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International Journal of Commerce and Management The impact of internal control requirements on profitability of Saudi shareholding companies Ali A. Al-Thuneibat, Awad S. Al-Rehaily, Yousef A. Basodan,
Article information: To cite this document: Ali A. Al-Thuneibat, Awad S. Al-Rehaily, Yousef A. Basodan, (2015) "The impact of internal control requirements on profitability of Saudi shareholding companies", International Journal of Commerce and Management, Vol. 25 Issue: 2, pp.196-217, https://doi.org/10.1108/IJCOMA-04-2013-0033 Permanent link to this document: https://doi.org/10.1108/IJCOMA-04-2013-0033
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The impact of internal control requirements on profitability of Saudi shareholding companies
Ali A. Al-Thuneibat, Awad S. Al-Rehaily and Yousef A. Basodan Accounting Department, Faculty Economics and Administration,
King Abdulaziz University, Jeddah, Saudi Arabia
Abstract Purpose – This paper aims to investigate the compliance of Saudi shareholding companies with the requirements of internal control as set by the Saudi standard on internal control and its impact on the profitability of these companies. Design/methodology/approach – A questionnaire was used to collect data about the compliance with internal control requirements, and four measures of profitability including earnings per share (EPS), return on assets (ROA), return on equity (ROE) and profit margin (PM) for profitability were calculated using data from the financial statements of these companies. Then, Multiple Regression and t-test were used to analyze the data and test the hypotheses. Findings – The results of the study revealed that the degree of compliance with all components of internal control is very high. It also appears from the analysis that the effect of internal control and its components on ROA and ROE is significant and positive, while the effect on EPS and PM is positive but statistically insignificant. Practical implications – Corporate managements should review the effectiveness of the implementation of internal control requirements, especially those related to control environment, information and communication and monitoring. Social implications – The findings of the study shed light on the relevance of internal control systems of the Saudi shareholding companies in improving the financial performance of the these companies, which is expected to help in safeguarding the interests of all interest groups and improve the society’s well-being. Originality/value – The paper provides new evidence about the relationship between internal control and profitability in the Saudi Arabian environment. The findings of the study add good contribution to the literature because they direct our attention to the expected effect of the environment on the relationship between internal control and performance. The results may suggest that there is a need to expand this study using other methodologies to delve into the depths and understand this phenomenon within its context.
Keywords Profitability, Monitoring, Risk assessment, Internal control, Control activities, Control environment, Information and communication
Paper type Research paper
Introduction The growing concern with corporate continuity and the reduction in business risks that may prevent business entities from achieving their objectives encourage regulators and bodies of standard setting to give more attention to control mechanisms and corporate governance (Corici, 2009; Tseng, 2007). This concern emerges clearly when observing the continuous development in internal control systems since the 1940s. It is recognized
The current issue and full text archive of this journal is available on Emerald Insight at: www.emeraldinsight.com/1056-9219.htm
IJCOMA 25,2
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Received 15 April 2013 Revised 22 July 2013 Accepted 27 July 2013
International Journal of Commerce and Management Vol. 25 No. 2, 2015 pp. 196-217 © Emerald Group Publishing Limited 1056-9219 DOI 10.1108/IJCOMA-04-2013-0033
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by the standard setting bodies and regulators all over the world that good internal control systems provide managers with reasonable assurance that the basic objectives of management will be achieved (Postan, 2010; Mawanda, 2008; O’Leary et al., 2006; Conard, 2003; Venables and Impey, 1991). The International Federation of Accountants (IFAC) (2012a) stated that one of the best defenses against business failure and an important driver of business performance is having an effective internal control system.
Management typically has three broad objectives when designing an effective internal control system (IFAC, 2012b). First, management is responsible for preparing financial statements for investors, creditors and other users. Therefore, the reliability of financial reporting is the first basic objective of an internal control system. Second, controls are meant to encourage efficiency and effectiveness of operations, that is, effective use of resources to optimize the company’s goals. Third, internal control encourages the compliance with laws and regulations.
Therefore, it is generally accepted that a good internal control system will provide reasonable assurance that the business is doing well. It is expected that the financial performance of business entities that have strong internal control systems is better than the performance of those entities that have weak systems (Tseng, 2007; Chirwa, 2003; Greenley and Foxall, 1997). Tseng (2007) stated that firms with weak internal controls have lower market value. The IFAC (2012a) ascertained that successful organizations know how to take advantage of opportunities and counter threats, in many instances through effective application of internal controls, and therefore improve their performance. This concern with the relationship between internal control systems and financial performance creates opportunities for researchers to delve into this area and provide regulators and the various interest groups evidence of this relationship.
The growing concern with many corporate issues, such as internal control, corporate governance, financial performance, corporate failure and collapse and audit failure all over the world, enhances the need for investigating and debating these issues, especially in the Middle East countries. In the Kingdom of Saudi Arabia, the standard setters developed an audit standard to manage this issue. Saudi companies are required to design their control system taking into consideration the requirement of this standard. Accordingly, this study will investigate the compliance of the Saudi shareholding companies with the requirements of the Saudi internal control standard, and the effect of their compliance on their financial performance. More specifically, the study will answer the following questions:
• To what extent do the Saudi shareholding companies comply with the requirements of the Saudi Standard “Internal Control for Financial Statements Audit”? (SOCPA, 2010)
• What is the effect of the compliance of the Saudi shareholding companies with the requirements of the Saudi internal control standard on their profitability?
It is recognized that strong internal control systems and financial performance of business entities are of great interest to all parties interested in economic prosperity and corporate continuity (Kiabel, 2012; Aigbe and James, 2011; Bejide, 2006; Hermanson and Rittenberg, 2003; Eiseberg, 1998). This study makes several important contributions related to internal control and performance. It makes an important theoretical contribution to the extant literature dealing with the expected impact of internal control components on profitability. Additionally, to our knowledge, this study is the first to
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provide empirical evidence of the impact of internal control regulations on many measures of profitability in a Middle East country (The Kingdom of Saudi Arabia).We expect that our study will help in reducing the research gap about these issues in Saudi Arabia, and provide evidence from a different environment. It is expected that our research will be of great interest to all stakeholders, that is, effective corporate performance and financial transparency are at the top priorities of shareholders and investors.
