Internal control system and the operational efficiency of banking
institutions
Name:
Sidney David
Student number:
11318902
Thesis supervisor:
Edo Roos Lindgreen
Date:
June 14, 2018
Word count:
13940, 0
MSc Accountancy & Control, specialization Accountancy
Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student Sidney David, who declares to take full responsibility for
the contents of this document.
I hereby declare that the text and the work presented in this document is original and that no
sources other than those mentioned in the text and its references have been used in creating it.
The faculty of Economics and Business is solely responsible for the supervision of completion
of the work, not for the contents.
Abstract
In this paper, I examine whether and how internal control effectiveness affects banks operational efficiency. Preceding research document some evidence suggesting that internal control effectiveness leads to a better operational efficiency through improving the quality of internal reports for managerial decision making. I find that operational efficiency, using operating cash flow ratio as efficiency measure likely leads to a better performance through improving the efficiency of the operations. Operational efficiency is significantly higher for firms with internal control effectiveness. I further examined if internal control effectiveness and operational efficiency are higher for firms with higher profitability. I find no significant evidence to support this notion. I also examined whether firms size has an implication on the benefit accumulated from the possession of an effective internal control system. I find that there is a significant difference between the benefits of having an effective internal control between smaller banks and larger banks. Overall this study extends the literature by posing statistical evidence on the implications of internal control effectiveness on banks operational performance defined as efficiency.
Contents
Introduction ... 6
Literature review ... 9
2.1
Internal control ... 9
2.2
Information technology ... 10
2.3
Financial institutions ... 11
2.4
Cash and the cash flow statement ... 13
2.5
Cash flow ratios ... 14
2.6
Operating cash flow ratio as a measure of operational efficiency ... 14
Hypothesis development ... 16
Research design ... 19
4.1
Sample selection ... 19
4.2
Measuring operational efficiency ... 20
4.3
Measuring profitability ... 20
4.4
Association using Libby boxes ... 21
4.5
Regression model ... 21
4.6
Descriptive statistics ... 23
4.7
Empirical results ... 24
4.7.1
Analyses of Internal control effectiveness and bank operational efficiency ... 24
4.7.2
Analysis of Internal control effectiveness and profitability ... 25
4.7.3
Additional analyses on firm size ... 26
Discussion, conclusion and limitations ... 27
5.1
Discussions ... 27
5.2
Conclusion... 27
5.4
Acknowledgement ... 28
Reference ... 29
Appendix A Database overview ... 35
5.5
Audit analytics ... 35
5.5.1
Audit + compliance ... 35
5.5.2
Peer reporter ... 35
5.5.3
Data Feeds ... 35
5.5.4
Custom research ... 36
5.5.5
Financial restatement ... 36
5.6
Compusat ... 37
Appendix B Variable definitions ... 38
Appendix C Data analysis ... 40
Winsorization (at the 5% and 95% level) and log transformation ... 42
Introduction
In this study, the effect of internal control on the performance of banking institutions is explored. The investigation focuses mainly on banking institutions (universal Banks or commercial banks) due to the fact that little research is carried out specifically in this sector. It is common sense that banking institutions require an adequate internal controlled environment to function properly but insufficient research has been carried out to specifically examine its impact on the operational efficiency of these institutions (Almbaidin, 2014). A few studies have documented the main benefits and importance of an effective internal control in an organization, such as lower cost of capital, safeguarding of assets and a better financial reporting quality (Alexander, 2013). Due to the fact that SOX is still a developing phenomenon, it is of outermost importance to examine the costs and benefits of maintaining an effective internal control (Cheng. et al. 2015).
In these present times, the Sarbanes-Oxley act of 2002 (SOX 404) compels companies to assess and disclose their internal control information and auditors to provide an opinion on the clients financial statement and also give an opinion on the client's internal control policy over financial reporting in order to protect or safeguard corporate assets and facilitate generally accepted accounting principles (GAAP)-based financial reporting (Alexander, 2013). Pre SOX regulations, however, do not require management or auditors evaluations of internal control or public affirmation about the degree of control effectiveness (Ashbaugh-Skaife et al. 2008). The main goal of the SOX act is to improve the quality of internal control and improve the reliability of financial reporting (Doyle et al. 2007a). However countless critics argue that the benefits of providing an opinion regarding the internal control over financial reporting are not consistent with the high compliance costs (Defond and Francis, 2005; Michaels, 2003; Powell, 2005; Romano, 2005).
There is, however, a positive relationship between internal control quality and management guidance accuracy, persistent with the fact that an ineffective internal control will lead to an inaccuracy of internal management reports (Feng et al. 2009). An organization is believed to have ineffective internal control if it reports at least one material weakness in internal control (Cheng et al. 2015). Feng et al (2013) investigated if an ineffective internal control has an effect on the operating activities of production organizations, the results show that an ineffective internal control would subsequently lead to the ineffectiveness of operations within an organization, such as suboptimal order quantities which leads to higher inventory levels and higher holding costs. Their study, therefore, gives insight into how an ineffective internal control over inventory would have an effect on the inventory management and thus the operational efficiency of the organization. It is however not clear if an effective internal control improves the operational efficiency of banking institutions, the issue will be examined and reviewed in this paper.
A banking institution can be categorized as a substantial financial establishment with a highly and notably known brand name and an international existence to a small entity with a local presence. Banking institutions are in an aggressive, competitive environment on a worldwide scale. (Harker & Zenios, 2000). A banking institution activity generally involves various types of lending, but nowadays the banking industry has transformed from merely financial intermediaries to retail service providers. These changes require a swift expansion in technology and hence push banks to adapt in order to survive. All this does is create a highly competitive environment (Harker et al. 1997). Negurita et al (2016) revealed in their research that there are operational risks or potential problems such as internal fraud, irregular practices etc. that banks have to manage in order to reach their goals. Banking institutions are therefore in search of a countermeasure that will drive the achievement of an efficient operational performance (Siklos, 2001).
