Internal Controls and Financial Reporting Quality

INTERNAL CONTROLS AND FINANCIAL REPORTING QUALITY IN PRIVITIZED
COMPANIES IN UGANDA:
A CASE OF CENTRAL PURCHASING COMPANY LIMITED (CPCL)
ABAS JASPER OLWOL
DBS, Bsc Accts/Finance (Hons)
11/2/501/E/428
SUPERVISOR: Dr Henry Buwule Musoke
PhD, Msc, BBA (Hons)
A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS
ADMINISTRATION DEGREE OF NDEJJE UNIVERSITY
SEPTEMBER, 2013

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DECLARATION
I Abas Jasper Olwol do hereby declare that this dissertation is my own original work and
has not been presented to any institution/University for academic award or otherwise by
any person.
Signature ………………………… Date………………….
Abas Jasper Olwol
Reg No: 11/2/501/E/428

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APPROVAL
This dissertation has been submitted for examination with my approval as a University Supervisor
Signature……………………………… Date…………………………………
DR. Henry Buwule Musoke

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DEDICATION
I dedicate this research dissertation to the almighty God, my late Father Benjamin Okwenye, my Mother
Ms Leah Okwenye, my Wife Ms Deborah Olwol and Children (Glad, Gloria and Gabriel), brothers and
sisters, my friend Opio Amed Sunday and all those whose desire has seen me where I am now. May God
bless you all

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ACKNOWLEDGEMENT
Most of all I thank the Almighty God for being a source of inspiration and for providing me
wisdom and the Grace to complete this research. I am greatly indebted to my Supervisor, Dr. Henry
Buwule Musoke for his guidance, encouragement and patience even when I seemed not to
understand. I also extend my profound appreciation and thanks to family and most especially my
parents the late Benjamin Okwenye and Ms. Leah Okwenye, my wife Deborah and Children,
brothers and sisters Robinson, Dianah, Janet, Night and Gift for having been understanding,
tolerant, supportive for along time. My gratitude also goes to my colleagues especially Opio, Filder,
Nicho, Wanyana, Harriet, Olive, Maureen, Kamukama, Cissy and Linda who assisted and offered
me the academic company I needed during the MBA program, my pastor Moses Kakembo together
with the family of Luzira Healing Springs Church. Special thanks go to the Central Purchasing
Company management for allowing me carry out this research; I also thank all staff especially those
who participated in this research by responding to questionnaires. For all the above various groups
and individuals and many others that I may not have mentioned, in this acknowledgement, I owe
this achievement to you all and I will always remain indebted to you.

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TABLE OF CONTENTS
DECLARATION………………………………………………………...…..…...Error!
Bookmark not defined.
APPROVAL……………………………………………………………….....…..Error!
Bookmark not defined.
DEDICATION………………………………………………………………...…iii
ACKOWLEDGEMENT…………………………………………………… .….iv
TABLE OF CONTENT……………………………………………………..…..v
LIST OF TABLES…………………..………………………………………....viii
LIST OF FIGURES……………………………………………………………..ix
ABBREVIATIONS AND ACRYOMNS..... …………………………………….x
ABSTRACT........................................................................................................... xi
1.0 INTRODUCTION .......................................................................................... 1
1.1 Background to the study ................................................................................. 1
1.2 Statement of the problem................................................................................ 6
1.3 Objectives of the study...................................................................................... 7
1.3.1 General objective ........................................................................................... 7
1.3.2 Specific objectives ......................................................................................... 7
1.4 Research Questions......................................................................................... 7
1.4.1 Hypothesis.................................................................................................... 7
1.5 Significance of the study................................................................................. 7
1.6 Conceptual frame work..................................................................................... 8
1.7 Scope of the Study ............................................................................................ 9
1.7.1 Geographical Scope ....................................................................................... 9
1.7.2 Content Scope................................................................................................ 9
1.7.3 Time scope..................................................................................................... 9
1.8 Definition of Key Concepts used in this Study................................................ 9
1.9 Organization of the study................................................................................ 11
CHAPTER TWO…………………...…………………………..………………12
LITERATURE REVIEW .................................................................................. 13
2.1 The nature of Internal Controls....................................................................... 13

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2.1.1 Preventive Internal controls:........................................................................ 14
2.2 Financial Reporting Quality.......................................................................... 26
2.3 Internal Controls and Financial Reporting Quality......................................... 33
2.4 Preventive Controls and Financial Reporting Quality.................................... 35
2.4.1 Detective Controls and Financial Reporting Quality................................... 36
2.5. Conclusion .................................................................................................... 38
CHAPTER THREE…………………………………………………………….38
METHODOLOGY ............................................................................................. 39
3.1 Research Design.............................................................................................. 39
3.2 Study Area and Population ............................................................................. 39
3.2.1 Study Area ................................................................................................... 39
3.2.2 Study Population.......................................................................................... 39
3.3 Sampling Design and Sample Size ................................................................. 40
3.3.1 Sampling Design.......................................................................................... 40
3.3.2 Sample Size.................................................................................................. 40
3.4 Data Collection Sources, Methods and Instruments....................................... 40
3.4.1 Data Sources ................................................................................................ 40
3.4.2 Data collection methods............................................................................... 41
3.4.3 Data collection instruments.......................................................................... 42
3.5 Data Processing and Analysis......................................................................... 43
3.5.1 Data Processing............................................................................................ 43
3.5.2 Data analysis ................................................................................................ 43
3.6 Ethical Considerations .................................................................................... 43
3.7 Limitation of the Study................................................................................... 44
CHAPTER FOUR............................................................................................... 45
FINDINGS OF THE STUDY ............................................................................ 45
4.1 Demographic Characteristics.......................................................................... 45
4.1.1 Gender and departments of respondents...................................................... 45
4.1.2 Length of Service in the Organization......................................................... 46
4.3. Preventive and Detective Internal Controls ................................................... 48
4.4. Financial Reporting Quality........................................................................... 52
4.5. Relationship Between Internal Controls and FRQ......................................... 55

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4.6. Regression Analysis....................................................................................... 58
4.6.1 Qualitative Data Presentation ...................................................................... 59
4.6.3 Internal controls ........................................................................................... 59
4.6.4. Effectiveness of internal controls................................................................ 60
4.6.5 Accountability procedure............................................................................. 61
4.6.6 Reporting procedure..................................................................................... 61
CHAPTER FIVE…………………...……………………………………....……61
5.0 SUMMARY,CONCLUSIONS AND RECOMMENDATIONS…………62
5.1 Summary of Major Findings........................................................................... 62
5.1.1. Objective One. ............................................................................................ 62
5.1.2. Objective two.............................................................................................. 62
5.1.3. Objective Three........................................................................................... 63
5.2 Conclusions.................................................................................................... 63
5.3 General Recommendations ............................................................................. 64
5.3.1 Objective one ............................................................................................... 64
5.3.2 Objective Two.............................................................................................. 65
5.3.3 Objective Three............................................................................................ 65
5.5 Recommendation for further research ............................................................ 65
REFERENCES…………………………………………………………………..65
APPENDIX I SELF – ADMINISTERED QUESTIONNAIRE...................... 69
APPENDIX II INTERVIEW GUIDE:.............................................................. 73
APPENDIX III :( NATURE OF INTERNAL CONTROLS) ......................... 74
APPENDIX IV (NATURE OF FINANCIAL REPORTING QUALITY)..... 75
APPENDIX V KREJICE AND MORGAN (1970) .......................................... 76
APPENDIX VI INTRODUCTORY LETTER…………………………………..76

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LIST OF TABLES
Table 3.1: Sample Size ......................................................................................... 40
Table 3.2: The Content Validity Index ................................................................. 42
Table 3.3 Reliability Test Table............................................................................ 43
Table 4.1 Respondents and their departments ...................................................... 45
Table 4.2: Length of Service in the Organization................................................ 46
Table 4.3. Age of Respondents............................................................................. 46
Table 4.4 Level of Education of the Respondents ................................................ 47
Table 4.5.Likert Scale........................................................................................... 48
Table 4.6.showing Descriptive statistics controls................................................. 48
Table 4.7 showing Descriptive Statistic of FRQ…………………………...……51
Table 4.8 Relationship between Internal Controls and FRQ……….……....……54
Table 4.9 Relationship between preventive control and Compliance……...….…55
Table 4.9.1 Relationship between preventive control and Reliability……...……55
Table 4.9.2 Relationship between detective control and Compliance……...……56
Table 4.9.3 Relationship between detective control and Reliability...……...……56
Table 4.9.4 Model summary………………………………………....……...……57
Table 4.9.5 Analysis of Variables (ANOVA)……………………………………57
Table 4.9.6 Standardised Coefficient………...………...…………....……...……58

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LIST OF FIGURES
Figure 1.1: Conceptual frame work of ICs and FRQ in Privitised Companies in Uganda…...........7