Amongst the parties that will benefit from the findings of this study are the bodies in charge of regulating the profession and regulating companies. Solid evidence would prove the effectiveness of internal controls in achieving corporate objectives and improving their profitability, thus supporting the notion of the mandatory application of internal control requirements, or else, a revision of the standard may be needed. Additionally, it is expected that the results of this study provide decision makers with information about the degree of management commitment in designing and implementing internal control as required by the Saudi standards, and whether the implementation is effective in promoting performance or not.
Theoretical framework and hypotheses development The primary responsibility for the achievement of corporations’ objectives rests with both those charged with governance of the entity and management. It is their responsibility to design, implement and develop a strong internal control system that includes all components and procedures that persuade every part of the organization to work in the best interest of the organization as a whole. It can be argued that the top priority of any corporation is the financial performance (Hussain and Bhatti, 2010; Ramlall, 2009; Chirwa, 2003). Performance, basically, is reflected in liquidity, solvency and profitability. It is this performance that will result in the financial well-being of corporations.
The overall financial well-being of corporations may be considered as an important determinant of the society’s well-being, as well as the interested groups and individuals’ well-being. The concern with financial well-being, transparency and trust influenced regulator’s thinking and decisions since the inception of shareholding companies. Regulators’ concern with safeguarding the interest of the stakeholders of corporations all over the world has been a basic factor behind the regulators’ concern with internal control systems since the early days of the creation of corporations (Eiseberg, 1998).
The International Standard on Auditing, ISA 315, has defined internal control as a process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations (IFAC, 2012b). These objectives of internal control systems are comprehensive and interrelated, that is, all of them are expected to contribute to the well-being of any corporation. The financial performance of a corporation can be expressed in terms of profitability, liquidity and solvency. These measures of financial performance are the concern of creditors, investors and shareholders. These measures are also the concern of regulators as well as those responsible for corporate governance. The remaining part of this theoretical framework addresses the theoretical arguments
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regarding the relationship between internal control systems and financial performance of corporations represented by companies’ profitability.
Reliability of financial reporting, which is the first objective of internal control, should reflect the actual performance of the entity, that is, the management should implement internal control that provides reasonable assurance about the reliability of financial statements. The most important internal controls usually preside over the financial information of a company. Improperly reporting financial information is considered fraud and will quickly cause problems. DeFond and Jiambalvo (1991) argued that past research finds that financial reporting errors are negatively associated with performance. This means that good internal control is expected to enhance the performance of companies.
The second basic objective of internal control is the achievement of the efficiency and effectiveness of operations. It can be stated that the satisfaction of customer demands and the achievement of high level of sales and other revenues are the basic sources for increasing profitability. However, these objectives and the sources to achieve these objectives must be accompanied with an efficient management of using resources. That suggests controlling costs and limiting excessive spending. Internal controls help promote efficiency and effectiveness for all operations, this means that internal control should help in producing high-quality products and services and control all operations to achieve good control over all types of costs. In other words, this objective of internal control is also concentrated on the achievement of financial well-being of the organization. Altamuro and Beatty (2007) argued that improvements in real operating activity can lead to higher persistence in earnings because a system with better controls is easier to monitor and is less likely to be subject to operating surprises that induce earnings volatility.
The third objective of internal control systems is the achievement of the compliance with applicable laws and regulation. The Saudi standard on internal control stated that the effect of laws and regulations on financial statements varies considerably. Those laws and regulations to which an entity is subject constitute the legal and regulatory framework. The provisions of some laws or regulations have a direct effect on the financial statements, in that they determine the reported amounts and disclosures in an entity’s financial statements. The compliance with such regulations is expected to force management to present the actual financial performance. This adherence to regulations and actual performance is expected to stimulate the improvement of financial performance of an entity. Rogers (2008) argued that the significant contributors to financial performance include openness and reliability. Openness and reliability are measures of trust which, in turn, has a significant impact on financial performance. The standard also stated that non-compliance with laws and regulations may result in fines, litigation or other consequences for the entity that may have a material effect on the financial statements.
The above discussion of internal control objectives shows how these objectives are interrelated and work as forces to enhance corporate performance. Brown et al. (2008) suggested a positive effect of internal control regulation on earnings quality; for example, he stated that German firms experienced a frequency of small positive earnings, consistent with less earnings management. Altamuro and Beatty (2007) investigated the relationship between earnings characteristics and mandated internal control reforms. They investigated the impact of internal control on earnings
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persistence, earnings’ ability to predict future cash flows and the earnings response coefficient. They stated that internal control reforms lead to improvements regarding each of these earnings characteristics for banks affected by the regulation relative to unaffected banks during the same period.
Dechow et al. (2011) investigated the characteristics of misstating firms on various dimensions, including financial and non-financial performance. One of their findings is that both financial and non-financial measures of performance are deteriorating. This conclusion seems to suggest that bad internal control which results in a deteriorating condition of earnings management will result in deteriorating performance. The fear of bad financial performance will result in a fear of decreasing stock prices. Dechow et al. (2011) also found that managers of misstating firms appear to be sensitive to their firm’s stock price. Mawanda (2008) investigated the relationship between internal control systems and financial performance in an institution of higher learning in Uganda. He concluded that there is a significant relationship between internal control systems and financial performance in an institution of higher education.
However, there is limited empirical evidence on whether internal control regulation leads to systematic improvements in earnings (Jensen, 2011; Ashbaugh-Skaife et al., 2008; Bédard, 2006). Jensen (2011) stated that fundamental technological, political, regulatory and economic forces are radically changing the worldwide competitive environment. However, during the past two decades, corporate internal control systems have failed to deal effectively with many changes including the reduced growth rates of labor income, excess capacity and the requirement for downsizing and exit.
