As asserted by the Basel Committee on Banking Supervision (1998), effective internal control should lead to not only reliable, timely, and complete financial and management information but also to the efficiency and effectiveness of activities (performance objectives) in the value chain of a bank. Performance objectives are concerned with how effectively and efficiently the banks utilize their assets and other available resources to promote profitability and protect themselves from losses. First, to achieve performance objectives, a management control system anchored on an effective accounting system will be used to control costs in the banking operations through the process of planning, control, and feedback. Second, to achieve efficiency and effectiveness of banking activities, an accounting system based on effective internal controls must be integrated into the entire process. Third, efficiency and effectiveness will lead to profitability and protection from losses.
The definition of internal control by the Basel Framework implies that there are three types of risk to be controlled by a bank’s internal control: information risk (unreliable, incomplete, and untimely financial and management reporting), performance risk (inefficient and ineffective activities), and compliance risk (violations of laws and regulations). Controlling performance risk will increase the probability of the efficiency and effectiveness in the value chain, thus leading to a positive performance.
According to Lai et al. (2011), many past and recent accounting scholars focused on the two objectives of reliability of financial reporting and compliance with government regulations (Doyle et al., 2007b; Klam & Watson, 2009; Masli et al., 2010). It is only recently that the efficiency and effectiveness objective of internal control in relation to firm performance is beginning to come under empirical research scrutiny (Jokipii, 2006; Lai et al., 2011; Tang & Xu, 2008). No study has been found to investigate the relationship between internal control effectiveness and financial performance in the banking industry. However, research findings related to nonbank companies will be applied to banks as they share the same internal control objectives (Basel and COSO).
Past research studies have largely found that weak internal controls have a negative impact on a firm’s performance. Boritz and Lim (2008) and Yazawa (2010) found that companies reporting internal control weaknesses have weaker financial performance than those reporting otherwise. Doyle, Ge, & McVay (2007a) reported that firms disclosing material internal control weaknesses tend to be financially weaker, whereas companies that are weak in internal control tend to affect the quality of profit (Ashbaugh-Skaife, Collins, Kinney, & Lafond, 2008). Stoel and Muhanna (2011) found that firms reporting weak IT internal control have a lower earnings response coefficient. In reporting that companies with internal control weaknesses tend to be financially weaker, Yazawa (2010) also stated that a material weakness is related to quality of earnings. In a more direct reference to the consequence of a weak internal control, Lu et al., (2010) stated that the absence of effective internal control results in a weak financial performance. In Berete (2011) and Mittal et al. (2008), EVA was also used as dependent variable. Doyle et al. (2007b) and Tang and Xu (2008) on their part found and thereby confirmed that internal control affects corporate performance whether financial or operational. In these empirical studies, the independent variable was internal control effectiveness (ICE).
The internal control process which previously was a mechanism for checking instances of fraud, misappropriation, and errors (Morehead, 2007), has become more extensive, addressing the various risks organizations face (Tseng, 2007). Accordingly, an effective internal control has come to be widely recognized to be critical to the achievement of corporate goals and to maintain financial viability (Brown et al., 2010; Doyle et al., 2007b; Jokipii, 2010; Richard et al., 2009; Tang & Xu, 2008).
With a condensed reference to the Nigerian banking industry, if the observed distress and mismanagement continued, the situation would result in total bank failure with adverse economic consequences. Empirical results of a study on local economic effects of bank failures indicated that such failures cause a reduction in the volume of sales in local markets, and in many cases, the liquidation of failed banks aggravate unemployment (Gilbert & Kochin, 1989). Generally, bank distress deters economic growth (Ochejele, 2007; Rose & Hudgins, 2010). As the CBN did not report any signs of bank distress before 2009, it would be necessary to examine the financial performances of the banks during the period before the stress tests that revealed the significant distress in eight of the 24 banks in 2009. It would also be necessary to examine their post intervention financial performances.
General research studies on internal control have revealed that beyond evaluating the effectiveness of internal controls by traditional qualitative methods, they can also be evaluated using quantitative methods premised on empirical results (Boritz & Lim, 2008; Stoel & Muhanna, 2011; Tseng, 2007). Since a major cause of the distress is suggested to be the absence of effective internal controls (Cook, 2011), building on all of this evidence, the relationship between ICE and financial performance in the banking industry in Nigeria can be assessed empirically. This can be done regardless that there has been a dearth of academic research examining internal control systems in the banking industry or their consequences on banks’ financial performance. This research study will fill that gap and provide some insight on the banks’ internal control effectiveness and their financial performance.