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ABBREVIATIONS AND ACRYNOMS
ACCA Association of Chartered Certified Accountants
AICPA American Institute of Certified Public Accountants
COBIT Control Objectives for Information and Related Technology
COSO Committee of Sponsoring Organizations
CPCL Central Purchasing Company Limited
CPD Continuing Professional Development
CVI Content Validity Index
FCPA Foreign Corruption Practices Act
FRO Financial Reporting Organizations
GCPC Government Central Purchasing Corporation
HRO Human Resource Organizations
ICPAU Institute of Certified Public Accountants of Uganda
ICS Internal Control System
IFRS International Financial Reporting Standards
IIA-UK Institute of Internal Auditors- United Kingdom
SAC System Audit ability and Control
SAIGA The South African institute of government auditor
SD Standard Deviation
SOX Sarbanes- Oxley Act
SSA Sub Saharan Africa

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ABSTRACT
Whereas extensive studies have been carried out to explore and explain internal
controls and financial reporting quality in Privatized Companies worldwide, very few
of these have focused on Developing Africa and Uganda as a whole. This study assessed
internal controls and financial reporting quality in privatized companies focusing on
central purchasing company limited (CPCL). A conceptual framework was developed
on the internal controls and financial reporting quality of Central Purchasing
Company. The specific objectives were (i) To access the nature of internal controls
used by Central Purchasing Company Limited. (ii) To examine the nature of financial
reporting quality at (Central Purchasing Company Limited). (iii) To establish a
relationship between Internal Controls and Financial Reporting Quality. A
quantitative correlational cross-section survey and a case study research design were
used to collect data. Stratified and purposive sampling techniques were used to select
the respondents. Microsoft Excel and SPSS were used to analyze the data and to
present the findings. Findings indicates that, the company had average internal
controls and most of them were functioning properly .The correlation coefficient of
r=0.914 indicated that there is a strong positive relationship between internal controls
and financial reporting quality. It’s thus recommended that Central purchasing
company management should ensure that all its internal controls that are implemented
are properly functioning and are not undermined by its staff as a way of attaining
financial reporting quality (B.K. Sebbowa, 2009), .(Gerrit and Mohammad J. 2010). In
conclusion, given the correlation coefficient above it’s evident that there is a strong
positive relationship between internal controls and the financial reporting quality of
the company. Recommendations were made focusing mainly on the need to improve
the weak areas such as verification of documents an aspect internal control so as to
achieve sustainable financial reporting quality.

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CHAPTER ONE
1.0 INTRODUCTION
This study presents internal controls and financial reporting quality in privatized companies with
Central Purchasing Company as a case study. This Chapter covers the background to the study,
statement of the problem, objectives of the study, research questions, hypotheses, significance of
the study, scope of the study, the conceptual frame work and definition of key terms, and
organization of the study.
1.1 Background to the study
An internal control is a process implemented by an organization structure work and authority
flows, people and management information systems, designed to help the organization
accomplish specific goals or objectives with means of directing, monitoring and measuring of
organization resources. (COSO, 2005).
Internal control activities have been established by practitioners, primarily auditors. Rather than
investigate to control activities themselves, academics focused their research efforts on issues
surrounding the controls using an explicit, or implied, assumption that the properties of the
control activities are known. (Barra & Roberta 2010; Ashton1974; Bodner 1975; Cushing1974;
Doty et al1989; Hornik and Ruf 1997 Simon 1974 and Curtis1998) Aldridge and Colbert (1994)
define internal control as the process designed and effected by those charged with governance,
management and other personnel to provide reasonable assurance about the achievement of the
entity’s objectives with regard to the reliability of financial reporting, effectiveness and
efficiency of operation and compliance with applicable laws and regulations.(Gerrit and
Mohammad J. 2010),
Also internal control is defined as a process designed to provide reasonable assurance regarding
the achievement of financial reporting quality through reliability of financial reporting and
compliance with applicable laws and regulations. (Schaefer& James 2010; Peluchett & Joy
2009).
Internal control is a process effected by an entity's board of directors, management, and other
personnel designed to provide reasonable assurance regarding the achievement of objectives in

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the following categories: reliability of financial reporting, effectiveness and efficiency of
operations, compliance with applicable laws and regulations.( Stephen H, 2003), Internal
controls have existed from ancient times. It is common knowledge among practicing
accountants, managers and business scholars that good internal controls prevent errors and frauds
leading to unqualified auditors opinion. External auditors may test the effectiveness of internal
controls and place reliance on the underlying records as a basis for the preparation of financial
reports. (ACCA- Managerial Finance Paper 8; 2010; and Panday;2008) .
In the United States many organizations have adopted the internal control concepts presented in
the report of the Committee of Sponsoring Organizations of the Tread way Commission
(COSO). Published in 1992.COSO describes internal control as consisting of five essential
components. These components, which are subdivided into seventeen factors, include:The
control environment
Risk assessment
Control activities
Information and communication
Monitoring
The COSO model is depicted as a pyramid, with control environment forming a base for control
activities, risk assessment, and monitoring. Information and communication link the different
levels of the pyramid. As the base of the pyramid, the control environment is arguably the most
important component because it sets the tone for the organization. Factors of the control
environment include employees' integrity, the organization's commitment to competence,
management's philosophy and operating style, and the attention and direction of the board of
directors and its audit committee. The control environment provides discipline and structure for
the other components. (Gerrit & Mohammad J, 2010).
Risk assessment refers to the identification, analysis, and management of uncertainty facing the
organization. Risk assessment focuses on the uncertainties in meeting the organization's
financial, compliance, and operational objectives. Changes in personnel, new product lines, or
rapid expansion could affect an organization. Sebbowa , (2009),

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Control activities include the policies and procedures maintained by an organization to address
risk-prone areas. An example of a control activity is a policy requiring approval by the board of
directors for all purchases exceeding a predetermined amount. Control activities were once
thought to be the most important element of internal control, but COSO suggests that the control
environment is more critical since the control environment fosters the best actions, while control
activities provide safeguards to prevent wrong actions from occurring. Sarens, G. & De Beelde,
I. (2006b)
Information and communication encompasses the identification, capture, and exchange of
financial, operational, and compliance information in a timely manner. People within an
organization who have timely, reliable information are better able to conduct, manage, and
control the organization's operations.
Monitoring refers to the assessment of the quality of internal control. Monitoring activities
provide information about potential and actual breakdowns in a control system that could make it
difficult for an organization to accomplish its goals. Informal monitoring activities might include
management's checking with subordinates to see if objectives are being met.
A more formal monitoring activity would be an assessment of the internal control system by the
organization's internal auditors.In Hellenistic Egypt there was a dual administration, with one set
of bureaucrats charged with collecting taxes and another with supervising them. The sacking of
Troy was a classic example of the failure of internal controls. Mwindi (2008).
Internal Control System (ICS) is a very important function in the achievement of the
organizational success and successful management functions (The South African institute of
government auditor SAIGA 2003). It further pointed out that when administrative and financial
management decisions go wrong, reference is usually made to ICS to seek out possible reasons.
On the other hand, financial statement is a written report which quantitatively describes the
financial health of a company or an organization which usually includes the income statement,
balance sheet, cash flow statement and the statement of retained earnings. (Myojung; Kim and
Lim 2010).

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Financial report Quality on the other hand refers to statements prepared to the required
accounting financial reporting standards to show the financial position of the business at the end
of the financial/accounting year and these statements must meet the following characteristics
which include; understandability, comparability, relevance and fair presentation.(Aharony, J and
A. Dotan, 2004) According to Welsch and Chesley(1990) the notes of balance sheets, cash flows
statement, statements of changes in are integral part of financial statements and help users
interpret the statement, elaborated on accounting policies, major financial effects and certain non
quantifiable events that may contribute to the success or failure of the business. The objective of
financial statements is to provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders and other creditors in making decisions in their
capacity as capital providers. (Murray, 2010).
The Financial Accounting Standards Board and the International Accounting Standards Board
releases a joint exposure draft proposing significant changes to how businesses present their
financial statements. Two major objectives of the proposed financial statements are
‘’disaggregation’’ and "cohesiveness." Disaggregation means, simply, that information on the
financial statements will be broken into more detail than is currently done, Cohesiveness means
that financial information expenses on the statement of comprehensive income to specific assets
or liabilities on the balance sheet and to specific cash flows on the statement of cash flows.
(Wagoner, Joel, 2011).
According to Osborne and Gaebler 1992, privatization is the shift of functions, activities and
responsibilities from the public (government) sector to the private sector. It involves a process
where the government gradually and progressively eliminates their involvement in direct service
provision while maintaining responsibility and authority over key functions such as
standardization, certification and accreditation. According to Megginson and Netter 2001,
Privatization is the deliberate sale by a government of state-owned enterprises or assets to private
economic agents.Andrews and Dowling, 1998 describe Privatization as a process by which state
owned enterprises are sold to the private sector