In order to test the level of operational efficiency of banking institutions, the operating cash flow ratio is used. The cash from operations gives more accurate information regarding the efficiency of the business operational activities (Bragg, 2002). Therefore shareholders view cash flow from operating activities as an essential tool in analyzing a company's operational efficiency. In that light, the operating cash flow ratio measures how well current liabilities of an entity are covered by the cash flow generated from the entity's operational activities. The operating cash flow ratio can be used to determine the liquidity of a company in the short term (Mills & Yamamura, 1998). The research is taken a step further in analyzing the profitability of banks with an effective internal control and banks with ineffective internal control. In order to adequately analyze profitability, operating profit margin is used. Operating profit margin means the cash that is raised from operating activities without taking into account additional transactions and expenses (Tulsian, 2014). A high operating profit margin implicates that an organization has been able to inflate cash from operations while reducing operating expenses (Tulsian, 2014). Also, the benefit of operational efficiency and internal control is analyzed for large banks and small banks. According to Cheng. et al (2015), smaller firms tend to encounter an unbalanced amount of expenses for implementing SOX.
It is expected that effective internal control will have a positive effect on a bank's operational efficiency due to the fact that effective internal control should increase revenue from operations and by giving management adequate information in order to make day to day decisions regarding operations and thereby reduce operational costs and other inefficiencies or risks. Notwithstanding the above assertion, there are various reasons as to why the result of the hypotheses between an effective internal control system and operational efficiency might not be consistent. Namely, internal control cannot give unconditional assurance due to its implicit limitations as supported by the SEC report regarding the evaluation and assessment of internal control. Also, the fact that the management could override a well-designed internal control at will is seen as a potential threat to the research. Override of controls is relatively common in various organizations because of the fact that management override is difficult to
detect. This is due to the fact that override of controls is not documented and override of controls is done to cover up suspicious actions (AICPA 2005; COSO 2013). Therefore for these reasons internal control alone, might not be able to improve operational efficiency.
The association between internal control effectiveness and operational efficiency is tested, using a sample of firm-year observations that disclosed internal control opinions under SOX 404 in the period between 2004 to 2017. A firm is said to have an ineffective internal control if it discloses at least one internal material weakness. Following prior research, I use the operating cash flow ratio to measure the efficiency of banking institutions. Consistent with the prediction, I find that operational efficiency, using operating cash flow ratio as efficiency measure is significantly higher for firms with internal control effectiveness. Effective internal control is likely to lead to a better operational performance. I further conducted an analysis on, if internal control effectiveness and operational efficiency are higher for firms with higher profitability. I find no statistically significant evidence to support this claim. I also conducted an analysis on, whether firms size has an implication on the benefit accumulated from the possession of an effective internal control system. I find that there is a significant difference between the benefits of having an effective internal control between smaller banks and larger banks. Overall, the above result indicates that effective internal control likely leads to a higher operational efficiency and this result is stronger for smaller banks.
This study expands prior research by documenting the effect of internal control on firms operational performance, specifically the study depicts the impact of an effective internal control system on a bank’s performance defined by efficiency through eliminating the likelihood of misappropriation of assets and improving the quality of internal management report for decision making. Furthermore, the study gives an indication of the costs versus benefits of reporting under SOX 404 and also couples efficiency with profitability. This study, therefore, adds to emerging literature that researches the ramification of internal control quality on the performing capability of banking establishments. This study also complements Harker et al. (2000), whose research examined the performance of financial institutions (banks, insurance, pension funds, government agencies etc.), financial market and the drivers of performance and its impact on the financial environment. I believe that this results and findings can be of great use to managers, investors and other researchers, whose interest lies in the impact of internal control effectiveness on banking institutions.
The rest of this paper progresses as follows. The next section examines the relevant literature and section 3 develops the hypothesis based on the literature. Section 4 which is the research design section, describes the sample data and research methodology. Section 5 gives a conclusion on the research, while section 6 describes the databases used to collect the data.
Literature review
The thesis is related to two streams of literature. Firstly all relevant aspects of internal control will be reviewed, aspects such as internal control framework and the information system. Secondly, financial institutions and specifically the banking sector will be reviewed. Furthermore, the literature review will shed light on operational efficiency measure, specifically the operating cash flow ratio.
2.1 Internal control
Peter Drucker implied that "The productivity of work is not the responsibility of the worker but of the manager" hence managers are generally central to an organization's business activities. For that reason, the main objective of the management is to achieve a maximum output from minimum inputs (i.e. operational efficiency) by maintaining and establishing an effective internal control framework (Lee, 2015). Previous literature on internal control effectiveness shows that firms with higher accounting risk, complex business, financial concern, and auditor change are more likely to have internal control weaknesses (McVay, 2005; Ashbaugh-Skife et al., 2007; Doyle et al., 2007a; Ogneva et al., 2007; Bedard et al., 2009). Furthermore, firm size, firm maturity, and profitability are important factors or components, which are associated with the internal control. Ashbaugh-Skaife et al (2007) suggested that firm size, firms maturity and profitability are negatively associated with the existence of an ineffective internal control or internal control weakness.
What is internal control? Internal controls are methods put in place by a company to ensure the integrity of financial and accounting information, meet operational and profitability targets, and transmit management policies throughout the organization (Marshall & Romney, 2015). COSO (The Committee of sponsoring organizations of the Treadway Commission) has defined internal control as "a process, effected by a firm's board of directors, management, and other personnel, which is designed to give reasonable and valid assurance pertaining to the achievement of objectives relating to operations, reporting and compliance. The framework comes with three categories of objectives which allows organizations to fixate on, namely operations objectives; which relates to the effectiveness and efficiency of the organizational operations. Reporting objectives; which relates to internal and external reports including financial and non-financial reports and must include reliability, transparency, timeliness and fundamental and enhanced qualitative characteristics. Compliance objectives; these relate to adherence to the laws and regulations set forth by regulators. The internal control is expressed by five integrated components namely; Control environment, risk assessment, control activities, information and communication and monitoring activities.
Furthermore, the COSO framework characterizes effective internal control as an adequate system of internal control, which reduces to a sufficient level, the risk of not accomplishing an entity's objective. It requires that each of the five components is well designed and implemented properly in order to
achieve its objectives. In addition, all five components must work together in an integrated manner in order to relinquish major deficiencies, which may exist in the implementation of the system. One of the most important goals of an organization is to implement a system, which helps them improve their business efficiency and therefore boost competitiveness. In order for an organization to have an effective internal control system, there must be an adequate information technology that ensures the accomplishment of operational objective and performance (Hla & Teru, 2015). An organization is believed to have ineffective internal control if it reports at least one material weakness in internal control (Cheng et al. 2015).