Jeffrey et al. (2007) stated that poorly performing firms simply may not be able to adequately invest time and/or money in proper controls. Good internal control requires both financial resources and management time, and this may not be a priority for firms that are concerned with simply staying in business. Wijewardena et al. (2004) stated that there is a positive relationship between internal control complexity and performance.
Some researchers argued that a quickly growing firm may outgrow any internal controls it has in place, and it may require time to establish a new procedure (Kinney and Mcdaniel, 1989). New personnel, processes and technology are usually needed to match the internal control with the firm’s growth. Krishnan (2005) stated that the existence of a loss is positively associated with reporting an internal control problem in audit-change firms. He expected to find fewer internal control weaknesses in firms with stronger financial health. The inconclusive results regarding the interaction between internal control and financial performance lead us to draw the following hypothesis:
Ha. There is a significant influence of internal control systems on financial performance (represented by profitability) of Saudi shareholding companies.
This is the basic hypothesis of the study. It will be sub-divided into five hypotheses about the effect of each component of the internal control system on profitability. For this purpose, the remaining part of this theoretical framework will discuss the five components of internal control and their expected impact on performance.
Internal control components and financial performance Internal control is the most common term used to describe the processes an organization uses to achieve its objectives. It is recognized as the cornerstone of corporate governance (Verschoor, 1998). The Saudi standard on internal control (SOCPA, 2010) and the
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International Standard on Auditing (ISA 315) defined internal control as a process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations (IFAC, 2012b). The Saudi standard for internal control identified five components of internal control systems, which are the same as those mentioned by the international standard. These components include control environment, control activities, communication and information, risk assessment and monitoring (SOCPA, 2010).
Control environment Integrity and ethical behavior are products of the entity’s ethical and behavioral standards. The enforcement of integrity and ethical values includes, for example, mitigating conflict of self-interest, that is, the ethical values promote the management and employees to work in the best interest of the company (Berrone et al., 2005), and this is expected to be an important factor in enhancing the profitability of the company. Additionally, ethical values include management actions to eliminate or mitigate incentives or temptations that might prompt personnel to engage in dishonest, illegal or unethical acts. Many research papers show that ethical values are very important in prompting performance (ACCA, 2010; Berrone et al., 2005; Stainer et al., 2004).
The ACCA (2010) conducted a ground-breaking multinational survey of chief financial officers (CFOs) carried out by Association of Chartered Certified Accountants (ACCA) CFO research services about the link between ethics and business performance. The survey showed that those companies which build a culture of ethics are more likely to succeed financially. The survey revealed that there is a strong evidence of a correlation between ethics and financial performance. It showed that the European CFOs in those companies that had outperformed the others financially believed their boards had given more consideration to ethical issues.
Stainer et al. (2004) explored the relationship between values, ethics and stakeholders in a performance context. The foundations and importance of core values to every business were discussed in relation to modes of behavior and decision-making practices. They are demonstrated as under-pinning the strategic direction, conveying what is expected by both the organization itself and the major stakeholders.
Berrone et al. (2005) empirically assessed the impact of the Corporate Ethical Identity (CEI) on the firm’s financial performance. They argued that firms with a strong ethical identity achieve greater degree of stakeholder satisfaction, which, in turn, positively influence the firms’ financial performance. However, their study indicated that, while revealed ethics has informational worth and enhance shareholder value, applied ethics has a positive impact through the improvement of stakeholder satisfaction.
Competence, as an important figure in the control environment, includes the knowledge and skills necessary to accomplish tasks that define the individual’s job. It is one of the important factors necessary to enable individuals to carry on their duties and responsibilities and therefore, to help in achieving the entities’ objectives.
Another determinant of control environment is participation by those charged with governance. It plays an important role in the process of reviewing the effectiveness of the entity’s internal control. This participation builds a solid ground for directing all efforts toward the achievement of the entities’ objectives and improving performance.
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Summers and Hyman (2005) conducted a study on employee participation and company performance. Their study revealed that a combination of financial and work-related participatory measures can have a positive impact on company performance, as all employees do not react to participation initiatives in the same manner. Some respond well to financial initiatives and others to more work-related elements. The researchers concluded that a combination of participation and welfare measures (such as equal opportunities and family-friendly policies) are expected to enhance organizational performance and the quality of working life.
Control environment also includes the establishment of a relevant organizational structure, assignment of authority and responsibility and the setting of human resource policies that emphasize the most efficient standards for recruitment and therefore stress competence, integrity and ethical values. These elements of control environment are expected to play an important role in ensuring that all personnel understand the entity’s objectives, know how their individual actions interrelate and contribute to those objectives (Summers and Hyman, 2005; Meijaard et al., 2005). These theoretical arguments about control environment and performance lead to setting the first sub-hypothesis of the basic research hypothesis, which states that:
There is a significant influence of the control environment on financial performance (represented by profitability) of Saudi shareholding companies.
Entity’s risk assessment process The second component of internal control is the entity’s risk assessment process. It forms the basis for how management determines the risks to be managed. The management should have a reasonable assurance that the risk assessment process is appropriate to the circumstances, including the nature, size and complexity of the entity. For financial reporting purposes, the entity’s risk assessment process includes how management identifies business risks relevant to the preparation of financial statements in accordance with the entity’s applicable financial reporting framework, estimates their significance, assesses the likelihood of their occurrence and decides upon actions to respond to and manage such risks and their results. Similarly, risk assessment includes the risk of failure to meet prior objectives, quality of personnel, geographic dispersion of company’s operations and entrance of new competitors (Elder et al., 2012). Several studies explored the relationship between good risk management practices and improved financial performance (Mackay and Moeller, 2007; Nocco and Stulz, 2006; Schroeck, 2002; Hakim and Neami, 2001; Smith, 1995). These studies propose that prudent risk management practices reduce the volatility in financial performance, particularly operating income, earnings, firm’s market value, share return and return on equity. Mackay and Moeller (2007) argued that risk management can add value when revenues and costs are non-linearly related to prices.