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In 1991/92 financial year, Uganda had about 140 State-Owned Enterprises covering a diverse
range of activities from trade and commerce, agricultural production and processing,
manufacturing, hotel and tourism, banking, insurance and utility services. Over 85% of these
State-Owned Enterprises were commercial in nature and were considered unlikely to survive in
competition with the emerging private sector without significant continuing government subsidy
(Adam Smith Institute, 2005).
In 1993, privatisation and reform supporting legislature, the Public Enterprises Reform and
Divestiture Statute 1993, Statute No. 9, (thereafter referred to as the PERD 1993 Statute) was
then passed by parliament and enacted to give legal backing to the policy reform objectives. This
was a pre-reform set of activities and an enabling law formulation that legalized the Economic
Reform process. The law served to safe guard outcomes of the operations and future legal
consequences. However some of the enterprises such as Lake Victoria bottling company– a soft
drinks company and Nile Breweries had already been privatised before the law was passed!
The PERD 1993 Statute provided guidelines for the reform and divestiture. It categorized the
enterprises that were to be reformed or divested under the programme, laid down the
implementers and the modes of privatisation that would be used in the process. There were
subsequent amendments to the statute along the way.
Following continued criticism from the World Bank and International Monetary Fund (IMF)
regarding poor performance of public enterprises especially in Sub-Saharan Africa (SSA), many
governments have had to implement Structural Adjustment Reforms to try and improve their
economies and to gain access to financial credit facilities and so did Uganda (Tangri et al. 2001).
In May 1987, Uganda government took a stand to embrace a radical Economic Recovery
Programme (ERP) to improve the performance of the economy and ensure sustainable growth.
This programme introduced privatisation into the economy and this involved rationalization of
state ownership, liberalization, rehabilitation, divestiture, consolidation and liquidation. The
privatisation programme is part of the overall Economic Recovery Programme (ERP) and its
adoption was intended to invigorate the private sector so that it could make the private sector
play a leading role in the development of the economy (Privatisation Unit 2005).

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The Central Purchasing Company was formed following the divestiture of the Government
Central Purchasing Corporation (GCPC). GCPC had been set up by government to procure
common-user items in bulk and supply these materials to Government at lower prices taking
advantage of economies of scale. GCPC eventually started supplying to the private sector as
well. In June 2000, GCPC was privatized by way of a Management Employee Buyout under
which the former employees of GCPC forfeited their terminal benefits for stock in the company.
The company which was originally owned by eighty six (86) individuals now trades as the
Central Purchasing Company Ltd (CPCL) with its main business being procurement and trading
for both the public and private sector.
The company set up should be designed to realize the objective of the company. However an
evaluation of the company structure, management of staff, financial performance, decision
making structures and levels that procurement function did not portray alignment to the
objectives. For instance Company’s capacity assessment of 1999 conducted by private sector
foundation revealed that most private companies go down in business due to weakness and laxity
in control systems. B.K. Sebbowa, (2009)
1.2 Statement of the problem
Despite the availability of professional staff and their continued development, internal and
external auditor’s contribution in most Companies still experience difficulty in presenting
financial reports that reflect the financial condition and results of operations in rational and
meaningful manner. According to Blackbeard (2006), information is often delayed, inaccurate
and relayed from person to person rather than via reports; making it hard for Organizations to
achieve financial reporting quality .
However despite all the above efforts, the company still struggles with meeting acceptable
financial reporting quality, financial reports are not made timely, accountability for the financial
resources are still wanting, frauds and misuse of the Company’s resources have been unearthed (
Auditors Report,2011). If the Company continues in this direction, decisions made may not be
informed and this may lead to declined performance. While there are many factors that affect
Financial Reporting Quality of privatized Companies, particularly Central Purchasing Company
Limited, Internal Controls may be playing a significant role. It is for this reason that the

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researcher embarked on this study relating Financial Reporting Quality (Compliance and
Reliability) to Internal Controls, specifically preventive and detective controls in Central
Purchasing Company Limited.
1.3 Objectives of the study
This sub section spells out the general and specific objectives of the study
1.3.1 General objective
The general objective of the study was to find out the effect of internal controls on financial
reporting quality in privatized companies in Uganda, using CPCL as a case study.
1.3.2 Specific objectives
i) To assess the nature of Internal Controls used by CPCL.
ii) To examine the nature and Quality of Financial Reporting at CPCL.
iii) To establish a relationship between Internal Controls and Financial Reporting Quality in
CPCL.
1.4 Research Questions
i) What internal controls are being used by Central Purchasing Company?
ii) What is the nature and quality of financial reporting at CPCL?
iii) What relationship exists between the internal controls and the Financial Reporting Quality?
1.4.1 Hypothesis
There is no significant relationship between Internal Controls and Financial Reporting Quality.
1.5 Significance of the study.
(i) The study may help management of CPCL in setting policies that are relevant to company’s
performance in improving their financial reporting.
(ii) The study may provide information and knowledge to academicians and other researchers
and also the study findings can generate knowledge for the government about why privatized
companies fail to comply with financial reporting requirements. This can help the government to
identify what kind of technical support they should provide the privatized companies before
giving them any funding in order to ensure acceptable quality of financial reports.

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(iii) The study may provide information that will assist workers of CPCL and other stakeholders
to improve on the existing internal controls in the Company
(iv) The study findings can also help privatized companies in improving their compliance to
financial reporting requirements and thus improving their capability to attract more development
and ensure their company’s sustainability.
1.6 Conceptual frame work
Independent Variable Dependent Variables
Mediating Variables
Source: Conceptualized by Researcher
Figure 1.1 Relationship between internal controls and financial reporting quality.
Fig.1.1 provides a conceptual framework relating internal controls to financial reporting quality.
The independent variables are internal controls and the framework depict two elements of
internal controls, namely preventive controls and detective controls, all conceptualized to have
an effect on financial reporting quality. The dependent variable in this study is the financial
reporting quality which was measured in terms of compliance to International financial reporting
standards and reliability for its purpose. The framework further shows that there are moderating
variables such as company policies and systems, organizations efficiency through experience,
skills, knowledge and ethical behavior of staff ,For example, despite the expected relationship
between internal controls and Financial Reporting Quality, organizational inefficiency can have
an opposite effect.
Financial Reporting QualityInternal Controls
 Compliance
 Reliability
Preventive Controls
Segregation of Duties
 Approvals, Authorizations,
and Verifications:
Detective Controls
 Reviews of Performance
 Reconciliations
 Internal Audit
Company policies and
systems
Organizational
Efficiency
Experience, skills
and knowledge of
Staff

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1.7 Scope of the Study
This sub section covers geographical scope, content scope and time scope.
1.7.1 Geographical Scope
The study was undertaken at the head office of Central Purchasing Company Ltd located on plot
56 Bell Avenue West, Jinja and two branches in Jinja District and Malaba in Busia District. The
researcher selected Central Purchasing Company Ltd because it was the first Government
Corporation to be sold to its own employees under the privatization unit and pioneer of takeover
by employees in Uganda. The locations were chosen because Jinja and Malaba office are the
only remaining operational offices of Central Purchasing Company Limited.
1.7.2 Content Scope
The study focused on accounting controls and was limited to two dimensions of accounting
controls ( preventive controls and detective controls) as independent variables and financial
reporting quality measured in terms of compliance and reliability of financial reporting as
standards of measurement under internal financial reporting .
1.7.3 Time scope
The study covered the period from 2002 to 2009 in order to review the significance of internal
controls on financial reporting quality so as to come up with the necessary conclusions and
recommendations which would be generalized and applicable to justify the study. The researcher
was interested in this period because it was the time Central Purchasing Company started selling
off its properties in Kampala and laying off employees.
1.8 Definition of Key Concepts used in this Study.
Internal controls: refers to a control environment and control procedures adopted by
management of an entity, to assist in achieving the practicable; the orderly and efficient conduct
of its business, adherence to management policies, safeguarding assets, prevention and detection
of fraud and error, accuracy and completeness of records and timely preparation of reliable
financial information. (ISA 400 Risk assessment and Internal control), Internal controls are those
measures which ensure the accuracy of financial statements through preventive and detective
control. Millichamp, (1996).

