This chapter reviews related literature from various sources according to the objectives of the study. The review of available literature therefore attempts to establish whether there is a relationship between internal control systems and financial performance in SACCOs. Therefore the chapter presents the theoretical review and empirical literature on the effects of internal control systems on financial performance of SACCOs in Embu Town. This section also presents the conceptual framework, critique of the literature and research gap.
This section introduces three theories advanced by scholars that are relevant to understanding the effects of internal controls systems on performance of SACCOs. These theories include the agency theory, Information Asymmetry theory, Modigliani and Miller theory, life cycle theory of savings and modern portfolio theory
The Agency Theory
Agency theory describes firms as necessary structures put in place to maintain contracts and exercise control and minimize opportunistic behavior of agents (Adams, 1994). The theory harmonizes the interests of the agent and the principal through a comprehensive contract which addresses the interest of both the agent and the principal.
Internal control is one of the many mechanisms used in business to address the agency problem (Morris, 2011). Others include financial reporting, budgeting, audit committees, and external audits (Jensen and Payne 2003). Internal controls therefore play a major role in moderating the agency problem in corporations and can also apply in SACCOs. Whittington and Pany (2001) have attempted to explain the meaning and significance of internal controls, and the components of a company’s internal controls.
Information Asymmetry Theory
Adverse selection is the problem financial institutions face in distinguishing low risk from high risk loan applicants before making a loan. Lloyd (2006) defines adverse selection as the tendency for worse loan defaulters to borrow while those who are likely to repay do not get attracted to loans. For example, poor people will be more attracted to loans while the rich people are less likely to be attracted to bank loans. In general persons who are most undesirable as borrowers are most likely to pursue a transaction. In this case individuals with the highest probability of experiencing financial problems search most aggressively for loans. Such individuals are more likely to borrow than do highly prudent and conservative individuals and are willing to pay relatively high interest rates to obtain funds (Larson, Wild ; Chiapetta, 1999).
Hence, dealing with adverse selection requires safeguards. But the safeguards may be costly and require monitoring. However, because of the danger of default, a lender needs to gather and process information on the borrower, negotiate and write a contract and monitor the compliance. Lending contacts may create incentives for the borrower to behave in ways that harm the interest of the lender. Safeguards built into the contract can help, but they may also hinder the operations of the borrower. Lenders prefer their loan to be as liquid as possible while borrowers prefer the funds to be committed as solidly as possible (Cuevas and Fischer, 2006)
Modigliani and Miller Theory
The Modigliani-Miller theorem states that, under a certain market price process, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed (Modigliani and Miller, 1958).
The Modigliani-Miller theorem has been used to promote and expand the use of leverage. When misinterpreted in practice, the theorem can be used to justify near limitless financial leverage while not properly accounting for the increased risk, especially bankruptcy risk that excessive leverage ratios bring (Modigliani and Miller, 1963). This theory is selected to guide this study since it attempts to give the management of Sacco’s autonomy by the fact that it downplays losses and risks associated with wrong investment decisions that may require internal controls.
Life-Cycle Theory of Savings
According to the life-cycle model of savings, people save when young to finance consumption during retirement. In theory, in the absence of a bequest motive, the dissaving of the old should offset the saving of the young, so that in a stationary population (with a stable age distribution and no population growth) there is no aggregate saving. However, if the age structure of the population is unbalanced, as occurs under population growth, or if the economy is undergoing rapid economic growth and the wage incomes of the young are high relative to the retirement incomes of the old, the savings of different cohorts may not cancel out, and aggregate savings, or dissaving, may occur (Ando & Modigliani, 1963).
Modern Portfolio Theory
In investment, modern portfolio theory management is a critical theory. It tries to look for the most efficient combinations of assets to maximize portfolio expected returns for given level of risk. Alternatively, minimize risk for a given level of expected return. Portfolio theory is presented in a mathematical formulation and clearly gives the idea of diversifying the assets investment combination with a purpose of selecting those assets that will collectively lower the risk than any single asset. In the theory, it clearly identifies this combination is made possible when the individual assets return and movement is opposite direction. An investor therefore needs to study the value movement of the intended asset investment and find out which assets have an opposite movement.
Empirical Literature review
According to the COSO Framework, everyone in an organization had responsibility for internal control to some extent. Virtually all employees produced information used in the internal control system or take other actions needed to effect control. Each major entity in corporate governance has a particular role to play (COSO 2013). At the specific transaction level, internal control is referred to the actions taken to achieve a specific objective, for example how to ensure the organization’s payments to third parties are for valid services rendered (Atrill, 2003).