Schroeck (2002) and Nocco and Stulz (2006) stress the importance of good risk management practices to maximize firm value. In particular, Nocco and Stulz (2006) argued that effective enterprise risk management has a long-run competitive advantage for firms compared to those that manage and monitor risks individually. These theoretical arguments addressing risk assessment and performance lead to setting the second sub-hypothesis of the basic research hypothesis, which states that:
There is a significant influence of risk assessment on financial performance (represented by profitability) of Saudi shareholding companies.
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Information and communication systems An information system consists of infrastructure, software, people, procedures and data. The quality of system-generated information affects management’s ability to make appropriate decisions in managing and controlling the entity’s activities and to prepare reliable financial reports. The IFAC (2012a, 2012b) recommends managements to ensure regular communication regarding the internal control system, as well as the outcomes at all levels within the organization, to make sure that the internal control principles are fully understood and correctly applied. Malone and Crowston (1994) stated that the first business trend is the use of information and communication technology (ICT) to decrease costs and increase capabilities.
Thaddeus and Chimezie (2011) explored the effect of ICT adoption and usage on the performance of commercial banks in Nigeria and found that ICT adoption and subsequent usage has positively influenced the service quality and financial performance of commercial banks. The analysis proves that the use of ICT has a huge impact on the overall branch profit. Weill (1992) stated that there is a positive relationship between the investment in operational information technology and corporate performance because of the efficiency in reducing costs, but there is no significant relationship between information technology used in information systems and financial performance. Corici (2009) investigated the changes that facilitate the interaction under the direct impact of information technology and communication as a means of influence on organizational performance. He argued that the role of knowledge is a distinct factor of production aimed at renewing and applying information for the maintenance and survival of the organization. The expected effect of information and communication systems and performance leads to setting the third sub-hypothesis of the basic research hypothesis, which states that:
There is a significant influence of information and communication systems on financial performance (represented by profitability) of Saudi shareholding companies.
Control activities Control activities are the policies and procedures that help ensure that management directives are carried out (COSO, 2001). Control activities include segregation of duties, authorization, documentation, physical controls over assets and records and performance reviews (IFAC, 2012a, 2012b; COSO, 2011; SOCA, 2010). These control activities include:
• reviews and analyses of actual performance versus budgets, forecasts and prior period performance;
• relating different sets of data – operating or financial – to one another, together with analyses of the relationships and investigative and corrective actions;
• comparing internal data with external sources of information; and • reviewing functional or activity performance (IFAC, 2012b).
These control activities represent very important tools in corporate governance, which, in turn, enhance firm’s performance. Brown and Caylor (2006) investigated the relationship between corporate governance and firm performance. They used six performance measures allocated to three categories:
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(1) operating performance (return on equity, net profit margin [PM], sales growth); (2) valuation (Tobin’s Q); and (3) shareholder payout (dividend yield and stock repurchase).
The study found that better governed firms were relatively more profitable, more valuable and paid out more cash to shareholders, while poorly governed firms had lower operating performance and paid out less cash to shareholders.
All control activities contribute in the achievement of internal control objectives. For example, efficient financial control contributes in preventing and eliminating dysfunctions, improving the organization and the management of the decision-making process and enhancing the overall efficiency of the economic activity (Postan, 2010). The expected effect of control activities on performance leads to setting the fourth sub-hypothesis of the basic research hypothesis, which states that:
There is a significant influence of control activities on financial performance (represented by profitability) of Saudi shareholding companies.
Monitoring of controls Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the effectiveness of controls on a timely basis and taking necessary remedial actions (IFAC, 2012b; COSO, 2011; SOCPA, 2010). Management’s monitoring of controls includes considering whether they are operating as intended and that they are modified as appropriate for changes in conditions. Previous research discussed many monitoring techniques that provide reasonable assurance regarding the role of monitoring in prompting performance (Kiabel, 2012; Aigbe and James, 2011; Bejide, 2006; Eiseberg, 1998). Monitoring of controls may include internal auditors’ evaluation of sales personnel’s compliance with the entity’s policies on terms of sales contracts, and the legal department’s oversight of compliance with the entity’s ethical and legal requirements (IFAC, 2012a; 2012b; Aigbe and James, 2011; Hermanson, and Rittenberg, 2003).
Aigbe and James (2011) argued that monitoring is a key technology in the commercial lending business model, and the theoretical literature in finance suggests that monitoring is value enhancing. They added that banks which devote more resources to monitoring are more profit efficient and the effect is large. Venables and Impey (1991) stated that internal audit is an “invaluable tool of management for improving performance”. Bejide (2006) argued that an effective internal audit service in particular can help reduce overhead, identify ways to improve efficiency and maximize exposure to possible losses from inadequately safeguarded company assets, all of which can have a significant effect on the bottom line.
Kiable (2012) stated that most internal audit professionals argue that an effective internal audit function correlates with improved financial performance. However, Kiable found no strong association between internal auditing practices and financial performance, and political influences do not significantly impact on this relationship. The weak association between internal auditing practices and financial performance is attributed to these enterprises’ inadequacy and poor implementation of internal auditing practices. Where internal auditing is de-emphasized, it cannot impact positively on performance. Greenley and Foxall (1997) note that although studies have
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found an association between accounting control systems and performance, theory also predicts that these associations will be influenced by external environmental influences.
These theoretical arguments about monitoring controls and performance lead to setting the fifth sub-hypothesis of the basic research hypothesis, which states that:
There is a significant influence of monitoring controls on financial performance (represented by profitability) of Saudi shareholding companies.
Study design and methodology Data and data sources: for the purpose of this study, we used two appropriate data sources, which are generally acceptable to provide a basis for the measurement of our variables. The first type of data is the responses of the financial managers and internal auditors of the Saudi shareholding companies about the compliance of the firms with the requirements of internal control related to the five components of internal control. A questionnaire was designed to collect the data of the compliance of the Saudi shareholding companies with the requirements of the internal control standard. The questionnaire included questions covering each component on internal control as set by the Saudi standard for internal control. The second source of data is the financial statements of the firms who responded to the questionnaire. We used the financial statements to calculate the profitability measures used in the study. The measures of profitability included the earnings per share (EPS), return on assets (ROA), return on equity (ROE) and PM.