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These are measures which ensure the accuracy of financial statements. Once financial
statements are known to be accurate, there will be increased reliance on the underlying
accounting system as a basis for the preparation of accounting reports. Accounting control may
include authorization, management accounts (profit, loss account and balance sheet) produced
monthly, periodic stocktaking and valuation and reconciliation of bank statements with the cash
book. Millichamp (1996).
Detective Internal Controls: These controls are meant to expose those frauds and errors that
have not been prevented. An audit, both internal and external will serve to detect errors and
frauds, reconciliation of bank accounts, reconciliation of debtors ledgers to their controls
accounts, cash and stock accounts will detect anomalies that need to be investigated and decision
to correct them made by management. Supervision is also a detective control. (Institute of
Chartered Accountants of Britain and Wales, sept.1999).
Administrative Internal Controls are controls that are put in place by management to ensure
operational efficiency, effectiveness and compliance with management policies in all
departments or sections of an organization. Administrative control may include authorization to
use equipment or entry to certain offices, security of all the assets of the organization. Finance
Markets ‘Authority (AMF).January2007.
Financial Reporting. According to Frank wood and Sangster, (1998) financial reporting is
defined as a discipline concerned with the preparation and presentation of financial statements.
While ACCA, (Foulks Lynch, 2005), defines financial reporting as preparation of financial
statement in accordance to accounting standards.
It’s a statements prepared to the required accounting financial reporting standards to show the
financial position of the business at the end of time period and also the operating results by
which the business arrives at this financial position .It is of view that accountants rely on record
keeping systems particularly, double entry to produce meaningful financial reports that
summarize both the past and current financial positions of the organization. Also financial

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reporting show past and projected finances and these reports are both the sources of tax
information and the means of analyzing the business. Blake J (1999), Brookson (2001.
Financial reporting quality. Financial report is said to be of quality when it meets all its
characteristics like reliability, comparability, relevancy, understandability and also measures a
company's financial performance during a specific accounting period.
Compliance of financial reporting. Compliance refers to practical application of the existing
laws and regulations and internal policies in relations to IFRS framework. Coco indicates that
control comprises: those elements of an organization (including its resources, systems, processes,
culture, structure and tasks) that, taken together, support people in the achievement of the
organization's objectives.
Reliability of financial reporting is all about information being fit for purpose. Where people
have a clear responsibility to do something and they need to use information to do this, it brings
the whole issue of reliability into focus. The purpose for any financial information is aiding
management with clear decision concerning financial matters as reliability is seen as an
important concept in a number of other fields such as engineering and research we are keen to
see if the theory in these areas may help us to understand how reliability relates to audited
financial statements.
1.9 Organization of the study
The Study covered five chapters as follows Chapter one covers the background to the study,
statement of the problem, general objectives of the study, specific objective of the study,
research questions, hypothesis tested, significance of the study, the conceptual frame work, and
scope of the study, definition of key terms and organization of the study.
Chapter two presents a review of related literature on internal controls and financial reporting
quality.
Chapter three is the detailed descriptions of the research methods and instruments employed in
the study.

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Chapter four is a presentation and discussion of the study findings based on the objectives
aiming at internal control system and financial reporting quality for the last seven years.
Chapter five presents the summary of the results, conclusion and recommendations from the
study.

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CHAPTER TWO
LITERATURE REVIEW
This chapter comprises the concepts and views of authorities in this area of study that is internal
control and financial reporting quality and the relationship between the two variables of the
study.
2.1 The nature of Internal Controls
There are numerous definitions of internal control, most of them having been drafted by
professional accountants’ organizations.
This is the case for the definition of internal control provided in 1977 by the French Institute of
Chartered Accountants: “internal control is the set of security measures which contribute to the
control of a company. Its aim is to ensure, on the one hand, the security and safeguard of assets
and the quality of information, on the other hand, the application of instructions given by Senior
Management, and to encourage improvements in performance. It is evidenced through the
organization, methods and procedures for each of the company’s activities, so as to ensure the
continuity of that company”. Finance Markets ‘Authority (AMF).January2007.
Internal control is a company’s system, defined and implemented under its responsibility, which
aims to ensure that: Laws and regulations are complied with; the instructions and directional guidelines
fixed by Executive Management or the Management Board are applied, The Company’s internal
processes are functioning correctly, particularly those implicating the security of its assets.
In determining its policies with regard to internal control, and thereby assessing what constitutes
a sound system of internal control in the particular circumstances of the company, the board’s
deliberations should include consideration of the following factors: the nature and extent of the
risks facing the company; the extent and categories of risk which it regards as acceptable for the
company to bear; the likelihood of the risks concerned materializing; the company’s ability to
reduce the incidence and impact on the business of risks that do materialize; and the costs of
operating particular controls relative to the benefit thereby obtained in managing the related
risks. (Institute of Chartered Accountants of Britain and Wales, sept.1999).An internal control is
broadly classified into administrative and accounting controls.

14
Administrative internal controls are controls that are put in place by management to ensure
operational efficiency, effectiveness and compliance with management policies in all
departments or sections of an organization. Administrative control may include authorization to
use equipment or entry to certain offices, security of all the assets of the organization.
Accounting internal controls are those measures, which ensure the accuracy of financial
statements. Once financial statements are known to be accurate, there will be increased reliance
on the underlying accounting system as a basis for the preparation of accounting reports.
Accounting control may include authorization, management accounts (profit, loss account and
balance sheet) produced monthly, periodic stocktaking and valuation and reconciliation of bank
statements with the cash book. Mill champ (1996).This control is further classified into;
Preventive, Detective and Corrective internal controls.
2.1.1 Preventive Internal controls: These are controls that are put in place by management to
prevent the accuracy of errors and frauds in the financial statements. These controls include
internal audit, recruitment of the right people with adequate training and experience in the right
places, segregation of duties, authorization and approval of transactions and surprise cash
accounts in the cash office among many more. Coe, Charles K, Ellis, Curtis (2010)
Separating Approval and Payment. A requirement that an employee who is authorized to
initiate a payment to a vendor is not also authorized to sign vendor payment checks would be a
preventive control. Among other things, such a control is designed to reduce the risk of
unauthorized payments,( Krishnan, J. 2005).
Limiting Access to IT Systems. Controlling access to software programs related to accounting
or payment functions through the use of passwords and access codes is another type of
preventive control. Limiting the persons who can change IT programs reduces the risk of
unauthorized transactions. (Conor, Errol &Divesh, 2006).
Segregation of Duties: One of the building blocks of internal control is segregation of duties.
This concept involves assigning responsibility for different parts of a process to different people
so that no one person can control the entire process. The importance of segregation of duties
stems in part from the fact that collusion between two individuals is less likely than misconduct

15
by a single individual. Segregation also reflects the lower probability that two persons will make
the same error with respect to the accounting for a transaction. Assigning responsibility for
physical access to a supply room to a different person than the individual who is responsible for
maintaining the records of the supplies inventory is an example of segregation of duties. (COSO,
2010).
Approval, verification, and authorization
The first step towards controlling financial reporting is to ensure that all transactions are properly
authorized in accordance with management’s policies. Management authorizes employees to
perform certain activities and execute certain transactions within limited parameters. In addition
management specifies those activities or a transaction that needs supervisory approval before
they are performed or executed by employees. A supervisor’s approval (manual or electronic)
implies that he or she has verified and validated that the activity or transaction conform to
established policies and procedure (Rezaee, I&Zabihellah.B, 2002).
Authorization is the delegation of authority and it may be general or specific. Giving a
department permission to expend funds from an approved budget is an example of general
authorization, specific authorization relates to individual transactions; it requires the signature or
electronic approval by a person with approval authority. Approval of a transaction means that the
approver has reviewed the supporting documentation and is satisfied that the transactions is
appropriate, accurate and comply with the applicable laws, regulations, policies and procedures.
Generally approvers review supporting documents, question usual items and make sure that
necessary information is present to justify the transactions before they sign off on the transaction.
As a general rule, authorizations do both of the following (COSO, 2010).Require advance
approval, require written documentation of approval, Dittenhofer, M. (2001).
2.1.2 Detective internal controls:
These controls are meant to expose those frauds and errors that have not been prevented. An
audit, both internal and external will serve to detect errors and frauds, reconciliation of bank
accounts, reconciliation of debtors ledgers to their controls accounts, cash and stock accounts
will detect anomalies that need to be investigated and decision to correct them made by
management. Supervision is also a detective control, (Hayes et al. 2005).