2.2 Information technology
The ability of a firm to achieve its objective helps increase overall performance and boosts competitiveness (Hla & Teru, 2015). Information technology can help improve information sharing, responsiveness, decision-making, coordination, distribution, and product quality, (Gurbaxani & Whang 1991; Brynjolfsson, 1993; Brynjolfsson & Hitt, 1996). Information technology has drastically improved since 1950; there are increasing developments in the storing and processing of information (Hossain et al. 2001). The role of information technology has evolved in the last decades and has grown to become an integral part of how companies manage, utilize and control their resources (Teng & Calhoun, 1996). Imagine a business environment without information technology; imagine the hardship in dealing with the everyday transaction. Imagine the uncertainty managers' face due to the lack of knowledge they experience when trying to make a difficult decision. Now imagine an environment where information is integrated, imagine an organization which implements an information system that helps them collect, save, process and store data which could be helpful to managers when faced with a difficult decision. Don't you expect this organization to perform better and enable the manager make better strategic or operational decisions? (Hossain et al. 2001).
Extant literature offers insufficient deposition regarding the relationship between Accounting information system (AIS) and firms performance. AIS are hypothesized as important organizational instruments that are crucial for the efficacy of decision management and control in organizations (H. Sajjadi, M. Dastgir & H. Hashemi Nejad, 2008). The implementation of an information system, which fits the strategy of an organization, boosts not only the business operations but also the strategic performance (Chenhall, 2003, Gerdin & Greve 2004). AIS improve the performance by facilitating management decision-making, improving internal control quality, improving the quality of the financial report and it also helps facilitate transactions. Adopting an information system ensures that all levels of management get adequate, pertinent and timely information for planning and controlling their day to day activities within the organization (Hla & Teru, 2015).
What ways are there to help guide a firm in the desired direction? By the adoption of a well-designed information system. Accounting literature and preceding researches claims that strategic success is considered a result of Accounting Information System's design (Langfield-Smith, 1997). Adopting AIS will serve as leverage in achieving a stronger and more corporate culture to face changes in the environment and therefore boost competitiveness. Moreover, innovation is an incentive that leads to better firm performance and serves as a solution to overcoming different financial and organizational hardship (Soudani, 2012).
2.3 Financial institutions
Our understanding of the efficiency of the operational performance of financial institutions is underdeveloped (Harker & Zenios, 2000). The financial service industry is probably the most consequential sector in modern economies. In the United States, the financial sector is responsible for the employment of 5.4 million people and it is responsible for 5% of the gross domestic product (GDP) in the country. In highly developed European economies such as; Italy and Germany, the financial sector is responsible for 3,5% and 5,5% of the gross domestic product respectively. In relatively smaller economies such as Switzerland and Cyprus, the financial sectors account for 9% and 18% of the country's GDP respectively (Demirguc-Kunt & Levine, 1996). Due to the high importance of the financial sector and the increased competitive pressure, financial institutions should be aware of the efficiency of the performance and the role they play in today's economies. It is, therefore, no surprise that the performance of the financial institutions faces huge review from scholars and professionals (Merton, 1990).
Banking institutions tend to encounter an aggressive, fast-moving, competitive environment at a worldwide scale. A banking institution can be categorized as a large financial establishment with an eminently distinguishable brand name and an international existence to a small entity with a local presence (Harker & Zenios, 2000). A banking institution’s activity consists of various sorts of lending, for instance corporate finance, project finance, small-medium enterprises, short-term finance, housing, retail, trade, and other. There are changes in the sector that cannot be neglected, changes such as; Liberalized domestic regulations in the United States, financial unification policies in Europe, various intensified worldwide competition, fast-moving innovational changes in new financial instruments, ever growing customer demands and the swift expansion in information technology. All these changes push firms to adapt in order to survive and all these fuels a highly competitive environment (Hacker et al. 1997). Soteriou and Zenios, (1999) shows that the highly competitive environment brings about serious inefficiencies on the output side of banking institutions by reducing revenues and raising costs in operations. Negurita et al (2016) revealed in their research that there are operational risks or potential problems, which banks have to manage in order to reach their goals, problems such as;
- Business disruption or system malfunctions
- Problems related to security of electronic banking systems
- Irregular practices related to customer product and activities
- Internal fraud (e.g. employees completion of transactions for their own account)
Banking institutions are therefore in search of a countermeasure that will drive the achievement of an efficient operational performance (Siklos, 2001).
Internal control system and specifically information technology is the main issue for banks in today's world, due to the complex organizational choices that besiege the introduction of new banking services (Harker & Zenios, 2000). The Deloitte and Touche study (1995) shows that technology is responsible for the fast-moving, storage and distribution of financial products. Large banks in the U.S allocate huge capital to Internal control especially information technology, a large bank in the U.S tends to spend approximately 20% of non-interest expenses on information technology and this investment does not seem to slacken. A typical large bank in the United States spends approximately $392.000 per year on platform automation and a supplementary $502.000 on increasing the quality of information and transaction processing. Furthermore, there is significant evidence that Information technology improves productivity and thereby the profitability of organizations. The estimates on the return on investment regarding Information Technology is between 50-60%. Harker and Zenios (2000) claim that while it is arguable that Information technology makes the bank more profitable, IT cannot be neglected as a key driver of operational efficiency. However, Prassad and Harker (1997) revealed in their study that the elasticity of IT capital is positive but limited, and it also has a very low significance of 7%, showing that there is a relatively high probability of 0.93 that implementation of an effective IT has little or no positive effect on bank productivity.
According to the Deloitte and Touche (1995) study, the late 1970’s is a symbolic time perk for the banking sector, since the late 1970’s the banking industry has transformed from merely financial intermediaries to retail service providers. As a result of this extraordinary transformation, retail banking is now fixated on the following operational activities;
—
Retail servicing: This entails the selling and servicing of a series of product to individual clients through a variety of delivery channels of the client choosing. The three most relevant functions of this activity are; deposit, credit and money management.—
Product origination: This entails the formulation of products such as savings or mortgages for direct delivery to customers or indirect delivery through intermediaries.—
Back office operations: This entails the provision of a supporting function that assists in the achievement of a fruitful and efficient accomplishment of the two primary activities listed above.The Deloitte and Touche (1995) study also claims that banking institutions are slowly and gradually reshaping and transforming into institutions that carry out one or more of these activities.