Population and sample: the target population of this study consists of all the Saudi shareholding companies listed on the Saudi Bourse for the year 2011. The number of listed companies is 160 companies. To create a unifying theme between the firms in the study sample and eliminate any factors that might create noise, and thus affect the findings of this study, firms in the sample were selected based on the following criteria:
• The firm’s shares should be listed for trading on the Bourse during 2011, which is the period of study.
• The firm’s financial statements must be available for the year 2011, to provide for the financial data needed to calculate the study’s variables.
• The firm should not have undergone an extraordinary event, such as a merger or acquisition, or other similar transactions that might result in reorganization of the firm’s business segments and, as a consequence, affect the entity and its financial statements.
Based on the above criteria, the number of firms included in the sample amounted to 120. A questionnaire was sent to all these companies. We used many methods of communication with the respondents, by mail, e-mail and in person. However, the number of responses was 90 with a response rate of 75 per cent which is reasonably acceptable. We used these firms’ financial statements to calculate the profitability ratios and then test the hypotheses. In other words, two sources of data were used, the first one is the responses of the firms to the questionnaire and the other is the financial reports of those firms which responded to the questionnaire.
Limitations: even though a questionnaire represents a structured technique for collecting primary data, there are some limitations of such research method, that is, respondents to questionnaires may record their own answers. Additionally, care has to be taken when creating a questionnaire. However, it is a technique in which various
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persons are asked to answer the same set of questions and we think that our questionnaire is well designed to motivate the respondents to give accurate and complete information to get reliable and relevant data. Furthermore, we discussed the questionnaire with our colleagues to assure its relevance for measuring the variables of the study. To assess whether the different items of the questionnaire form a reliable measure of internal control, Cronbach’s alpha was computed. The alpha coefficients for the items measuring control environment, risk assessment, control procedures, control activities and monitoring were all close to 0.85, which indicates strong internal consistency and reliability.
Data analysis: the data were analyzed using the appropriate statistical methods including one-sample t-test and multiple regression. The basic model for the study is:
Pr � � � �1 CEi,t � �2 RAi,t � �3CAi,t � �4ICi,t � �5Mi,tt � �i,t,
where, Pr: profitability; CEi,t: control environment; RAi,t: risk assessment; CAi,t: control activities; ICi,t: information and communication; and Mi,t: monitoring.
Results and discussion The starting point for our analysis is to investigate the reliability of the data collected by the questionnaire and investigate the normality of distribution of the data related to all study variables.
To assess whether the different items of the questionnaire form a reliable measure of internal control, Cronbach’s alpha was computed. The alpha coefficients for the items measuring control environment, risk assessment, control procedures, control activities and monitoring were all close to 0.85, which means strong internal consistency and reliability.
One of the basic assumptions required to use regression analysis is that the data have a normal distribution. Therefore, a test for the normality must be done for the data before using regression analysis. For this purpose, we used the one-sample Kolmogorov–Simrnov (K–S) test. Table I shows the values of significance corresponding to the K–S values of the data related to all variables, which are more than 0.05, which means that the data have a normal distribution.
Descriptive statistics To test the research hypotheses, we started by investigating the degree of compliance with internal control requirements as set by the Saudi standard on internal control. We
Table I. One-sample K–S test
Variable Mean SD K–S Significance
Earnings per share (ES) 2.88 2.19 0.753 0.622 Return on assets (ROA) 5.44 7.44 1.18 0.122 Return on equity (ROE) 10.92 10.56 0.81 0.52 Profit margin (PM) 0.41 0.76 1.70 0.06 Control environment 4.26 0.60 0.91 0.36 Risk assessment 4.26 0.67 0.83 0.49 Control procedures 4.45 0.53 1.03 0.24 Information and com 4.67 4.87 1.70 0.06 Monitoring 4.34 0.47 0.63 0.80
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investigated the compliance of Saudi shareholding companies with the basic components of internal control and the detailed requirements of each component.
Table II shows some descriptive statistics about the internal control of the firms in our sample. It provides evidence about the compliance of the firms with the requirements of internal control according to the Saudi standards. Also it shows a high level of the degree of compliance with all components of internal control.
There is a high degree of compliance with each component of internal control, that is, the minimum degree of compliance is 4.26 and the maximum is 4.67 on a five-point Likert scale. This means that the range of compliance is approximately between 85 and 93 per cent, which represents a high degree of compliance. These percentages of compliance mean that there is a very good internal control and a high degree of compliance with its requirements. The table shows that the t-values ranged from 37.29 to 56.6 and all significance values are less than 0.05, which means that the degree of compliance with all internal control components is statistically significant.
According to the views of the respondents, the degree of compliance with the control environment is approximately 85 per cent. The control environment includes all issues necessary to help in achieving the basic objectives of internal control. For instance, the regulations of the Saudi companies seem to give a high degree of priority to integrity and moral values and encourage those who are responsible for governance and all employees to give attention to such characteristics. The responses of all companies to the questionnaire show that they devote their efforts to create a control environment that helps in setting a solid ground for the other components of internal control. Control environments of these companies concentrate on competence, training and continuous learning and improvement that are accompanied by a flexible organizational structure with emphasis on participation and human resources development.
Table II shows that the Saudi companies are very interested in risk assessment, that is, there is a wide concern with all types of risks that may reduce the ability of the companies to achieve their objectives. The respondents of the companies declared that there is a continuous improvement in risk evaluation, including internal and external risks that may affect the success or failure of achieving the objectives of the company. There is a continuous development of comprehensive plans to manage risks and continuous evaluation of all risks including risks related to the preparation of the financial statements.
