls (Putra, 2011).
A small business can nonetheless implement some highly effective internal controls. Business
entities often evaluate their internal control systems to maintain a competitive advantage over
other organizations. Stronger, reliable, and current systems of internal controls are hence the
cornerstone of greater enterprise financial performance.

Elements of Internal Control

Different internal control system operates with different levels of effectiveness. If indeed
the five components of an internal control system—the Control Environment, Risk Assessment,
Control Activities, Information and Communication, and Monitoring—are present and working,
it may be assessed whether the system is effective. Effective controls provide a reasonable level
of assurance regarding the success of established objectives. For the purpose of this study, I will
limit the components of ICS to three; control environment, control activities and monitoring of
controls (Anduuru, 2005).

Control Environment
The control environment, as established by the organization's administration, sets the tone
of an institution and influences the control consciousness of its people (Whittington and Pany,
2001). The management attitude should be committed to following the established control
procedures and ethical business practices. This serves as the foundation for all other internal
control elements by establishing structure and discipline. Integrity and ethical values, a
dedication to competency, a philosophy of leadership and operational style, as well as how
management delegated authority and responsibility and structured and developed its workforce,
are all variables that affect the control environment. 
Control Activities
Management directives are carried out by control activities, which are the policies and
procedures. They assist in making sure that the required steps are made to address risks to
achieving the entity's objectives. At all levels and in all functions, there are control activities
taking place throughout the company. They cover a wide range of tasks such as authorizations,
verifications, reconciliations, reviews of operating performance, security of assets, and
segregation of duties. Control activities usually involve two elements: a policy establishing what
should be done and procedures to affect the policy. All policies must be implemented
thoughtfully, conscientiously and consistently (Anduuru, 2005).

Monitoring of Controls
Monitoring internal control systems is necessary since it determines how well the system
performs over time. Ongoing monitoring occurs in the ordinary course of operations, and
includes regular management and supervisory activities, and other actions personnel take in
performing their duties that assess the quality of internal control system performance (Colbert &
Bowen, 1996).
A risk assessment and the effectiveness of ongoing monitoring processes are the primary
factor of the scope and frequency of separate evaluations. Internal control deficiencies should be
notified upstream, with major issues being quickly reported to top administration and governing
boards. Internal control mechanisms change throughout time. The way controls are applied may
evolve once effective procedures can become less effective due to the arrival of new personnel,
varying effectiveness of training and supervision, time and resources constraints, or additional
pressures. Furthermore, circumstances for which the internal control system was originally
designed also may change. Because of changing conditions, management needs to determine
whether the internal control system continues to be relevant and able to address new risks (Roth,
1997).

Review of Empirical Studies on Internal Control System

As it has been mentioned before, internal control system is a critical component of an
organization’s management and a foundation for its safe and sound operations (Drogalas et al.,
2005; Karagiorgos et al., 2010). Internal control comprises five components; the control
environment, the entity’s risk assessment process, the information and communication systems,
control activities and the monitoring of controls (Hayes et al., 2005). However, for the sake of
this study, the investigation was limited to just three elements of the internal control system.
These include control activities, control environment, and control monitoring. The internal
control systems' other elements were kept constant.
 The risk and control awareness have an influence on the scope of the ICS (Sarens & De
Beelde, 2006). These results suggest that when management is aware of risks and control
activities, they are more likely to understand the role of the ICS in monitoring risk and control
activities, thus it is more likely that they will support a relatively larger ICS (Sarens & De
Beelde, 2006; Selim & McNamee, 1999). According to Kotler (1992), strong performing firms
are those that can stay in business for a good number of years. Dwivedi (2002) also found out
that, the ability of a firm to survive in business in an indicator of good financial performance. 38
active British businesses went into liquidation in the third quarter of 1992 and in 1991 a total of
21,827 businesses failed compared to 15,051 in 1990, majorly because of weak ICS (Richardson,
Sonny & Suzan, 1994).

Financial Performance
According to Stoner (2003), performance refers to the ability to operate efficiently,
profitability, survive grow and react to the environmental opportunities and threats. In agreement
with this, Sollenberg & Anderson (1995) asserts that, performance is measured by how efficient
the enterprise is in use of resources in achieving its objectives. It is the measure of attainment
achieved by an individual, team, organization or process (EFQM, 1999). Hitt, et al (1996)
believes that many firms' low performance is the result of poorly performing assets (businesses).
It's common for strategic errors made during the acquisition in earlier years to be linked to low
performance from underperforming assets. For instance, some businesses acquire businesses
with the erroneous hope of creating a synergy between the acquired assets and the current sets of
assets. A common reason for such errors is managerial hubris (Roll, 1986) or overvaluation of
managerial capability in the acquisition process.