16
Review of performance : While business firms require ongoing changes in organizations'
activities (Alles et al, 2006), they also provide internal control effectiveness thoroughly
understanding in the way continuous monitoring adequacy is because continuous monitoring
ensures that firms are subject to operational effectiveness, reliability of financial reporting, and
regulatory compliance. Therefore, continuous monitoring adequacy is a component of internal
controls that it serves preventive and detective control, for example, when staff members who
know their work as well, they always perform their duties. In this research, continuous
monitoring adequacy is defined as the sufficient and appropriate process of methodology for
issuing the extent of firm to monitor and evaluate internal control system, involvement of long
and short term action plan that the organization uses to assess their plan on strategic objectives.
The appropriate and sufficient monitoring control includes of a performance by firm's evaluators
who respect, trust, and believe the operational control system. The monitors such as internal
auditors or to whom a company assigns their duty to be continuous or ongoing monitoring by
using a highly a control skills, knowledge, and ability that they can evaluate, summarize, and
control effectively. Hence, continuous monitoring leads to preventive and corrective firms'
control system before all members have gotten an effect on organization's goals. The continuous
monitoring adequacy will provide the strongest support for company reporting, particularly, a
reliance of financial reporting (Shapiro and Matson, 2008)
Communication: Within organization, communication is very important baseline in business
firms for both inside and outside the firms (Duxbury and Neufeld, 1999). However, particular
intra organization communications want more links from the staff members and college to
encourage information and knowledge (Zhang et al, 2005). When firm acquires new information
or company rules of internal control, the senior management will make connections with the
target groups and might be aware of information and consciousness within the firm (Yang and
Maxwell, 2011). Therefore, the role of intra organization communication needs a clear
communication skills, or communication in practice. Effective communications within
organization allows employees to recommend and suggest internal control guidance on practical
performance which is used in the day to day operations of a business (Harvey et al., 2000).
Organization communication has been defined as a comprehensive and thorough of firm
members who are receiving or addressing on particular internal control topics and issues

17
completely, clearly, reliability and timeliness. The potential of intra origination communication
may address or stress on the awareness between organization staffs regarding how a quickly was
relation with internal control information it is. If firm members felt that their behavior had
received incomplete or not clear information that firm sends from the firm particular internal
control policies announcement, they perhaps feel most dissatisfied consequently internal control
doesn't effectiveness (Oberg and Walgenbach, 2008). The control of channel communication
distribution information can help build effectiveness of internal control mechanism (Nunlee,
2005).
Firm must be quickly expanding internal control information to all employees' levels. Moreover,
firm policies should show that its reliability can be assisted by providing internal control actually
happening at the intra communication level within organization (Carlsson et al 2010; Hogard et
al, 2005).) Intra-firm communication possess is sharing information, a potential adapter collect
information before making a decision impact on innovation in finance (Everdingen and Wiernga
2002). On the other hand, intra organization communication should be designed to help both
users and contributors to communicate and share information within organization easily (Yang
and Maxwell, 2011; Bardir et al 2009; Russo and Harrission, 2005; Millson and Wilemon, 2002).
The wide domain of potential intra organization communication related to internal control
effectiveness has a significant criterion such as task performance and respect (Driskill and
Downs, 1995) especially accounting policy and firm member belief or behavior respectively.
(COSO). 2007
Risk assessments: At present, every business firms requires risk assessment to avoid and mitigate
firm risk purposes. Risk management system consists of manager's style and his philosophy,
linked with business strategy, and objective setting in operating (Arena et al., 2010). The risk
management today has moved from the entity area of the firm to the corporate cover the firm
(Arena et al., 2010, Power, 2009). The sufficient and appropriated risk management procedure
may present internal control effectiveness by senior executive management and board of director
policies. Hence, the senior management and board of director must understand risk appetite more
as the consequence organizational process (Power, 2009). The clear and sufficient accounting
policies can make appropriate internal control effectiveness (COSO, 2004). Therefore, risk
management efficiency is intended to reflect that firm has been updated rules, standard of work,

18
guidance, and especially a quality of compliance. However, organizations using a weaker risk
management process focused on control compliance and experience are with more difficulty
(Arnold et al., 2011). The outcome of risk management efficiency on the internal effectiveness is
reliability of financial reporting. Hence, risk management efficiency is a part of the internal
control effectiveness. Therefore, internal control system is stemmed from the attitude and
behavior of senior executive management and Board of Directors' behavior that must
transparency, integrity, accountability, and competiveness, (B.K. Sebbowa, 2009).
Reconciliations. Independently comparing two sets of records that relate to the same transaction
and analyzing any differences is a detective control. Reconciling the cash account balance on the
company’s books to its bank records could identify whether any payments recorded by the com-
pany were not received by its bank, or whether any withdrawals reported by the bank were not
accounted for by the company, (B.K. Sebbowa, 2009).
Internal Audit, Whittington & Pany (2001) suggest that internal auditing is performed as part of
the monitoring activity of an organization. It involves investigating and appraising internal
controls and the efficiency with which the various units of the organization are performing their
assigned functions. An Internal Auditor is normally interested in determining whether a
department has a clear understanding of its assignment, is adequately staffed, maintains good
records, properly safeguarding cash, inventory & other assets and cooperates harmoniously with
other departments. The internal auditor normally reports to the top management. (Gupta, 2001)
on the other hand asserts that “Internal audit is an independent appraisal function established
within an Organization to examine and evaluate its activities as a service to the organization”.
The objective of internal audit is to assist members of the organization in the effective discharge
of their responsibilities. According to Gupta “the scope of internal audit is determined by
management”. This may however, impair the internal auditor’s objectivity and hampers his
independence, it is quite hard to report negatively on someone who determines the scope your
work. Although at a Seminar organized by the Institute of Certified Public Accountants of
Uganda (ICPAU), Sebbowa, 2009 in his presentation “The role of Internal Audit function in
Organizations”, states that “Independence is established by organizational and reporting
structure” and that “Objectivity is achieved by an appropriate mindset”. Sebbowa, 2009 also

19
defines “Internal auditing is an independent, objective assurance and consulting activity designed
to add value and improve an organization’s operations.ICPAU,(2009).
It helps an organization accomplish its objectives by bringing a systematic, disciplined approach
to evaluate and improve the effectiveness of risk management control and governance
processes”. He further mentions the principles of Internal audit to include; Integrity, Objectivity,
Confidentiality and Competency. However, given that Internal Auditors are appointed by
management, report to management, and are employees of an organizations, their objectivity is
usually highly compromised Adams, M. B. (2006).
In accordance to Institute of Internal Auditors (IIA-UK; 1997), independence is applicable to all
categories of auditors. This means the opportunity granted to the auditors to report directly to the
top authority. Woolf (1986), says, although an internal auditor is an employee of the enterprise
and cannot therefore be independent of it, he should be able to plan and carryout his work as he
wishes and have access to the highest level of management. However, Millichamp (1993) says,
effective internal audit should be carried out by an independent personnel though they are
employees appointed by management, for them to work efficiently, they should have scope to
arrange priorities and activities have un restricted access to records, assets and personnel.
Adams, M. B. (1994)
According to Bhatia (2003), Internal Auditing is the review of operations and records sometimes
undertaken within the business by especially assigned staff. It’s also an independent appraisal
function established within an organization to examine and evaluate the effectiveness, efficiency
and economy of managements control system (Subramaniam, 2006). Its objective is to provide
management with re-assurance that their internal control systems are adequate for the need of the
organization and are operating satisfactorily (Reid & Ashelby, 2002). It is a component of the
internal controls set-up by management of an enterprise to examine, evaluate and report
operations of accounting and other controls. The quality and effectiveness of internal audit
procedures in practice are necessary since internal auditors cover a wide variety of assignments,
not all of which will relate to accounting areas in which the external auditor is interested. For
example, it’s common these days for internal audit to undertake the extensive and continuous
task of setting management goals and monitoring its performance (Woolf, 1996).

20
Emasu (2010) notes that “The effectiveness of internal audit function partly depends on; legal
and regulatory framework, placement of the function and its independence, existence of audit
committees, resources allocated to the function and professionalism of internal audit staff”. It is
however a bitter reality that internal audit departments are rarely adequately facilitated.
Regarding the size and facilitation of the Internal Audit Function, Gerrit and Mohammad (2010),
found evidence in support of the monitoring role of the Internal Audit Function. They
specifically, found evidence that management ownership is positively related to the relative size
of the Internal Audit Function, which is inconsistent with traditional agency theory arguments
that predict a negative relationship, but more in line with recent studies on earnings management.
This finding suggests that increased management ownership may influence the board of directors
to support larger Internal Audit Functions to allow them to closely monitor managers’
performance. It is also plausible that management with higher share ownership is motivated to
invest in larger Internal Audit Function for better monitoring of earnings and for signaling to the
board of directors that, despite their high stake in earnings, they are convinced that appropriate
use of resources has to be assessed on a regular basis. Gerrit and Mohammad also believe that
the proportion of independent board members to have a negative effect on Internal Audit
Function size. This finding may indicate a substitution effect, which means that independent
board members may be considered as an alternative monitoring mechanism to the Internal Audit
Function. They further assert that the control environment has a significant effect on the relative
size of the Internal Audit Function. Specifically, a supportive control environment characterized
by formalized integrity and clear ethical values, a high level of risk and control awareness, the
perception that risk management is important and the fact that responsibilities with respect to risk
management and internal control are clearly defined is associated with a relatively larger Internal
Audit Function. ACCA (2010)
Using a US sample, Wallace & Kreutzfeldt (1991) found that companies with internal audit
departments are observed to be significantly larger, more highly regulated, more competitive,
more profitable, more liquid, more conservative in their accounting policies, more competent in
their management and accounting personnel, and subject to better management controls. Carey et
al. (2000) found that agency variables do not explain the voluntary use of internal audit by