Table II. One-sample t-test
Variable Mean SD t-value Significance
EPS 2.88 2.19 7.78 0.000 ROA 5.44 7.44 4.32 0.000 ROE 10.92 10.56 6.11 0.000 PM 0.41 0.76 3.17 0.003 Control environment 4.26 0.60 41.85 0.000 Risk assessment 4.26 0.67 37.29 0.000 Control procedures 4.45 0.53 49.01 0.000 Information and com 4.67 4.87 56.80 0.000 Monitoring 4.34 0.47 54.21 0.000
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The third important component of internal control is represented by the control procedures. On average, the respondents of the companies declared that managements of their companies give major importance to the control procedures mentioned by the Saudi standard. That is, the degree of compliance with all control procedures is approximately 89 per cent. Segregation of duties, performance evaluation, safeguarding of assets and authorization represent the basic control procedures used by the Saudi shareholding companies.
The fourth component of internal control is information and communication. The degree of compliance with all requirements of information and communication is approximately 94 per cent. The respondents of the companies stated that the accounting systems of their companies are based on clear concepts and principles and these systems provide the required information in the appropriate time and quantity. They also stated that the communication systems include effective documentation to control the various types of transactions.
The fifth component of internal control is the monitoring process. The most important tool of the monitoring system is the internal audit function. The respondents’ views provide evidence that the degree of compliance with the requirements of internal control is 87 per cent. The responses show that the internal audit function is comprehensive and includes all types of audit, i.e. financial, compliance and operational audit.
The results show also that, on average, most of the firms in our sample are profitable. Table II shows that, on average, the EPS is 2.88, the ROA is 5.44, the ROE is 10.92 and the PM is 0.41. These indicators of profitability suggest that the Saudi shareholding companies are profitable.
Hypotheses testing. Before interpreting the results of regression, a test of multicollinearity must be done to check whether the values of regression coefficients are not inflated because of the correlation between the independent variables. The general rule of thumb is that variance inflation factors (VIFs) exceeding 4 warrant further investigation, while VIFs exceeding 10 are signs of serious multicollinearity requiring correction (Kaplan, 1994; Leahy, 2000). Looking at Tables IV, VI, VIII and X, we see that the VIF values for all independent variables are ranging between 1.6 and 3.3, which means that the factors are very small, and therefore, the expected effect on the regression results is minimal.
The effect of internal control on EPS. The model summary in Table III shows some statistics related to the relationship between internal control and EPS. The table shows that the correlation between internal control and EPS is 0.497, which means that there is a positive relationship between them. In other words, the higher the compliance with internal control, the higher the EPS.
The adjusted R2 is used to assess the explanatory power of models used for testing our hypotheses. The table shows that the adjusted R2 is equal to 11.7 per cent, which means that 11.7 per cent of the variation in financial performance (measured by earnings
Table III. Model summary and ANOVA results (Internal control and EPS)
R R2 Adjusted R2 Standard error of
the estimate F Significance
0.497 0.247 0.117 2.05990 1.902 0.125
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per share EPS) is interpreted by internal control. However, the ANOVA test in Table III also provides information about the overall regression because the value of the significance is 0.125 which is higher than 0.05; thus, it can be concluded that the relationship between internal control in general and EPS is statistically insignificant at a level below 0.05. In other words, no statistically significant linear dependence of the mean of EPS on internal control was detected.
Table IV shows the regression coefficients for each component of internal control. The correlation coefficient for variable control environment is 0.869 and the significance value is 0.294, which is higher than the significance level used in this research (0.05); therefore, the effect of control environment on EPS is insignificant.
The correlation coefficient for variable risk assessment is 2.211 and the significance value is 0.006; therefore, the effect of risk assessment on EPS is significant. The correlation coefficient for variable control procedures is 2.443 and the significance value is 0.044; therefore, the effect of control procedures on EPS is significant. The correlation coefficient for variable information and communication is 2.101 and the significance value is 0.122; therefore, the effect of information and communication on EPS is insignificant. The correlation coefficient for variable monitoring is 0.777 and the significance value is 0.418; therefore, the effect of monitoring on EPS is insignificant.
The effect of internal control on ROA. The model summary in Table V shows some statistics related to the relationship between internal control and ROA. The table shows that the correlation between internal control and ROA is 0.723, which means that there is a positive relationship between them. In other words, the higher the compliance with internal control, the higher is the ROA.
The table shows that the adjusted R2 is equal to 44 per cent, which means that 44 per cent of the variation in financial performance (measured by return on assets ROA) is interpreted by internal control. The ANOVA test in Table V also provides information about the overall regression because the value of the significance is 0.000; thus, the conclusion is that the relationship between internal control in general and ROA is
Table IV. Regression
coefficients (Internal control and EPS)
Variable
Unstandardized coefficients
Standardized coefficients
t Significance
Collinearity statistics
� Standard error � Tolerance VIF
Control environment 0.869 0.812 0.238 1.070 0.294 0.523 1.912 Risk assessment 2.211 0.752 0.684 2.941 0.006 0.479 2.086 Control procedures 2.443 1.158 0.599 2.110 0.044 0.323 3.100 Information and communication 2.101 1.319 0.467 1.592 0.122 0.302 3.311 Monitoring 0.777 0.945 0.168 0.821 0.418 0.621 1.610
Table V. Model summary and
ANOVA results (Internal control and
ROA)
R R2 Adjusted R2 Standard error of
the estimate F Significance
0.723 0.523 0.440 5.57254 6.352 0.000
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statistically significant at a level below 0.05. In other words, a statistically significant linear dependence of the mean of ROA on internal control was detected.
Table VI shows the regression coefficients for each component of internal control. The table shows that the correlation coefficient for variable control environment is 3.427 and the significance value is 0.130; therefore, the effect of the control environment on ROA is insignificant. The correlation coefficient for variable risk assessment is 9.912 and the significance value is 0.000; therefore, the effect of risk assessment on ROA is significant. The correlation coefficient for variable control procedures is 11.093 and the significance value is 0.001; therefore, the effect of control procedures on ROA is significant. The correlation coefficient for variable information and communication is 5.607 and the significance value is 0.127; therefore, the effect of information and communication on ROA is insignificant. The correlation coefficient for variable monitoring is 2.848 and the significance value is 0.275; therefore, the effect of monitoring on ROA is insignificant.