Measuring the efficiency of performance in today's world is quite a demanding issue. In the old days, the economy was different; there was the main presence of mass production and buying and selling (consumption) of commodities. In measuring performance in the old economy, output and quantity were suitable indicators of performance (Johnson et al, 1995). In these present times and notably in the banking and financial environments, traditional productivity and profitability measures are excessively burdensome to execute and they are also limited when used in generating information (Fornell et al, 1996). Due to the rise of immeasurable factors in the banking sector, it is extremely difficult and challenging to measure performance (Griliches, 1992). However using cash flow ratios as a measure of operational efficiency has been proven useful in adequately evaluating a company’s profitability from operating activities (Giacomino & Mielke, 1993).
What can the financial institution do to improve its operational efficiency? Do an effective internal control and implementation of Information technology lead to an efficient operational efficiency? In order to adequately carry out this research, the focus is placed solely on banking institutions. By primarily focusing on banking institutions instead of the whole financial institutions, it will be easier to comprehend the performance of the banking industry and what drives it.
2.4 Cash and the cash flow statement
Cash is an essential factor in every successful business; therefore in order for a business to survive, there must be an adequate and sufficient amount of cash (Defranco & Schmidgall, 1998). Similarly, cash flow has been known to have crucial meaning for many businesses in a wide range of sectors (Beck, 1994; DeFranco & Schmidgall, 1998; Epstein & Pava, 1994; Mills & Yamamura, 1998; Schmidgall, Sylvestre & Urbancic, 1994). Cash can easily be expressed as the "King" in an entity and it mirrors the differences between successful and unsuccessful operations (Beck, 1994).
A cash flow statement is an integral source of information for shareholders, creditors, suppliers and other stakeholders (Knechel et al. 2007). A cash flow depicts what activities have been financed internally through equity or externally through debt. It also assists in the assessment of an entity's ability to generate cash flows in the future, therefore a cash flow statement informs users about the current discrepancies between the operating profits and the increase or decrease in cash balance over a particular period (Amuzu, 2010).
2.5 Cash flow ratios
The statement of cash flows splits cash flows into three different categories namely; cash flows from operating activities, cash flows from investing activities and cash flows from financing activities (Herrick, 1993). In the United States, ratios are commonly used for analyzing financial statements (Ryu & Jang, 2004). It is originally developed for evaluating short-term credit but as time went by, its usage transformed and developed. Since then, analysts have been forced to develop so many financial ratios that are widely used by professionals in accounting. Due to these developments, the Financial Accounting Standards Board requires entities to prepare a statement of cash flow (Giacomino & Mielke, 1993). Financial ratios have been broadly implemented in the assessment of operational efficiency by managers, creditors, and investors. This enables them to attain added valuable information from the financial statement that cannot be received by simply analyzing the information reported in the documents (Andrew & Schmidgall, 1993).
Cash flow ratios are efficient ratios for the measurement of an entity's strength on an ongoing basis (Mills & Yamamura, 1998). Furthermore, Wall Street gurus, the rating agency, and lenders use cash flow ratios not just for analyzing financial statement but also in evaluating the risks associated with investments. This shows that the well being of businesses can no longer be assessed with just accrual basis accounting alone (Mills & Yamamura 1998). A further study done by Mills and Yamura (1998) reveals that the operating cash flow ratios show the unique aspect of firm's activities. The purpose of the cash flow from operating activities in the financial statement is to show the cash effects of a transaction and other affairs involved in obtaining net income (Giacomino & Mielke, 1993). Cash flow from operating activities (CFO) is an accounting/financial concept that illustrates the amount of cash an entity generates from regular business operations, such as producing, selling of goods or providing a service. It, therefore, excludes investment costs (Schmidgall, Geller, & Ilvento, 1993). According to Giacomino and Meike (1993), cash from operating activities can be classified into sufficiency ratio and efficiency ratio in order to define its usage in relation to performance evaluation. Sufficiency ratios are the cash flows ratios that directly measure the ability of an entity to generate cash that will be sufficient to pay its debts, reinvest in its activities and pay dividends to the shareholders. The efficiency ratios are the ratios which investors, creditors and others who have an involvement in the company are interested in. It gives information regarding the percentage of each dollar realized from continuing operations (Giacomino & Mielke, 1993).
2.6 Operating cash flow ratio as a measure of operational efficiency
In financial accounting, operating cash flow is the cash flow generated by core operations of an organization. Net cash flow from operating activities illustrates the net increase or decrease in cash, which resulted from operations displayed in the financial statement (Amuzu, 2010). Operating cash
flow is more efficient in measuring how much a company has generated from its operations when compared to other measures of operational efficiency like net income (Fabozzi & Markowitz, 2006). Alternatively, net income also gives users information about the efficiency of the operations but it is not very accurate due to the fact that it takes some factors into account, which blurs the picture regarding the cash obtained from the operating activities (Fabozzi & Markowitz, 2006). A company with a lot of fixed assets can reduce their net income through depreciation, but this cannot be done when using operating cash flow because depreciation is not a cash expense. Therefore operating cash flow of an entity gives a clearer picture regarding cash obtained from operations than net income (Amuzu, 2010).
Shareholders view operating cash flow as a source or earning just like the net income. For shareholders, the cash from operations gives more accurate information regarding the efficiency of the business operational activities (Bragg, 2002). The net income is established following a deduction of interest expenses but prior to the payments of dividends, while operating cash flow is established following payment of interests and dividends (Amuzu, 2010). The so-called business cash is the cash generated from all operating activities and it illustrates the amount of cash in contrast with accrued operating profit which is achieved from the operations carried out by an organization (Bragg, 2002).
Cash obtained from the operating activities gives the impression of the transactional effect of cash, which can be used to determine a company's net income (Berry et al, 2005). In that light, the operating cash flow ratio measures how well current liabilities of an entity are covered by the cash flow generated from the entity's operational activities. The operating cash flow ratio can be used to determine the liquidity of a company in the short term (Mills & Yamamura, 1998). The formula for calculating operating cash flow ratio is, Operating cash flow divided by net income.
