Introduction
In this chapter literature review on internal controls and revenue collection is discussed. The theoretical framework is presented first, followed by empirical literature on studies involving internal control and revenue collection. The conceptual framework is discussed last and then the chapter summary concludes the chapter.
Theoretical Review
The main theories that premise the relationship between internal controls and revenue collection are the Agency theory. Attribution theory, and Reliability theory.
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Agency Theory
Jensen & Meckling (1976) postulate that a firm consists of a nexus of contracts between the owners of economic resources (the principals) and managers (the agents) who are charged with using and controlling those resources .According to the agency theory, agents have more information than principals and this information asymmetry adversely affects the principals ability to monitor whether or not their interests are being properly served by agents.
A contract should be written to address the interest of both the agent and the principal. The agent-principal relationship is strengthened more by the principal employing auditors and control systems to monitor the agent (Jussi & Petri, 2004).
Jensen & Meckling (1976) postulate that the agency theory assumes that principals and agents act rationally and use contracting power to maximize their wealth. This theory is applicable to internal control and revenue, because internal control are a mechanisms used in business to address the agency problem by reducing agency costs that affects the overall performance of the relationship. Internal control reduces information asymmetry by providing additional information to shareholder about the behavior of management that reduces information asymmetry.
Attribution Theory
The attribution theory examines the use of information in the social environment to explain events and behaviors (Schroth and Shah, 2000). Reffett (2007) asserts that when evaluators believe more people would have acted differently in a given circumstance, they attribute responsibility for an outcome to the person. So, failure to detect internal control on revenue generation by auditors when it is their duty, imply the auditors are negligent. Auditors are more likely to be sued when they fail to detect common misappropriations that would result to decreased revenues (Bonner et al. (1998). It is so because evaluators believe that the fraud could have been detected by other auditors.
In short attribution theory calls for auditors to report on the effectiveness of firm’s internal control. When fraud occurs, auditors should be held accountable (Reffett, 2007).
Reliability Theory
According to Gavrilov & Gavrilova (2001) reliability theory describes the probability of a system completing its expected function during an interval of time. According to the reliability theory, each component of an internal control system needs to be a defined measure of success. Internal control systems should be reliable in the assessment and control of risks. Weak internal control systems result in more substantive work and hence increased costs. Organisations are required to assure the functionality of systems, internal control included.
Conceptualising Internal control
Internal control are mechanisms to prevent errors from entering the process or detecting errors. Management rely on internal control to make sure things don’t get goofed up (Kenneman, 2004). Puttick (2001) adds that internal controls as a set of organizational policies and approved internal processes crafted by management of an organization to achieve management’s primary objective of ensuring that the business operates flawless. The Financial Management Journal (2005), postulate Internal control represents an organization’s plans, methods, and procedures used to meet its objectives of safeguarding assets and preventing and detecting errors, fraud, waste, abuse and mismanagement.
Ongeri (2010) stipulate organizations need five interrelated components of an Internal Control which control environment, risk assessment, control activities, Information and communication, and monitoring components.
Control Environment
The control environment influences the control consciousness of its people (Whittington & Peny, 2001). Control environment comprises of factors like integrity and ethical values of employees, competence of person performing assigned duties, audit committees, management operating style and organizational structure. The effectiveness of these factors depends on their interaction with internal and external auditors.
According to Aldridge and Colbert (1994) control environment reflects the attitude of management in regard to importance of internal controls in revenue generation. Effective internal control requires a strong control environment under which the components of systems are well implemented.
Risk Assessment
According to Karagiorgos et al (2009) risk assessment refers to the assessment of factors that affect the possibility of objectives of the organization not being achieved. It is the process of identifying management relevant risks to the preparation of financial statements that would be presented fairly in conformity with general accepted accounting principal (GAAP). The purpose of risk assessment is to identify, analyze and manage risks that affect entity’s objectives. The aim is to keep the firm’s risk at an acceptable level. A firm should use its risk management systems to help assess potential opportunities and threats to its objectives. Internal control is about understanding and controlling risk as well as acting as a monitoring function.