The effect of internal control on ROE. The model summary in Table VII shows some statistics related to the relationship between internal control and ROE. The results show that the correlation between internal control and ROE is 0.564, which means that there is a positive relationship between them. In other words, the higher the compliance with internal control, the higher is the ROE. The table shows that the adjusted R2 is equal to 20 per cent, which means that 20 per cent of the variation in financial performance (measured by return on equity ROE) is interpreted by internal control. The ANOVA test in Table VII also provides information about the overall regression. Because the value of the significance is 0.04, it can be concluded that the relationship between internal control in general and ROE is statistically significant at a level below 0.05. In other words, a statistically significant linear dependence of the mean of ROE on internal control was detected.
Table VIII shows the regression coefficients for each component of internal control. The table shows that the correlation coefficient for variable control environment is 4.248
Table VI. Regression coefficients (Internal control and ROA)
Variable
Unstandardized coefficients
Standardized coefficients
t Significance
Collinearity statistics
� Standard error � Tolerance VIF
Control environment 3.427 2.197 0.277 1.560 0.130 0.523 1.912 Risk assessment 9.912 2.034 0.903 4.874 0.000 0.479 2.086 Control procedures 11.093 3.131 0.800 3.542 0.001 0.323 3.100 Information and communication 5.607 3.569 0.367 1.571 0.127 0.302 3.311 Monitoring 2.848 2.558 0.181 1.114 0.275 0.621 1.610
Table VII. Model summary and ANOVA results (Internal control and ROE)
R R2 Adjusted R2 Standard error of
the estimate F Significance
0.564 0.318 0.201 9.44589 2.709 0.040
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and the significance value is 0.263; therefore, the effect of control environment on ROE is insignificant.
The table shows that the correlation coefficient for variable risk assessment is 10.583 and the significance value is 0.005; therefore, the effect of risk assessment on ROE is significant. The correlation coefficient for variable control procedures is 15.901 and the significance value is 0.006; therefore, the effect of control procedures on ROE is significant. The correlation coefficient for variable information and communication is 8.642 and the significance value is 0.164; therefore, the effect of information and communication on ROE is insignificant. The correlation coefficient for variable monitoring is 0.932 and the significance value is 0.831; therefore, the effect of monitoring on ROE is insignificant.
The effect of internal control on PM. The model summary in Table IX shows some statistics related to the relationship between internal control and PM. The correlation between internal control and PM is 0.284, which means that there is a positive relationship between them. In other words, the higher the compliance with internal control, the higher is the PM.
The table shows that the adjusted R2 is equal to 7.8 per cent, which means that 7.8 per cent of the variation in financial performance (measured by PM) is interpreted by internal control. The ANOVA test in Table IX also provides information about the overall regression. Because the value of the significance is 0.768, it can be concluded that the relationship between internal control in general and PM is not statistically significant at level below 0.05. In other words, a non-statistically significant linear dependence of the mean of ROE on internal control was detected.
Table X shows the regression coefficients for each component of internal control. The correlation coefficient for variable control environment is 0.157 and the significance value is 0.619; therefore, the effect of control environment on PM is insignificant. The correlation coefficient for variable risk assessment is 0.294 and the significance value is 0.318; therefore, the effect of risk assessment on PM is insignificant. The correlation
Table VIII. Regression
coefficients (Internal control and ROE)
Variable
Unstandardized coefficients
Standardized coefficients
t Significance
Collinearity statistics
� Standard error � Tolerance VIF
Control environment 4.248 3.724 0.242 1.141 0.263 0.523 1.912 Risk assessment 10.583 3.447 0.680 3.070 0.005 0.479 2.086 Control procedures 15.901 5.308 0.809 2.996 0.006 0.323 3.100 Information and communication 8.642 6.050 0.399 1.429 0.164 0.302 3.311 Monitoring 0.932 4.336 0.042 0.215 0.831 0.621 1.610
Table IX. Model summary and
ANOVA results (Internal control and
PM)
R R2 Adjusted R2 Standard error of
the estimate F Significance
0.284 0.081 0.078 0.79259 0.508 0.768
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coefficient for variable control procedures is 0.334 and the significance value is 0.459; therefore, the effect of control procedures on PM is insignificant. The correlation coefficient for variable information and communication is 0.217 and the significance value is 0.673; therefore, the effect of information and communication on PM is insignificant. The correlation coefficient for variable monitoring is 0.275 and the significance value is 0.456; therefore, the effect of monitoring on PM is insignificant.
Conclusions and recommendations The above discussion of descriptive statistics and hypothesis testing shows that the degree of compliance with all components of internal control is at a high level. The analysis revealed that all dimensions of internal control including control environment, risk assessment, control procedures, information and communication and monitoring had positive relationships with all profitability measures including EPS, ROA, ROE and PM. However, hypotheses testing showed that there are some differences in the significance of the relationship between internal control and profitability measures and in the relationship between the internal control components and the various profitability measures.
First, the analysis revealed that there is a positive relationship between internal control and ROA. In other words, the higher the compliance with internal control, the higher is the ROA. Additionally, a statistically significant linear dependence of the mean of ROA on internal control was detected. Similarly, it is noticed from the analysis that there is a positive relationship between internal control and ROE, which means that the higher the compliance with internal control, the higher is the ROE. Additionally, a statistically significant linear dependence of the mean of ROE on internal control was detected. These results of the study seem to be in congruence with those of some of previous studies in some instances. That is, as we mentioned in the theoretical framework, there is a positive relationship between internal control in general and profitability. The high degree of compliance with internal control requirements helps in the achievement of internal control objectives. The achievement of internal control objectives provides a solid ground for enhancement of profitability (Postan, 2010; Williams, 2005; Venables and Impey, 1991; Greenley and Foxall, 1997). Many researchers suggested that internal control is expected to act as a power that prevents deviations from the predetermined objectives and policies of organizations (Bejide, 2006; Conard, 2003; Hermanson and Rittenberg, 2003; Okezie, 2004). This part of our results
Table X. Regression coefficients (Internal control and PM)
Variable
Unstandardized coefficients
Standardized coefficients
t Significance
Collinearity statistics
� Standard error � Tolerance VIF
Control environment 0.157 0.312 0.124 0.503 0.619 0.523 1.912 Risk assessment 0.294 0.289 0.261 1.015 0.318 0.479 2.086 Control procedures 0.334 0.445 0.235 0.750 0.459 0.323 3.100 Information and communication 0.217 0.508 0.138 0.427 0.673 0.302 3.311 Monitoring 0.275 0.364 0.171 0.756 0.456 0.621 1.610
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suggests that internal control, if effectively implemented, can enhance the organization’s performance in certain issues. Accordingly, we may argue that the implementation of internal control activities related to assets and to the owners’ equity, in general, is effective and therefore the impact of internal control on ROA and ROE is statistically significant.