The numerator of the ratio consists of cash generated from the operations and the denominator depicts the net income found on the balance sheet. A ratio less than 1 means that the company generated less cash from operations, while a ratio higher than 1 means that the company is in no short-term cash flow problems. The higher the ratio, the more efficient the company is in its operating activities. This means that the company is able to effectively A high ratio usually means the company is able to turn a higher percentage of its revenue into profits and net cash flow (Mills & Yamamura, 1998). There is, however, no clear indication of whether an effective internal control is correlated with operating cash flow ratio. This issue will be examined in this paper.
Hypothesis development
In the literature review, it is depicted that ineffective internal control can and should have a negative effect on an organization's operational efficiency due to two reasons. Firstly improper internal control prevents the effective control of managers and this leads to agency problems (Lambert et al. 2007). Furthermore Ashbaugh-Skaife et al. (2013) shows in their research that misappropriation of assets is greater among organizations with an ineffective internal control system, due to the fact that an ineffective internal control system can lead to a lenient environment which could aid the diversion of company resources by top management and therefore generate a lower amount of cash or revenue from operating activities. Ineffective internal control can, therefore, lead to an increase in the likelihood of internal fraud or diversion of input available for production by managers or personnel for their own private gain (Amuzu, 2010).
Secondly, previous studies have revealed that firms with ineffective internal control tend to have a poorer financial reporting quality (Doyle et al. 2007a). Ineffective internal control can lead to a false internal management report and therefore affect the organization's operational efficiency. For example, improper internal control relating to information technology can diminish the banks' ability to collect, process and store transactional data from economic events, which could result in errors in internal management reports (Doyle et al. 2007a). Ineffective internal control ensure that management reports are less accurate and this inaccurate reports could form the basis for managers to make many poor day to day decisions which could have a huge effect on the efficiency of its daily operation and therefore lead to the reduction of revenues and the increase in operating costs (Feng et al. 2009). The operating cash flow ratio as mentioned earlier can be used to determine the liquidity of a company in the short term (Mills & Yamamura, 1998). The formula for calculating operating cash flow ratio is;
OCF = Operating cash flow Net income
With all this being said, does it mean that an effective internal control actually lead to a more efficient operating activity? Does an effective internal control absolutely limits business interruption on banks; improves the security of electronic banking systems; Ensures proper practices related to customer's products and activities; restricts misappropriation of assets; eliminates bad quality of internal reports and hence increase cash generated from operating activities and reduce costs?
The above questions lead to the first hypothesis:
H1: An effective internal control system legitimately leads to a higher operational efficiency in banking institutions
In other words; There is a positive association between a bank's operational efficiency and the presence of an effective internal control. There are however various reasons why results consistent with H1 might not be found. Firstly internal control cannot give unconditional assurance due to its implicit limitations. In an SEC report regarding the evaluation and assessment of internal control, it is stated that internal control contains human diligence and is in that case subject to error in judgments resulting from human negligence. Furthermore, in a report generated by the AICPA or in other words, The American Institute of Certified Public Accountants, it is stated that there is a high risk of fraud through management override of internal control. Internal control over may be well designed and effectively implemented by these control can also be overridden by management in every organization.
Secondly, the main objective of SOX 404 is to ensure a greater reliability of an organization's external reports in order to improve the decision making of external users (PCAOB, 2004). It is also stated that there is a possibility that managers might not buy into the idea regarding the implications of internal control for external reporting (Alexander et al. 2013). In addition to that, Alexander et al. (2013) also find that managers do not think that SOX 404 section can improve the efficiency of an organization's operating activities. Therefore there is a possibility that the hypothesized benefits of an effective internal control on operational efficiency may not emerge due to managerial incompetence. Thirdly, there are other organizational factors which could affect the effectiveness of an internal control system. Vu (2016) carried out an empirical research on the factors that could harm the effectiveness of an Internal control system in commercial banks. The factors that affect the effectiveness of the system are; the control environment, information and communication, Group interests, risk assessment, Monitoring, control activities and political interest. Amid this knowledge, I predict that an effective internal control does have a positive influence on the operational well-being of a financial institution.
In addition to the first hypothesis, a second hypothesis is developed. In the first hypothesis, I argue that effective internal control leads to a better operational efficiency by eliminating the prospect of misappropriation of asset and improving the quality of internal management reports, which then leads to better decision making. I took a step further in analyzing the profitability of banks with an effective internal control and banks with ineffective internal control. In order to adequately analyze profitability, the operating profit margin is used. Operating profit means the cash that is raised from operating activities without taking into account additional transactions and expenses (Tulsian, 2014). The higher the operating ratio, the better the operational efficiency of the business and vice versa (Cho et al. 2005). A high operating profit margin means that an organization has been able to increase cash from operational activities while reducing operating expenses (Tulsian, 2014). Operating profit margin can be calculated using the formula below:
Operating profit margin = Operating profit Revenue
Consequently, I should observe a stronger association between banks with effective internal control and a higher profit margin and vice versa.
The above deliberation leads to our second hypothesis:
H2: The positive association between bank operational efficiency and effective internal control as hypothesized in H1, is stronger for banks with a greater profit margin
There are also some reasons why results consistent with H2 might not be found. Firstly an increase or decrease in a firm's expenditure does not indicate that the firm's operating margin is improving. Furthermore, Internal control cannot give unconditional assurance due to its implicit limitations as supported by the SEC report regarding the evaluation and assessment of internal control. Also, the fact that the management could override a well-designed internal control is seen as a potential threat to the research. Override of controls is common in many firms due to the fact that management override is difficult to detect, this because they are not documented and are done to cover up the actions (AICPA 2005; COSO 2013). Therefore for these reasons internal control may not be able to improve operational efficiency and the relationship between profitability and internal control effectiveness might not be significant. In other words, there is a possibility that there are no results consistent with the above-mentioned hypothesis.
Research design
Research design entails forming research inquiries into research projects (Robson, 2002). This means that in order to adequately carry out a research, appropriate methods and techniques must be adopted. The research design is a program that guides the researcher through the complex process of gathering, analyzing and interpreting data (Nachmias et al. 1996). This section outlines the methods and sample data that will be used in this study. The section is divided into six different subsections; sample selection, Measuring operational efficiency, measuring profitability, descriptive statistics, regression model and empirical results.
