The Effect of Internal Control Systems on Fraud Mitigation in Micro Finance Institutions
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The occurrence of fraud is a prevailing issue in financial institutions and in the recent financial crisis of 2008/2009; fraud was advanced as one of the reasons for the banking scandals involved in the crisis. Consequently, effective internal controls systems have received considerable attention as one of the best deterrents of fraud within entities.
Thus, institutions are required to set in place internal control systems to guard against material misstatement of financial statements, asset misappropriation, and embezzlement. In this light, this thesis examines the effect of Internal Control Systems on Fraud Mitigation in Microfinance Institutions (MFIs).
It investigates and analyses the effects of the control environment (integrity and ethics) and control activities (internal checks and internal audits) component of the COSO model on Internal Controls measured by the respondent’s perception on the incidence of fraud in MFIs. Data was collected from microfinance institutions in the Buea sub-division.
Our results were analysed by multiple regression using the OLS technique and revealed that integrity and ethics as well as internal checks had a positive statistical impact on fraud mitigation. The overall F-test Statistic was significant at 58.4% of the explanatory variables. Thus, the stronger the internal checks, integrity and ethics and internal audit, the lesser can fraud prevail in MFIs as per the results obtained from the field survey.
Hence MFIs in the Buea sub-division are encouraged to maintain a strong control environment and control activities where management is seen to comply with the above-mentioned variables and standards at all times, carry out effective performance reviews and regular account reconciliations in order to prevent and detect should fraud occur.
The occurrence of fraud is a prevailing issue in most if not all financial institutions. In the recent financial crisis of 2008/2009; fraud was advanced as one of the reasons for the banking crisis. Consequently, effective Internal Controls have received considerable attention as one of the best deterrents of fraud within entities.
Thus, Microfinance Institutions are required to put in place Internal Control Systems to ensure an orderly and efficient conduct of the business, safeguard its assets, ensure the prevention and detection of fraud and error, verify the accuracy and completeness of the accounting records, promote operational efficiency, measure how far the policies of the organization are being implemented, to evaluate the efficiency of performance in all aspects of the organizations activities and to highlight the weaknesses and timely preparation of reliable financial information.
(ACCA F1 Essential study text.pdf 2008). It is important to note that internal controls can only provide reasonable and not absolute assurance as to whether the organization’s objectives are met.
This can be attributed to the presence of some inherent limitations of Internal Control Systems. Generally, there is the perception that the institution and enforcement of sound Internal Control Systems (ICS) highly contribute to an improvement in financial performance, as well as improve on the reporting process, as well as giving birth to reliable reports which enhance the accounting function of the management of the entity.
Nonetheless, available Literature still points out that in spite of elaborate systems of control in organizations, Financial Performance has been elusive in most of these organizations (OAG, 2010). With regards to Microfinance Institutions (MFIs), their growth and expansion in terms of outreach, services and products they offer has necessitated the adoption of an effective risk management framework.
MFIs over time have become financially stable reaching out to the society and making their impact felt. Internal Control Systems can be placed at the center of such an achievement as they prevent and detect potential risks and avoid unexpected losses which can occur as a result of rapid growth experienced by most MFIs.
This increasing demand for the services of microfinance institutions is backed by the large mass of poor people and low-income earners who need and want a range of financial products and services to build income and wealth, smooth expenditure patterns, and reduce risk (African Development Bank [ADB] & African Development Fund [ADF], 2006).
Apparently, commercial banks have not been able to meet the financial needs and services of the poor and economic operators in the informal sector. In sub-Saharan Africa small enterprises and the poor population have very limited access to deposits, credit facilities, and other financial services provided by formal financial institutions.
MFIs in the world are evolving from clubs and non-governmental organizations to self-sufficient financial institutions. The existence of MFIs dates as far back as the 18th century with clubs mobilizing funds to lend to members at very low interest rates. In the 1970s, most of the institutions were not profit oriented and at this time, financial self-sufficiency was a secondary plan.