21
Australian family firms. More recently, a study by Goodwin-Stewart & Kent (2006), using a
sample of Australian listed companies, shows that the existence of an Internal Audit Function is
positively associated with firm size and commitment to risk management. Sarens & De Beelde
(2006) also show that the risk and control awareness have an influence on the scope of the
Internal Audit Function. These results suggest that when management is aware of risks and
control activities, they are more likely to understand the role of the Internal Audit Function in
monitoring risk and control activities, thus it is more likely that they will support a relatively
larger Internal Audit Function (Sarens & De Beelde, 2006a; Selim & McNamee, 1999). Meigs et
al (1988) holds that there must be a strong internal control system and the internal auditor must
verify the operations of the system in much the same way, as the external auditor. It involves the
investigation, recording, identification and review of compliance tests of control, they also
argued that effective internal audit procedures provide sufficient relevant and reliable evidence in
order to detect and prevent fraud. ACCA (2009/2010)
Kochan (1993), considers auditing procedures in one company and describes steps taken in
implementing a quality assurance system, she discusses the use of internal audits as an essential
part of ISO 9000 certification process. Boakye-Bonsu (1999) asserts that internal audit
procedures are seen as ends in themselves rather than a means towards a specific objective, with
such an approach our rambler would undoubtedly get lost. Internal audit procedure is a form and
content manual that includes audits notes and responsibilities, documentation standards, local
reporting standards and targets, training requirements and expectations and performance
measures and indicators (Watts, 1999). Effectiveness is the achievement of goals and objectives
using factor measures provided for in determining such achievement. However, it has been
traditional in internal auditing that determination of internal auditing effectiveness can be
accomplished by evaluating the quality and effectiveness of internal auditing procedures that
result in determination by the internal auditors of the character and the quality of effectiveness of
the auditee’s control operations and if the auditing procedures are effectively carried out, then
the evaluative results are positive (Dittenhofer, 2001). Maitin (1994) says efficiency and
effectiveness of internal audit procedures is not a simple task, successful operation is governed
by the extent to which the element of internal audit procedures receive attention which include;
expertise, independence, objectivity and totality. Effectiveness of internal audit procedures is a
measure of the ability of the programme to produce a desired effect or results that can be

22
qualitatively measured (Harvey, 2004). Zabihollah (2001) argues that, there should be effective
internal audit procedures to ensure reliability of financial statements, operational reports
safeguarding corporate assets and effective organizational controls. Benston (2003) further
supplements that perception and ownership, organization and governance framework, legislation,
improved professionalism and resources were identified as functions in the public sector derived
from the effectiveness of the internal audit procedures. How far internal audit procedures
succeed in their effort of effectiveness is mainly judged by three factors that include; frequency
of irregularities committed by the staff in the organization in form of errors or fraud, the
promptness with which such irregularities are detected by the authorities and the planning which
makes possible repetition of such irregularities in future more difficult (Reid & Ashelby, 2002).
The work of the internal auditor should appear to be properly planned, controlled, recorded and
reviewed. Examples of the due professional care by the internal auditor are the existence of an
adequate audit manual, general internal audit plans, procedures for controlling individual
assignments and satisfactory arrangements for reporting and following up. Earnest and Young
(1995),
The need for an internal audit function will vary depending on company-specific factors
including the scale, diversity and complexity of the company’s activities and the number of
employees, as well as cost/benefit considerations. Senior Management and the board may desire
objective assurance and advice on risk and control. An adequately resourced internal audit
function (or its equivalent where, for example, a third party is contracted to perform some or all
of the work concerned) may provide such assurance and advice. There may be other functions
within the company that also provide assurance and advice covering specialist areas such as
health and safety, regulatory and legal compliance and environmental issues.
In the absence of an internal audit function, management needs to apply other monitoring
processes in order to assure itself and the board that the system of internal control is functioning
as intended. In these circumstances, the board will need to assess whether such processes provide
sufficient and objective assurance. Kombo & Tromp (2009)
Assurance. When undertaking its assessment of the need for an internal audit function, the board
should also consider whether there are any trends or current factors relevant to the company’s

23
activities, markets or other aspects of its external environment that have increased, or are
expected to increase, the risks faced by the company. Such an increase in risk may also arise
from internal factors such as organizational restructuring or from changes in reporting processes
or underlying information systems. Other matters to be taken into account may include adverse
trends evident from the monitoring of internal control systems or an increased incidence of
unexpected occurrences. http://audit.unlv.edu/InternalControls.htm
The importance of internal controls
A company’s system of internal control has a key role in the management of risks that are
significant to the fulfillment of its business objectives. A sound system of internal control
contributes to safeguarding the shareholders’ investment and the company’s assets.
Internal control (as referred to in paragraph 20) facilitates the effectiveness and efficiency of
operations, helps ensure the reliability of internal and external reporting and assists compliance
with laws and regulations. Kochan, A. (1993).
Effective financial controls, including the maintenance of proper accounting records, are an
important element of internal control. They help ensure that the company is not unnecessarily
exposed to avoidable financial risks and that financial information used within the business and
for publication is reliable. They also contribute to the safeguarding of assets, including the
prevention and detection of fraud. I. M. Pandey (2010).
A company’s objectives, its internal organization and the environment in which it operates are
continually evolving and, as a result, the risks it faces are continually changing. A sound system
of internal control therefore depends on a thorough and regular evaluation of the nature and
extent of the risks to which the company is exposed. Since profits are, in part, the reward for
successful risk taking in business, the purpose of internal control is to help manage and control
risk appropriately rather than to eliminate it. (Institute of Chartered Accountants of Britain and
Wales, sept.1999)
Does the company have clear objectives and have they been communicated. So as to provide
effective direction to employees on risk assessment and Control issues? For example, do
objectives and related plans include? Measurable performance targets and indicators? Are the

24
significant internal and external operational, financial, compliance and other risks identified and
assessed on an ongoing basis?
Significant risks may, for example, include those related to market, credit, liquidity,
technological, legal, health, safety and environmental, reputation, and business probity issues. Is
there a clear understanding by management and others within the company of what risks are
acceptable to the board?
Internal control will also be evaluated by the external auditors. External auditors assess the
effectiveness of internal control within an organization to plan the financial statement audit. In
contrast to internal auditors, external auditors focus primarily on controls that affect financial
reporting. External auditors have a responsibility to report internal control weaknesses (as well as
reportable conditions about internal control) to the audit committee of the board of directors.
(Nigel Turnbull, Rank Group Plc)
Internal control must be evaluated in order to provide management with some assurance
regarding its effectiveness. Internal control evaluation involves everything management does to
control the organization in the effort to achieve its objectives. Internal control would be judged
as effective if its components are present and function effectively for operations, financial
reporting, and compliance. The boards of directors and its audit committee have responsibility
for making sure the internal control system within the organization is adequate. This
responsibility includes determining the extent to which internal controls are evaluated. Two
parties involved in the evaluation of internal control are the organization's internal auditors and
their external auditors. (Tim Row bury Internal, Audit Consultant)
At the specific transaction level, internal control refers to the actions taken to achieve a specific
objective (e.g., how to ensure the organization's payments to third parties are for valid services
rendered.) Internal control procedures reduce process variation, leading to more predictable
outcomes. Internal control is a key element of the Foreign Corrupt Practices Act (FCPA) of 1977
and the Sarbanes–Oxley Act of 2002, which required improvements in internal control in United
States public corporations. Internal controls within business entities are also referred to
as operational controls.

25
Limitations of internal controls
Internal controls are procedures and policies to be followed when carrying out financial
transactions. Policies are mere guides to action to ensure consistency in treatment of similar item
at different times; being guides they are subject to personal error of judgment. It is in the interest
of the organization that set procedures are followed when handling financial transactions.
Internal controls can offer only reasonable assurance that management objectives are reached,
this is because of certain inherent limitations as follows;- Menon, K. & Williams, J. D. (1994),
Due attention is devoted to day to day operational matters, but at the finalization stage of
financial reports, major adjustments are passed which may contain errors and fraud.
Internal controls can lead to internal rigidities that delay decisions and financial reports. Internal
controls already in use may prevent creativity because procedures were set and must be followed
without deviation. Collusion among staff can be used to undermine the internal control
procedures leading to loss of assets.
Management resistance to controls. In a situation where management does not support internal
control procedures, it may override controls to its own advantage. Internal controls work well
where management support is evident.
Management support could arise in form of staff recruitment policies, reviews of financial
information and taking corrective action where deviation from control procedures is reported,
Sarens, G. & De Beelde, I. (2006b).
Some internal control procedures are not cost effective; the cost of a control is disproportionate
to the cost of potential loss due to errors and fraud.
The effectiveness of internal control system is always affected due to carelessness, distraction
and misunderstanding of instructions. Human weaknesses tone down the effectiveness of internal
control systems, Emasu (2007).
Changing business environment may cause inadequacy in procedural conduct of business and
thereby compliance with procedures becomes difficult. (M.S. Ramaswamy, 1997).
In the control activities, Authority usually flows from the Board of Director to general
management.