4.1 Sample selection
From Audit Analytics, I first identify a sample of 848,982 firm-year observations with a SOX 404 disclosure in the period 2004 - 2017. I then exclude 838,072 firm-year observations that are non-banking institutions, 5,222 firm-year observations with undisclosed cash from operating activities. The final sample from Audit Analytics consists of 5,730 firm-year observations. From Compusat, I first got the current liabilities data of the firms retrieved from Audit Analytics. I then excluded 4,091 firm-year observations with undisclosed current liabilities. The final amount of sample from Audit Analytics in combination with Compusat consists of 1131 firm-year observations representing 755 firms (banks). Table 1 summarizes the number of firm-year observations and number of firms observed from the year 2004 to 2017. The table shows a number of 86 observations with ineffective internal control whereof 64 unique banks with ineffective internal control. 7,6% of the observations have an ineffective internal control whereof 8,5% are banks with ineffective internal control. Ultimately, there is a declining movement in the rate of firm-year observations with ineffective internal control slumping from 18,18% in 2004 to 0% in 2017 as shown in figure 1 below. A percentage of 7,6 represents the total amount of observations from 2004 to 2017 with ineffective internal control. Which means that 92,4% of the firm-year observations has an effective internal control. For the purpose of this research, I will take a look at the 92,4% and 18,18% of firm-year observations and analyze if the absence of internal control weaknesses in organizations does lead to a higher operational efficiency as stated in hypothesis 1.
Figure 1: Percentage of ineffective IC per year
4.2 Measuring operational efficiency
In order to measure the bank operational efficiency (EFFICIENCY), the cash flow from operating activities is calculated using the formula; cash flow from operations divided by the net operating income. The numerator of the ratio consists of cash generated from the operations of the banks and the denominator depicts the liabilities of the banks that are due within a year and can be found on the balance sheet. A ratio less than one means that the company generated less cash from operations, while a ratio higher than one means that the company is in no short-term cash flow problems. The higher the ratio, the more efficient the company is in its operating activities.
In this research, banks carrying out specific operational activities are used in order to prevent bias of any sort. These operational activities are Retail servicing, Product origination, and Back office operations as mentioned earlier.
4.3 Measuring profitability
Measuring profitability (PROFITABILITY) means analyzing the profit margin. The profit margin is calculated using the formula; net operating income divided by revenue. The numerator consists of net cash that is generated from operations and the denominator consists of firm’s revenue. A ratio less than one means that the company is not profitable from its operations, while a ratio higher than one means that the company is profitable and operationally efficient. The higher the ratio, the more efficient the company is in its operating activities.
0,00 5,00 10,00 15,00 20,00 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Percentage of ineffective IC per year
Percentage of observations with ineffective IC (%) Percentage of banks with ineffective IC (%)
4.4 Association using Libby boxes
Internal control system and operational efficiency are abstract concepts, and they, therefore, have a causal relationship. Due to the fact that abstract concepts are not directly observable, a measurable proxy must be created for each abstract concept. The relationship is represented visually using Libby boxes (Bloomfield et al. 2015). As shown in Figure 2, the theory depicts that internal control system has an effect on the operational efficiency of banking institutions (link 1). The research design operationalizes the independent variable "internal control system" by measuring the effectiveness of internal control quality reported by the banking organization (link 2). Operationalization of the dependent variable "operational efficiency" is done using operating cash flow ratio (link 3). The association between the firm's internal control effectiveness and the cash flow ratio is also statistically established (link 4). Furthermore, there is an association of variables that might have an effect on the independent variable, this control variable is taken into account (link 5). Subsequently, there is an association of variables that might have an effect on the dependent variable, this control variable is also taken into account (link 6).
Figure 2: Libby-Box Framework for showing How Empirical Studies Test Theory
4.5 Regression model
To test the relationship between internal control effectiveness and banks operational efficiency using cash flow from operating activities, the following regression is estimated:
EFFICIENCYit =α + βICCONTROLit + φEFFICIENCY_CONTROLSit + γICMW_CONTROLSit +εit,
Where EFFICIENCY indicates the measure used to test operational efficiency, Internal control weakness (ICCONTROL) indicates the dummy variable that equals one if the bank discloses internal control material weakness in year t and zero otherwise. A bank with an effective internal control discloses zero internal control weaknesses. H1 predicts the coefficient on ICCONTROL to be positive
EFFICIENCY_CONTROLSit refers to the determinants of operational efficiency, the determinants of
operational efficiency as mentioned earlier is the operating cash flow ratio. Firstly, Net income (NET_INCOME) is a detrimental factor for determining operational efficiency or performance. Net income is positively associated with the profitability of a firm. Secondly, industry (INDUSTRY) is an important control variable, this research focuses mainly on the banking industry. Banks are expected to adopt a high degree of technology in order to properly perform in this day and age. Thirdly revenue (REVENUE) is quite an essential factor in determining the degree of operational efficiency. Organizations with high revenue tend to perform better in their operational activities. Profit margin (PRO_MARGIN) is also another variable which is essential to the research. Furthermore, the cost incurred during the business activities is taken into account. The cost incurred is the expense (EXPENSE) used to calculate the net income. Lastly, Cash from operating activities (CASH_OA) is another indicator variable that is taken into account as a determinant of operational efficiency.
Preceding studies claim that organizations with internal control material weaknesses tend to differ from organizations with internal control effectiveness (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007b). Therefore the determinants of internal control material weakness (ICMW_CONTROLS) are included to control for their impact on operational efficiency. Specifically, firms with material weaknesses in their internal control tend to be smaller, audited by Big 4 auditors and poorly performing. Therefore, ICMW_CONTROLS determinants include firm size (FIRM_SIZE). Larger banks with high annual revenues are usually more effective than others in setting up an internal control system. Bushman et al. (2004) revealed that bigger firms face more complex operational and informational surroundings and therefore are in need of more advanced monitoring activities in order to fend off moral hazard problems. Bodnar et al. (1999) also revealed that the degree of agency costs is high in larger organizations due to the amount of coordinating activities of a different part of the firm and also the amount of delegating activities is enormous. As mentioned, another indicator variable that would be taken into account is firms audited by a Big 4 auditor (BIG4). Appendix C includes the detailed explanation of all variables used in this study, In order to give an extended understanding of the variables and their data.