In SACCOs internal control systems have been applied worldwide. According to Ssemwanga (2009) governance is the system in which SACCOs are led, enabled and its leadership held accountable for the actions taken in a bid to manage the SACCOs in the interests of all members. However, corporate governance in SACCOs is a fairly touchy and much more complex issue as cooperatives are based on the principle of democracy in regards to decision making with much more spread ownership than classical firms (Labie ; Périlleux, 2009).
Independent Variables Dependent variables
Internal Controls Systems and Financial Performance of SACCOs
According to Hayes (2005) internal control comprises five components; the control environment, the entity’s risk assessment process, the information and communication systems, control activities and the monitoring of controls. However, for purposes of this study, the research narrowed down to only three components of the internal control systems. These were the control environment, risk control and control activity.
The other component of the internal control systems would be held constant. It is therefore worth noting that properly instituted systems of internal control ensure completeness of all transactions undertaken by an entity, that the entity’s assets are safeguarded from theft and misuse, that transactions in the financial statements are stated at the appropriate amounts, that all assets in the company’s financial statements do exist, that all the assets presented in the company’s financial statements are recoverable and that the entity’s transactions are presented in the appropriate manner according to the applicable reporting framework.
Risk control and financial performance
According to Deelchand & Padgett (2009) risk is the variability of returns associated with a given asset hence must be controlled or minimized. Pagach & Warr (2008) point out that risk is generally considered to be the possibility of outcomes that deviate from what were expected however, it is primarily negative outcomes that are of most concern to organizations. Risk taking is fundamental to every business (Spira, 2003). SACCOs have a high exposure to credit risk (Cuevas and Fischer, 2006).
SACCOs are also faced with operational risk (losses caused by internal failures or shortcomings of people, processes, and systems, as well as the inability of people, processes, and systems to cope with the adverse effects of external events). Mutesasira, et al (1999) observed that informal savings and credit mechanisms are often characterized by high transaction cost and high risks. As a consequence, the poor regularly lose their savings to fraudulent schemes, dishonest “friends” and neighbors, to thieves, to unnecessary spending. However, Deelchand & Padgett (2009) have stated that credit risk can be controlled whereas operational risk can only be minimized.
Environmental Control in SACCOs and Financial Performance
According to Whittington & Pany (2001) the control environment sets the tone of the organization by influencing the control consciousness of people. In SACCOs control environment is viewed as the foundation for all the other components of internal control. Environmental control factors include integrity and ethical values of personnel responsible for creating, administering, and monitoring the controls, commitment and competence of persons performing assigned duties, board of directors or audit committees, management philosophy and operating style (in terms of their aggressiveness or conservativeness which may determine the level of risk they may take on), and organizational structure. Ethical values and other elements of the control environment permeate the culture of an organization and affect the strength of all other controls.
Activity Control in SACCOs and Financial Performance
Whittington and Pany (2001) have observed that control activities are important component of internal controls that can be applied in a SACCO. Control activities are policies and procedures that help ensure that management directives are carried out. Activity Controls in an organization basically comprise; performance reviews, information processing, physical controls, and segregation of duties. This is aimed at ensuring that the internal controls continue to operate as intended. This can be achieved through ongoing monitoring or separate evaluations. Separate evaluations are non-routine monitoring activities such as period audits by the internal auditors.
Critique of the literature
The forgoing literature review has examined the role of internal control systems in SACCOs. It is evident that profitability and liquidity are important concerns for SACCOs. SACCOs often seek to generate profits in order to directly benefit the members. Thus internal control systems are necessary to ensure that members’ interests are safeguarded. In line with the WOCCU report (2005), Bauer (2007) states that cooperatives are organized to meet the needs of their members thus surpluses or profits are returned to members in the form of reinvestment in the credit union, dividends to members, or lower interest rates on loan products.
From the literature reviews done it has been found out that realization of positive financial performance and value for money depends on whether firms have Internal Controls. Non-compliance to the internal controls is one of the major hindrances to the attainment of positive financial performance in Saccos. Therefore, there is need to establish the relationship between the internal control systems and financial performance of Saccos in Embu.
According to the CGAP (2005) delinquency in SACCOs has increased and many SACCOs are challenged with overcoming delinquency in the loan portfolios as techniques of measuring and controlling delinquency are not strictly adhered to in SACCOs. Deshpande (2006) observes that excess liquidity in SACCOs limit incentives to mobilize additional deposits especially poor people’s deposits, which tends to be perceived a priori as short term, unstable, and costly. Thus the results of this study would fill the gap in the effects of internal control systems on the financial performance of SACCOs in Embu Town.