Information and Communication System
Internal control requires that all information be identified, captured, and communicated in a form that enable people to carry out their financial reporting responsibilities (Aldridge and Colbert, 1994). Effective communication should see information flowing down across and up within all sections of the organization (Theofanis et al 2011). They are pervasive characteristics that affect all aspects of the internal control framework and Effective information dissemination enable people to carry out their responsibilities to run and control the organization. Internally communication should be multi directional within the organization. External communication relates to communication with governing boards and regulatory agencies.
Control Activities
Aikins (2011) define control activities as policies and procedures to ensure directives of the management are properly carried out. Policies and procedural guidelines normally assist in the proper execution of control activities.
Monitoring and evaluation
Theotanis et al (2011) describe monitoring as the process of assessing the quality of internal control structure overtime. Amuda and Inenga (2009) avers that monitoring of operations ensures effective functioning of internal control system. Monitoring can be achieved by regularly supervising and managing activities like monitoring of customers complaint and audit conducted directly by internal auditors. Evaluations ascertain whether components of internal control continue to function as designed and intended. Internal control deficiencies are communicated to management for corrective action.
Internal Controls in Revenue Collection
According to Obat (2010) Internal controls include segregation of duties, custody of assets, strict authorization procedures, internal audit, passwords, proper record controls and management supervision.
Segregation of Duties
Matamande (2012) states that if work is done by one individual there is a chance that the person can fraudulently convert the assets of the organization to own use and also manipulate the accounting records. There must be a clear separation between those initiate records and those who are responsible for the collection of the money.
Custody of assets
Puttick et al (2008). Outline measures meant to ensure that only those authorized have access to the organization's assets.
- Money should be transported in fully armored cash in transit (CIT) vehicles.
- Money not banked within stipulated time (24hrs) should be kept under lock and key in a safe in a strong room.
- Cash in hand should be kept to a minimum by regularly clearing tills during the day and banking the takings promptly.
Authorization
Transactions should be entered into systems once they have been authorized by the appropriate individual. The system should deny access to unauthorized personnel (Matamande, 2012).
Internal Audit
Internal audits should be regularly and randomly in all departments. Internal audit is an effective tool in revenue management because internal auditors are employees hence are better placed to understand the accounting systems, the control procedures and the control environment (Matamande, 2012).
Management supervision
These are controls over the control systems which involve the following:
- Monitoring to ensure that laid-down procedures are operating as they were designed to.
- Analyzing error detected by internal controls and taking remedial action.
- Considering changes where the weaknesses have been exposed.
- Conducting surprise cash audits (Matamande, 2012).
Empirical Review
Abbott, et.al (2010) investigated the importance of the control environment on audit performance. The study essentially looked on whether audit committee activity and independent is inversely related to fraudulent financial statements. The result of the study indicated that firms with independent directors and with the minimum activity level are less likely to be associated with fraudulent financial statements.
Sovens and De Beelde (2006) studied the importance of the control environment when studying internal audit practice. The study established that control environment characteristics are significantly related to the role of the internal audit function and fraud detection within an organization.
Berra (2010) focused on control activities and monitoring, and investigated the effects of internal controls on employees’ propensity to be fraudulent. The result showed that the presence of control activities separation of duties increases the cost of committing fraud. Thus, the benefit from committing fraud has to outweigh the cost in an environment with internal controls.
Amudo and Inenga (2009) evaluated internal control systems on the Regional Member Countries (RMCs) of the Africa Development Bank Group (AFDB). It was found that there is ineffective internal control. The study recommended on improvement of the existing internal control systems.
In a study to establish the impact of internal control design and bank's ability to investigate staff fraud, Ewa and Udoayang (2012) found that internal control design influences staff attitude towards fraud. A strong internal control mechanism deter staff from committing fraud. On the other hand, a weak one exposes the system to fraud.
Conceptual Framework
The conceptual framework was developed after reviewing related literature on the study variables and it shows the relationship between the studies of variables under investigation. The independent variables were control environment, risk assessment, information and communication, control activities and monitoring and evaluation. Revenue collection was the dependent variable.
Figure 2.1 Conceptual Framework
Source: Researcher’s work
Summary
The chapter presented on the three theories anchoring this study namely the agency theory, the attribution theory and the reliability theory. This was followed by a discussion of empirical studies on internal control. Lastly the chapter presented the conceptual framework. Chapter three which follows presents on research methodology.
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