To test the profitability of an organization with internal control effectiveness with high efficiency, a profit margin is used. the following regression is estimated:
PROFITABILITYit =α + βICYESit +
λ
EFFICIENCY + φEFFICIENCY_CONTROLSit +γICMW_CONTROLSit +εit,
Where PROFITABILITY refers to the measure used to gauge the capacity to generate revenue from operations. To calculate profitability, operating profit margin is used. Internal control effectiveness (ICYES) refers to the variable that discloses the absence of internal control material weakness in year t. H2 predicts the coefficient on ICYES to be positive. EFFICIENCY refers to the measure of operational efficiency, using operating cash flow ratio. The same controls variables for EFFICIENCY and ICCONTROL is also used to measure PROFITABILITY from operations. The BIG_4 variable is not taken into account when measuring profitability due to the insignificance of the variable in tis test.
4.6 Descriptive statistics
In order to properly carry out this research, it was of great importance that the data used in this research must have a normal distributed population. Which entails that for a data research to be economically viable, the data must not be skewed and the kurtosis level must have the ideal height and sharpness. If skewness is positive, the input used are positively skewed or skewed to the right. If skewness is negative, the input is negatively skewed to the left. If skewness is equal to zero, the input is thoroughly symmetrical. In the case of the kurtosis, the higher values express a higher and sharper peak and lower values express a lower and less sharp peak. A reference measure is a normal distribution that has a kurtosis of 3. A skewness of precisely zero is highly unlikely for real-world data (Brown, 2011). The skewness of the various variables used in this research ranges from -0.350 to 2.210, while the kurtosis ranges from 1.651 to 5.830.
The principal sample of 1131 that was supposed to be used in this research was not economically viable and therefore not suitable to carry out the research. To be able to use the data acquired from the database, the outliers had to be eliminated using the Winsorization method. All continuous variables are winsorized at the 5% and 95% level. Furthermore, a log transformation was used to ensure that the data did not possess excess values, which could affect the research. The REVENUE, EXPENSE and NET_INCOME data were converted into REVENUElog, EXPENSElog and NET_INCOMElog because, the revenue, expenses and net income possesses a wide range of data, this is due to the fact that the level of revenue, expenses and net income generated from business activities are quite different for small and large banks. This range of data for revenue, expense and net income was too wide and too skewed, therefore a log transformation was essential to conduct this research. The number of samples was reduced to 716, split into 62 observations with ineffective internal control and 654 observations of firms with effective internal control after Winsorization and log transformation process.
Table 2 depicts the descriptive statistics on EFFICIENCY and other firm characteristics, independently for observations with effective internal control and firms with ineffective internal control or presence
of material weaknesses. The mean EFFICIENCY is significantly lower for observations with internal control material weakness (-0.065) than for observations with no internal control material weakness (1.162). This result shows preliminary indication of the positive association between effective internal control and operational efficiency. Among the several determinants of operational efficiency, I find that banks with ineffective internal control have less revenue, have a lesser net income and generate less cash from operations. In terms of expense, I find that banks with ineffective internal control spend less, this is likely because banks with effective internal control spend more on the maintenance of the system while banks with ineffective internal control spend less but ultimately, the benefit from an effective internal control is higher than costs. For the determinants of effective internal control, I find that firms with ineffective internal control are smaller and are audited by a BIG 4 auditor. These results are coherent with preceding studies. Table 4 shows the distribution of EFFICIENCY for the whole sample used to carry out the research. The average score for operational efficiency is 1.079.
Table 5 shows the Spearman correlation among banks operational efficiency, internal control effectiveness and control variables. Table 6 represents the Pairwise correlation among banks operational efficiency, internal control effectiveness and control variables. As anticipated, the correlation between EFFICIENCY and ICCONTROL is significantly positive using the Spearman correlation (0.006) and the Pairwise correlation (0.083). Also, the correlation between the presence of internal control material weakness (ICMW) and EFFICIENCY is significantly negative using the Spearman correlation (-0.007) and the Pairwise correlation (-0.092). The spearman correlation is the preeminent correlation used, this is due to the fact that the Spearman correlation controls for extreme observations, however, this study already controlled for extreme observations by winsorizing at the 5% and 95% percentile level of each of the variables.
4.7 Empirical results
The choice of the regression model used is mainly due to the fact that the independent variable contained dummy variables or binary components of 0 or 1. Binary components do not have normal distributions, so this means that other regression models cannot be used for this particular hypothesis. However, the linear regression model is used to measure profitability. This is done because in this test two or more independent variables (Efficiency, Internal control effectiveness, revenue, expense Cash from operations, bank size, Big 4) are used to predict the value of a dependent variable (Operational profit margin).
4.7.1 Analyses of Internal control effectiveness and bank operational efficiency
Table 7 illustrates the logistical regression output on the association between internal control effectiveness and bank operational efficiency. Table 7a only shows the control variables for the determinants of operational efficiency. The output shows that the coefficient on ICCONTROL is
positive (1.396) and significant (0.049), which reveals that, an effective internal control system likely leads to a higher operational efficiency in banking institutions. The coefficients on banks operational efficiency determinants implies that operational efficiency is likely higher for banks with less expense, more income, more revenue and more cash flows from operations. Although the results are statistically not significant.
Table 7b represents the output after including the determinants of effective internal control. The coefficients on ICCONTROL continues to be conclusively positive (1.607) and significant (0.040). The table indicates that operational efficiency is higher for larger banks. This finding suggests that the positive effect of internal control effectiveness on operational efficiency is substantial for smaller banks. Although the result of the net income is statistically not significant, I find that the net income is negatively associated with operational efficiency after the addition of the control variable FIRM_SIZE. The explanation for this result could be due to the fact that firm size and net income are positively correlated. The bigger the bank, the higher the net income and therefore the higher the efficiency. The smaller the bank, the lower the net income and therefore the lower the efficiency. An additional reason for the negative association between NET_INCOME and EFFICIENCY could be due to the fact that firms which have poorer financial performance, have a lower operational efficiency (Baik et al. 2013). This in turn legitimately leads to the escalation of internal control problems (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007).