26
General management therefore exercises delegated authority to ensure that all transactions both
financial and non financial are authorized.
Separation of duties is implemented to prevent intentional and unintentional errors and
misstatements. Duties such as custody of assets should be separate from authorization; posting
of ledgers should be separate from payments and receipting of cash, ( Subramanian, N. 2006)..
Documentation and record keeping provide proof for the accuracy of transactions. Transactions
must be supported by third party invoices, receipts and claim forms. Every transaction has to be
recorded permanently in the books of the organization, Ogneva, M., K. R. Subramanyam, and K.
Raghunandan. 2007.
Unauthorized access to some offices like cash, computer and stores is implemented to avoid loss
of portable assets and also to avoid deliberate damage to say computer programs. (KPMG Audit
Manual, 1988)
2.2 Financial Reporting Quality.
According to Collins and Collins (1978), a financial report is a means of portraying financial
accountability. In order for an organization to review the financial activities of the past year and
make plans for the future it prepares and publishes annual accounts or financial reports.
According to Samuel (1991), these are outputs of an accounting system and they are prepared at
the end of the year, hence the name final accounts. According to Horne (1998), the financial
reports should include a narrative description of the organization’s activities and audited
financial statements. He argues that these enable the stakeholders to see the organization’s
performance and the overall financial situation of the organization. Samuel (1991), states that
managers and accountants are usually required to defend the results shown in the financial
reports as part of the accountability process. According to Gale (2003), financial reports must
exhibit certain qualities that make them useful to the stakeholders and these include relevance,
reliability, understandability and timeliness. Australian Accounting Research Foundation (1990),
stated that it is important for financial reports to be relevant. They must have value in terms in
making and evaluating decisions about the allocation of scarce resources and in assessing the
rendering of accountability by the providers. The reports must also be reliable because users use
them for decision making. Reliability means that information is reasonably free from error and

27
bias and faithfully represents what it purports to represent. Understandability is the ability of
users to understand the financial reports. This will depend in part on their own capabilities and in
part on the way in which the information is displayed. Timeliness of financial reports is very
crucial because reports which are relevant and reliable may be rendered irrelevant if there is
undue delay in presenting them, (ACCA- Managerial Finance Paper 8; 2010; and Panday; 2008).
.
According to Gale (2003), poor quality of financial reports greatly diminishes the quality of
NGOs. Quality information is one that is readable, reliable, comparable, consistent, complete,
timely, decision-useful, accessible and cost effective. The integrity of the nonprofit sector is
served best if NGOs are accountable (Gale, 2003).
Financial reporting quality can be associated with investment efficiency in at least two ways.
First, it is commonly argued that financial reporting mitigates adverse selection costs by reducing
the information asymmetry between the firm and investors, and among investors (Verrecchia,
2001). For instance, Leuz and Verrecchia (2000) find that a commitment to more disclosure
reduces such information asymmetries and increases firm liquidity. On the other hand, the
existence of information asymmetry between the firm and investors could lead suppliers of
capital to discount the stock price and to increase the cost of raising capital because investors
would infer that firms raising money is of a bad type (Myers and Majluf, 1984). Thus, if
financial reporting quality reduces adverse selection costs, it can improve investment efficiency
by reducing the costs of external financing and, as discussed in more detail below, the potential
for financial reporting quality to improve investment efficiency is greatest in firms facing
financing constraints, (Gale, 2003)..
Second, a large literature in accounting suggests that financial reporting plays a critical role in
mitigating agency problems. For instance, financial accounting information is commonly used as
a direct input into compensation contracts (Lambert,2001) and is an important source of
information used by shareholders to monitor managers (Bushman and Smith, 2001). Further,
financial accounting information contributes to the monitoring role of stock markets as an
important source of firm specific information (e.g., Holmstrom and Tirole, 1993; Bushman and
Indjejikian, 1993; Kanodia and Lee, 1998). Thus, if financial reporting quality reduces agency

28
problems, it can then improve investment efficiency by increasing shareholder ability to monitor
managers and thus improve project selection and reduce financing costs,( Reid, K. &Ashelby, D.
2002).
Based on the discussion above that financial reporting affects both adverse selection and agency
conflicts, I predict an average negative relation between financial reporting quality and both
underinvestment and overinvestment. These links complement research in Bushman, Piotroski,
and Smith (2005), which studies the relation between country measures of timely loss
recognition and the country propensity to liquidate bad projects (i.e., mitigate overinvestment),
and in Wang (2003) which explores the relation between capital allocation efficiency and
accounting information quality for a sample of US firms, without making a distinction between
under- and overinvestment, Piotroski, and Smith (2005).
2.2.1 Compliance of financial reporting
Compliance refers to practical application of the existing laws and regulations and internal
policies in relations IFRS framework. Coco indicates that control comprises: those elements of
an organization (including its resources, systems, processes, culture, structure and tasks) that,
taken together, support people in the achievement of the organization's objectives,( Boubakri et al
2004).
Currently, many business firms have adhered to compliance financial reporting quality which is a
mechanism tool for the financial reporting procedure. Due to business, firms that senior
management use internal controls allow them to review and teach all staff how to achieve
companies' goals via policies. Firms that have staffs member activities with compliance qualities
also influence reliability of financial reporting. The compliance quality, particularly all firms
accept compliance of financial control practice that it is very important in every part of the
business (COSO, 2004). The ultimate aim must appear on financial reporting that firm has to
consider how compliance quality can be achieved with regard to the company performance
goals. For one reason, at least, the company requirement is to appoint stakeholders to implement
and monitor systems for achieving quality of financial reporting through internal control
effectiveness. Firm should be appropriate and complete an internal control system and the quality
of compliance monitored by manager. Including of all staff members of audit committee,

29
stakeholders, external auditor, and also internal auditor should be encouraged to comment upon
any matters which could improve the compliance quality on the internal control effectiveness,
Sarens, G. & De Beelde, I. (2006b).
Guidelines and procedures, Financial reporting process must relate with the agency rules and
procedures significantly to determine whether firm financial practices are in accordance with the
statutory regulatory principles set by the financial reporting standard board. For example, if a
firm has implemented a corporate financial management approach, its effectiveness will be
significantly determined by user rules and procedures which prescribe use of financial
information’s. Where client server e-mail is in use, e-mail specific guidelines will be in use
which account for the greater control exercised by users and the decreased irretrievability of
information (Adolph, 1998).
Regulators and accounting standard-setters establish laws, rules, and standards relating to the
preparation of financial statements for external purposes. These financial reporting rules and
standards form the basis upon which management specifies suitable objectives for the entity and
its subunits.
When specifying suitable external reporting objectives relating to the preparation of financial
statements, management considers the accounting standards that are applicable
to that entity and its subunits. Management also specifies the accounting principles that are
appropriate in the circumstances. For example, management may set an entity-level external
financial reporting objective as follows: “Our Company prepares reliable financial statements
reflecting activities in accordance with generally accepted accounting principles.”Management
specifies suitable sub-objectives for divisions, subsidiaries, operating units, and functions with
sufficient clarity to support entity-level objectives. For example, a US company applies
accounting principles generally accepted in the United States of America (US GAAP) to all
subunits in preparing its consolidated financial statements, and it applies International Financial
Reporting Standards (IFRS) to those subunits that submit subsidiary financial statements in
statutory filings in non-United States jurisdictions, O. Ray Whittington & Kurt Pany (2001).

30
Further, management specifies appropriate accounting principles (e.g., US GAAP, IFRS) to
apply to transactions and events of the entity. For example, management specifies that FASB
Accounting Standard Codification No. 605 Revenue Recognition and SAB 101A Revenue
Recognition in Financial Statements (US GAAP) or IAS 18 Revenue Recognition (IFRS) apply
to all sales transactions as applicable to the entity or subunits ‘respective external financial
reporting objective,IFRS,(2010).
2.2.2 Reliability of financial reporting
Increasingly, reliability of financial reporting in accounting context is very important for the
investors who used the information for decision management (Jenning et al., 2008). The
reliability of financial reporting is effective to internal control efficiency to insure that the
transactions of account bookkeeping are appropriate and properly authorized, valid, correctly
record, complete, and on time. Moreover, it is very important that companies are fairly
summarized of accounting information data disclosure. However, in general, a quality reporting
is affected by internal control mechanism. The internal control is essential corporate governance
mechanism of the firm based on internal control statement quality that it should be to control
effectiveness and also influences the reliability of financial reporting both in internal and
external's firm (Skaife et al, 2007) .
This research project is intended to promote original thinking to bring to life the concept of
‘reliability’ as applied to financial reporting. In particular, it will consider how auditors could
enhance users' confidence that information contained in audited financial statements is reliable
for the purposes for which they want to use it.
Reliability is all about information being fit for purpose. Where people have a clear
responsibility to do something and they need to use information to do this, it brings the whole
issue of reliability into focus. As reliability is seen as an important concept in a number of other
fields such as engineering and research we are keen to see if the theory in these areas may help
us to understand how reliability relates to audited financial statements, Maitin, T.P. (2004)..
Reliability and audited financial statements

