Maijoor (2000) identified two theoretical frameworks for the study of internal control in relation to organizational performance: agency theory and organization theory.
Agency theory, which originated in the 1970s, depicts top-level managers as agents whose interests may be divergent to those of their principals who are the shareholders, with both parties seeking to maximize utility (Katzman, Verhoeven, & Baker, 2009). Therefore, control structures are imposed on the agent with a view to curbing losses to the principal resulting from the interest divergence. The main focus of control in agency theory is on top-level management with emphasis on “the effects of uncertainty, the cost of the monitoring mechanism, and rewards for the control system” (Jokipii, 2006, p. 38). Critics of the theory, however, have argued that the assumptions made about the individualistic utility motivations that result in principal-agent divergence may not apply to all managers. Hence, it is undesirable to rely exclusively on the agency theory as it ignores the complexities of organizational life (Fong & Tosi, 2007). In the alternative, the organization (or management control) theory, which is based on a broader concept of internal control than the agency theory, was used in this study.
Organization theory: Organization theory explains the dynamics of business organizations, including the ways they exercise control for the attainment of set objectives. Modern organization theory, which has its roots in sociology, is grounded on concepts that were developed during the Industrial Revolution in the late 1800s and early 1900s. The origin of the theory was the idealized organizational structure research of German sociologist and engineer, Max Weber (1864-1920), who theorized that work should be guided by rules, policies, and procedures (Houghton, 2010). Weber based his model theory on legal and absolute authority, logic, and order. Among other important contributors to organization theory was Henri Fayol (1845-1925), who identified strategic planning and employee guidance through policies and procedures as key functions of management in creating and nourishing a successful organization (Pryor & Taneja, 2010). According to Laszlo, Laszlo, and Dunsky (2010), organization theory provides an interdisciplinary focus on such issues as performance, success, and survival of business organizations, among others, noting that the ultimate goal of the theory is to maximize the achievement of corporate objectives through the active involvement of all levels of the organization. Therefore, research in this area mainly examines internal control in the context of organizational effectiveness and performance.
Organization theory has been used in some past research studies relating to internal control. In their study involving senior executives at 50 companies in the United States, Mautz et al. (1980) used this perspective and found that internal control was seen as an important responsibility of management. Similarly, Feng, Li, and McVay (2009) examined the relationship between internal control quality and the accuracy of management guidance, and found that internal control quality has an economically significant effect on internal management reports and decisions. Daft, Murphy, and Willmott (2011) stated that organization theory provided a mechanism by which resources are directed, monitored, and measured. Well managed, organization theory can leverage maximum productivity and revenue from the different capacities within the organization. Poorly managed, however, organization theory can result in the loss of proper systems of internal control.
In 1992, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) provided a model that has been adopted as the generally accepted framework for internal control and is widely recognized as the definitive standard to assess the effectiveness of an internal control system. With particular reference to banking, the Basel Committee on Banking Supervision (1998, 2011) also provided frameworks for internal control systems in banking organizations. This group specifies that the three main objectives of the internal control process can be categorized as performance, information, and compliance objectives.
Within the ambit of organization theory, internal control, which traditionally had been a mechanism for checking instances of fraud, misappropriation, and errors (Morehead, 2007), has become more extensive, addressing all the various risks faced by organizations (Tseng, 2007). As a result, a sound internal control process has come to be widely recognized to be critical to the ability of a firm to meet its established goals and to maintain its financial viability (Brown, Pott, & Wompener, 2010; Doyle, Ge, & McVay, 2007b; Jokipii, 2010; Tang & Xu, 2008). Based on the above evidence, the relationship between ICE and financial performance in the banking industry in Nigeria was assessed.