Table 8 represents the output of the robustness check, carried out to ensure the legitimacy of the test. A robustness check is also carried out to give reassurances regarding the regression output. The interpretations based on these tests is changed. Most of the findings are statistically significant using the robustness check.
4.7.2 Analysis of Internal control effectiveness and profitability
To test the second hypothesis, a regression model was used to test the independent variables and predict the impact of the values on the dependent variable. Table 9 represents the regression output. The coefficients on EFFICIENCY (0.002) and ICYES (0.001) are positive. This result implies that the operational efficiency associated with operational efficiency is stronger for banks with a higher profitability, although the results are statistically not significant. The regression output further suggests that larger banks with higher revenue, less expense, and high net income are significantly more profitable. The coefficient on CASH_OA is however significantly negative (p = 0.001). This could be due to the fact that cash from operations is a predominant factor in measuring operational efficiency but less predominant in measuring operational profitability. The coefficient on FIRM_SIZE is also negative, indicating that smaller firms are less profitable than larger firms. Although this result is statistically not significant.
4.7.3 Additional analyses on firm size
The result from previous studies documents that relatively smaller firms tend to encounter an unbalanced amount of expenses for implementing SOX (Cheng. et al. 2015). However, the evidence on this differential benefit is not significant. Due to the fact that smaller firms tend to have less developed internal control systems and therefore a poorer segregation of duties. Smaller firms are therefore more prone to agency problems and information asymmetry (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007b; Gao et al. 2009). In this section, I will examine if there is a difference in the benefit of internal control effectiveness between smaller banks and larger banks based on market value of equity.
Table 10 represents the logistic regression output on bank size and other efficiency and control variables. The coefficient of ICCONTROL is significantly positive (p = 0.073), which suggests that the benefit of effective internal control is dependent on the firm size. The result also shows that the coefficient on ICMW is significantly positive (p = 0.100) which indicates that the severity of internal control material weaknesses depends on the firm size. Furthermore, the coefficient of efficiency is significantly negative (p = 0.000).
Overall, these results imply that there is a difference between the benefits of having an effective internal control between smaller banks and larger banks. Smaller banks would likely experience more benefit in terms of improved operational efficiency from internal control effectiveness. I believe that this results and findings can be of great relevance to managers, investors and other researchers, whose interest lies in the impact of internal control effectiveness on banking institutions.
Discussion, conclusion and limitations
In this section, the various discussions, the main conclusion, and the imminent limitations are addressed and interpreted.
5.1 Discussions
A different explanation can be found if an alternative theoretical context should be adopted. An alternative theoretical context would stress other variables such as the use of revenue and expense to measure the effectiveness of internal control. The results prompt readers to consider the significance of the control variables, such as cash from operations. In future research, I suggest that the return on investments (ROI) should be taken into consideration as a control variable and used to expand the research on costs and benefits of internal control systems.
5.2 Conclusion
In this study, I examine if internal control effectiveness has implications on banks operational efficiency. Utilizing a data sample from Audit analytics and Compusat database, of banks that disclosed internal control opinions under SOX 404 ranging from the period 2004 – 2017 to measure banks operational efficiency, I find that internal control effectiveness likely leads to a higher operational efficiency in banking institutions. Therefore H1 is accepted. This result holds after controlling for determinants associated with internal control and operational efficiency. The result is relevant due to the fact that, ineffective internal control, for example, can diminish the banks' ability to collect, process and store transactional data from economic events, which could result in errors in internal management reports (Doyle et al. 2007a). While an effective internal control improves banks ability to collect, process and store transactional data from economic events, which could result in higher efficiency in operations and improve internal management reports and subsequently the performance.
I further examined if internal control effectiveness and operational efficiency are higher for firms with higher profitability. I find no significant evidence to support this claim. The result shows that the operational efficiency associated with operational efficiency is stronger for banks with a higher profitability but the results are statistically not significant. Therefore H2 is rejected. A high profitability means that an organization has been able to increase cash from operational activities while reducing operating expenses (Tulsian, 2014). The reason as to why no significant evidence could be found to support this claim could be due to the fact that effective internal control requires costs to be made to keep the internal control effective and therefore profitability could be affected. Although the benefit of internal control effectiveness is higher than the costs.
I also examined if firms size has an impact on the benefit accumulated from the possession of an effective internal control system. I find that there is a significant difference between the benefits of having an effective internal control between smaller banks and larger banks. This finding suggests that the issue of internal control material weakness is especially severe for small banks, in order words, the positive effect of internal control effectiveness on operational efficiency is pronounced for smaller firms. This result supports previous studies, which documents that relatively smaller firms tend to encounter an unbalanced amount of expenses for implementing SOX (Cheng. et al. 2015).
Globally, this study and findings can be relevant to managers, investors and other researchers, whose interest lies in the impact of internal control effectiveness on banking institutions. This result endorses an emerging literature that examines the significance of internal control outside the limits of financial reporting. It also gives an indication of the costs versus benefits of reporting under SOX 404.
Overall, the above result indicates that an effective internal control likely leads to a higher operational efficiency and this result is predominantly stronger for smaller banks. This study extends the literature by posing statistical evidence on the implications of internal control effectiveness on not just banks operational efficiency but firms operational efficiency in the broader sense. The next research can investigate and shed light on other determinants of efficiency and control in banking institutions, which are not taken into account in this research.
5.3 Limitations
Although this study has reached its objective, there are some inevitable limitations. Firstly, because of the limited amount of samples for banks with ineffective internal control, no further research could be conducted using these samples. Therefore to generalize the result for this group, the research should have contained more participants. Secondly, because of the time limit, more hypothesis could not be tested. For the full scope of this research, an additional analysis could be done on the implication of internal control effectiveness on operational efficiency and the degree of effect it has on future firm performance.
Finally, winsorizing at the 5% and 95% level, eliminated a lot of sample data for smaller banks, which could have affected the research in one way or the other.
5.4 Acknowledgment
I would like to acknowledge my supervisor Edo Roos Lindgreen, my internship coach Christian Gotz and classmates for their support, assistance and time to ensure that my research goes according to plan. I would also like to acknowledge the facilities at the University of Amsterdam, which were utilized while carrying out this research. Information regarding the databases (Audit Analytics and Compusat) can be found in Appendix A.
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