31
We are starting from a strange set of circumstances. On the one hand, financial reporting
standard setters have taken steps to move away from the concept of ‘reliability’, to the extent that
it no longer exists in the IASB/FASB Joint Conceptual Framework. At this report, we also saw
auditing standard setter, IAASB, is inclined to accept the IASB/FASB view of reliability as well.
And so from the perspective of standards we are not supposed to talk about reliability. Yet on the
other hand, in reality, people (including regulators) still refer to the need for reliability of
financial statements. There are a number of credible sources for this. For instance, Hans
Hoogervorst, the incoming Chair of the IASB, said in a speech to a European Commission
conference on 9 February 2011 that 'Financial statements should contain information that is as
unbiased and reliable as possible.'
Also, the recent FRC paper on effective company stewardship refers to the importance of reliable
information and that ‘Investors and capital markets require reliable in-depth information about
the business of a company … and …that Directors should describe in more detail the steps that
they take to ensure the reliability of the information on which the management of a company,
and therefore the directors’ stewardship is based.’ The FRC paper goes on to say that the
reliability of financial statements is dependent on, among other things the quality of the external
audit.
Short summaries of some of the relevant fields and issues they raise are set out below. These are
presented in a way that introduces the idea of various levels to how we may think about
reliability, for example, from the starting point of reliability of individual numbers through to
audited financial statements as a whole and all the way up to reliability of organization’s whole
financial reporting processes. Such a way of looking at reliability might help us to resolve some
of the mixed messages received from users, ACCA (2009/2010).
Applying the concept of reliability to financial reporting quality
The intention is to come up with some different approaches that might help to connect with how
people are talking about reliability in practice in relation to financial reporting quality. It might
also provide a far better understanding of the role the auditors play in helping to enhance
reliability in audited financial statements.

32
We have been looking at research on how investors rely on financial reporting information and
talking to investors about what information is being used and how relevant and reliable it is for
their purposes. It exposes a mix of perspectives and objectives of investment professionals. The
problem is that investors are not necessarily clear about what they need and why and that parties
in the financial reporting process (including standard setters, companies and auditors) do not
fully understand how they use and rely on this information.
We think that by mapping investors different views on reliability to the different types of
reliability identified through looking at other fields it might help our understanding of them and
help piece together the different types of reliability that investors look for in audited financial
statements. This will be the next phase of our work.
Materiality of financial reporting, a material weakness is a deficiency, or a combination of
deficiencies, in internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of the company’s annual or interim financial statements
will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a
combination of deficiencies, in internal control over financial reporting that is less severe than a
material weakness; yet important enough to merit attention by those responsible for oversight of
the company’s financial reporting. A deficiency exists when the design or operation of a control
does not allow management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely basis. PCAOB Auditing Standard No.5
Understandability of financial reports, Madison (2010) was of the view that the objective of
financial statements is to provide about the financial position of an organization that is useful to
wide range of users in making economic decisions. Financial statements should be
understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are
directly related to an organization’s financial position. Financial statements are intended to be
understandable by readers who have a reasonable knowledge of business and economic activities
and accounting and who are willing to study the information diligently. Financial statements may
be used by users for different purposes. Owners and manager require statements to make
important business decisions that affect its continued operations. Financial analysis is then
performed on these statements to provide management with more detailed understanding of the

33
figures. (KPMG). These statements are also used as part of management’s annual report to the
stakeholders. Employees also need these reports in making decisions with management, in the
case of labour unions or for individual in discussing their compensation, promotion and rankings.
Prospective investors make use of financial to assess the viability of investing in a business.
Financial statement analysis are often used by investors are prepared by professionals (financial
analyst), thus providing them with the basis for making investment decisions. Financial
institutions (banks and other lending companies) use them to decide whether to grant a company
with fresh working capital or extend debt securities (such as a long term bank loan or debentures)
to finance expansion and other significant expenditures. (Groppelli, 2000).
Accuracy of financial reporting, Government entities (tax authorities) need financial statements
to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
Vendors who extend credit to a business require financial statements to extend credit to a
business require financial statements to assess the creditworthiness of the business. Media and
the general public are also interested in financial statements for a variety of reasons. Income
statement also known as profit and loss account (P&L), earnings statement, operating statement
or statement of operations is company’s financial statement that indicates how the revenue is
transformed into the net income (The purpose of the income statement is to show managers and
investors whether the company made or lost money during the period being reported.(Angelico
& Nikbakht).
2.3 Internal Controls and Financial Reporting Quality.
Effective internal control over financial reporting should provide reasonable assurance regarding
the reliability of financial reporting and preparation of financial statements for external purposes.
This exercise provides reasonable assurance, both to management and shareholders, about the
financial status of the company. Sovereign governments also publish their financial statements
and these have far implications. The financial statements of sovereign governments have an
impact on their international quality and are quite significant in the current context of global
business. (PCAOB, 2002) Poor internal control is regarded as the primary reason why fraud
occurs (KPMG, 1994). The federal government tries to emphasize the importance of internal
controls to organization through Chapter 8 of the federal sentencing Guidelines for organizations
(1991). Internal control and financial reporting have received increased attention especially since

34
the Tread way commission (1987) identified the tone set by senior management as the most
important factor contributing to the integrity of financial reporting process, B.K. Sebbowa
Bamweyana, (2009).
Brief (1996) and Rich (1990) concluded that ethical environment are more important than codes
of conduct in influencing accountants when resolving ethical problems. Basu (1992) found that
management’s attitude towards internal control was significant when public accountants were
asked to evaluate the control environment of an organization. Amore important issue however is
whether these internal control factors are actually related to misrepresented information. Fraud
and internal control; Internal control system plays an important role in the prevention and
detection of fraud. Under the Sarbanes-Oxley Act (2008), companies are required to perform a
fraud risk assessment and assess related controls. This typically involves identifying scenarios in
which theft or loss could occur and determining if the existing controls procedures effectively
manages the risk to an acceptable level. Financial reporting is also a key area of focus in fraud
risk assessment. (PCAOB, 2002) Internal controls and improvements; If the control system is
implemented only to prevent fraud and comply with laws and regulations, then an important
opportunity is missed. The same internal controls can also be used to systemically improve
businesses, particularly in regard to effectiveness and efficiency. (Trend way commission 1994)
Continuous controls monitoring; Advances in technology and data analysis have led to the
development of numerous tolls which can automatically evaluate the effectiveness of internal
controls. Used in conjunction with continuous auditing, continuous controls monitoring provides
assurance on financial information flowing through the business processes. (PCAOB, 2002)
At the organizational level, internal control objectives relate to the reliability of financial
reporting, timely feedback on the achievement of operational or strategic goals, and compliance
with laws and regulations.
Some users of the COSO report have found it difficult to read and understand. A model that
some believe overcomes this difficulty is found in a report from the Canadian Institute of
Chartered Accountants, which was issued in 1995. The report, Guidance on Control, presents a
control model referred to as Criteria of Control (CoCo). The CoCo model, which builds on
COSO, is thought to be more concrete and user-friendly. Coco describes internal control as
actions that foster the best result for an organization. These actions, which contribute to the
achievement of the organization's objectives, center around:

35
No system of ICFR can provide absolute assurance. Internal control systems are operated by
individuals, and individuals inevitably make mistakes. Further, while effective ICFR is a legal
requirement for some public companies, cost considerations may affect the design of control
systems. For these reasons, it is impossible to create a practical control system that will detect or
prevent all potential errors. In addition, intentional misconduct, such as fraud, collusion, or
management override, may prevent controls from operating as intended, regardless of how well
they are designed.
Accordingly, control systems can provide reasonable, but not absolute, assurance that financial
statements are reliable and prepared in accordance with GAAP. What is reasonable depends on
the facts and circumstances of each particular situation. The securities laws define reasonable
assurance as the degree of assurance that would satisfy prudent officials in the conduct of their
own affairs, Brennan, N. M., and J. Solomon. 2008.
2.4 Preventive Controls and Financial Reporting Quality
Preparing reliable financial information is a key responsibility of the management of every
company. The ability to effectively manage the company’s business requires access to timely and
accurate information. Moreover, investors must be able to place confidence in a company’s
financial reports if the company wants to raise capital in the public securities markets, Ettredge,
M. L., L. Sun, and C. Li. 2006.
Management’s ability to fulfill its financial reporting responsibilities depends in part on the
design and effectiveness of the processes and safeguards it has put in place over accounting and
financial reporting. Without such controls, it would be extremely difficult for most business
organizations — especially those with numerous locations, operations, and processes — to
prepare timely and reliable financial reports for management, investors, lenders, and other users.
While no practical control system can absolutely assure that financial reports will never contain
material errors or misstatements, an effective system of internal control over financial reporting
can substantially reduce the risk of such misstatements and inaccuracies in a company’s financial
statements.

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