However, the analysis shows that the effect of internal control components on ROA and ROE is nearly the same. The analysis revealed that the effect of risk assessment and control procedures on ROA and ROE is significant, while the effect of control environment, information and communication and monitoring is insignificant. The statistically significant effect of some components of internal control over profitability seems to support the idea that there is an effective implementation of some internal control activities, while the insignificant effect supports the idea of ineffective implementation of internal control activities in some instances.
Second, the analysis revealed that, in general, there is a positive relationship between internal control and EPS, that is, the higher the compliance with internal control, the higher the EPS. However, no statistically significant linear dependence of the mean of EPS on internal control was detected. The detailed analysis of the effect of internal control on EPS revealed that the effect of risk assessment and control procedures on EPS is significant, while the effect of control environment, information and communication and monitoring on EPS is insignificant.
Similarly, the analysis showed that there is a positive relationship between internal control and PM. In other words, the higher the compliance with internal control, the higher is the PM. However, a statistically insignificant linear dependence of the mean of PM on internal control was detected. Additionally, the detailed analysis of the effect of internal control components on PM revealed that the effect of control environment, risk assessment, control procedures, information and communication and monitoring on PM is insignificant. These results seem to agree with some previous research findings (Kiabel, 2012; Mawanda, 2008) that concluded that the effect of internal control on performance is not statistically significant. However, these results are not incongruent with many of those of previous studies in some issues (Aigbe, and James, 2011; Kim and Yoon, 2007; Wijewardena et al., 2004), that is, these studies suggested a statistically significant relationship between internal control and performance in general. Our results show that the effect of internal control on EPS and PM is positive but statistically insignificant, and the effect of internal control components on these measures of profitability is also statistically insignificant. This result may lead us to suggest that the implementation of internal control activities is not reasonably effective at all times and in all directions. We have to remember that regardless of the power of internal control systems, there are some limitations for any internal control system that may prevent it from achieving a high degree of effectiveness, that is, we receive only reasonable assurance of the achievement of internal control objectives (Elder et al., 2012; IFAC, 2012a, 2012b; Rittenberg and Schwieger, 1997). Therefore, even when we find that there is a high degree of compliance with internal control requirements, the limitations may reduce the effectiveness of internal control in the achievement of the companies’ objectives.
Based on the results of the study, the researchers would recommend the managers of shareholding companies to concentrate on internal control systems with all their components, to maximize the well-being of their entities. Even when we found that there
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is a high degree of compliance with all components of internal control, we found that the relationship between profitability and control environment, information and communication and monitoring is positive but insignificant. The insignificant relationship between internal control and some measures of profitability may direct our attention to us being careful of the proper implementation of internal control. That is the compliance with internal control requirements may not lead to effective implementation. We may have a proper designed internal control system but not properly implemented (O’Leary et al., 2006). The other idea we need to consider is that there are many other factors that may influence the performance and result in reducing or improving the power of internal control in persuading the objectives of the organization. For example Welsh et al. (2013) found that management practices, marketing capability and technological capability of microenterprises have a positive impact on performance sales, net profit and growth. Kung et al. (2013) stated that differentiation strategies have a significantly positive influence on the performance.
Regarding this issue, we suggest that the management of Saudi shareholding companies should review the effectiveness of the implementation of internal control requirements, especially those related to control environment, information and communication and monitoring. It can be argued that the compliance with internal control requirements and, at the same time, the insignificant relationship with some measures of profitability mean that the management of Saudi companies were unable to concentrate on the effectiveness of the system in all directions and issues and unable to achieve efficiency improvement in operating activities. The IFAC (2012a, 2012b) stated that:
[…] internal controls can only work effectively when they, together with the risks they are supposed to modify, are clearly understood by those involved. Therefore, controls should not be documented and communicated in isolation but integrated through formal and informal channels into the elements of the management system in which they are intended to operate, including the related objectives, activities, processes, systems, risks, and responsibilities.
Finally, we can argue that the results of our study would also suggest new evidence of the relationship between internal control and profitability in a Middle Eastern environment, which may suggest that there is a need to expand this study using other methodologies to delve into the depths and understand this phenomenon within its context. That is, the results, which are to some extent contradictory to some previous research findings, may point to the fact that there are some contextual factors preventing internal control from promoting performance in all instances and regarding all issues (Serrasqueiro and Nunes, 2008; Weiner and Mahoney, 1981; Grinyer et al., 1980). The impact of internal control on organizations’ performance may vary depending on organization specific factors, including size and the nature of its activities besides the macro factors.
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Corresponding author Ali A. Al-Thuneibat can be contacted at: [email protected]
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- The impact of internal control requirements on profitability of Saudi shareholding companies
- Introduction
- Theoretical framework and hypotheses development
- Internal control components and financial performance
- Control environment
- Entity’s risk assessment process
- Information and communication systems
- Control activities
- Monitoring of controls
- Study design and methodology
- Results and discussion
- Descriptive statistics
- Hypotheses testing
- The effect of internal control on EPS
- The effect of internal control on ROA
- The effect of internal control on ROE
- The effect of internal control on PM
- Conclusions and recommendations
- References