Development agencies and donors provided subsidized funds which acted capital, and the common belief was that the supply of such resources would remain reliable. The institutions were intermediaries, largely functioning as income transfer agencies for social purposes rather than serious financial intermediaries. Hence there was no formalization of the microfinance sector.
Formalization of the microfinance sector only began in the early 1990s as MFIs began offering more financial services, such as savings and insurance. Microfinance Institutions also demonstrated that they could improve the socioeconomic well-being of its clients and their families. The poor experienced positive changes in attitude as Microfinance Institutions helped them believe that they could lift themselves out of poverty. A sustainable credit culture was therefore created.
However with the economic crisis especially in most developing countries and resources being scarce for most of these financial institutions which originally set-up as non-profit organizations, the self-sufficiency of MFIs became paramount. Efforts were therefore made to transform these grant and subsidy dependent schemes into self-sufficient financial institutions (Lairap, 2004).
This led to the mainstreaming of Microfinance Institutions into the formal financial sector. According to the ADB & ADF (2006), “Microfinance is evolving to a point where the term itself is becoming obsolete and building inclusive financial systems for the poor is the term that is increasingly used as Microfinance becomes part of the formal financial sector without losing its focus on serving the poor”.
Mainstreaming requires that MFIs and other intermediaries operate according to the same standards of accountability, transparency, performance, and profitability as commercial banks and other formal financial institutions do.
This has necessitated the identification and management of risks thus emphasising the need for effective risk management techniques and tools. These developments in microfinance have set in motion a process of change from an activity that was entirely subsidy dependent to one that can be a viable business (ADB & ADF, 2006).
Management thus must set objectives and put in place measures and procedures which will facilitate the attainment of these set objectives and this implies effectively mitigating the risks which could seriously affect the growth and development of the Microfinance Institution especially operational risks. This mainstreaming phase only began in the mid-1990s.
The growth of Microfinance in Cameroon began to escalate in the early 1990s, although it had existed in the country for almost fifty years. The first cooperative in Cameroon was created in 1963 by a Dutch catholic Father by name Alfred Jansen in Njinikom, in the North-west region. This cooperative is the founding-father of CAMCCUL (Cameroon Cooperative Credit Union League) the biggest Microfinance institution and longest standing Microfinance network in the country (COBAC Annual Report, 2000, 2006).
The economic crisis of the 1980s led to the restructuring of financial institutions. This restructuring was viably amongst the contributing factors to the development of the Microfinance sector. During the economic crisis in the late 1970s certain banks in the country began to suffer from the unavailability of liquid funds.
By the early 1980s, banks in Cameroon became increasingly unable to support themselves as it became more difficult to receive international credit and they were largely unable to obtain their own resources from within the country. Consequently, the government took action in the late 1980s and there was a complete restructuring of financial institutions in the country causing many banks to go out of business taking along with them the savings of many Cameroonian citizens.
The banking crisis was the backbone behind the birth of Microfinance in Cameroon, as many citizens were still in need of banking services that were no longer readily available. The number of MFIs in the country has been increasing since then as they are proving to be able to provide these services through their operations.
However, the operations of a Microfinance Institution just like any other organisation continuously expose it to a wide range of risks. This includes operational risk, liquidity risk, credit risk, interest rate risk, transaction risk, fraud risk, market risk, legal and compliance risk, governance risks and many others.
Furthermore, the changing nature of the environment in which Microfinance Institutions operate exposes them to new risks thus making it necessary for them to adopt more sophisticated risk management tools (Microfinance Network, 2000). The financial services sector is one of the fastest changing and growing areas in the business field nowadays.
The exploitation of new and emerging technologies and industry deregulation have resulted in financial institutions having the ability to deliver a variety of products and services with an increasing number of delivery channels (Aub & Russell, 2001). The possibility of fraud occurring in MFIs is now higher with the recent changes in their business environment, resulting in more flexible products and services for customers.
According to Aub & Russell (2001), “the benefits and flexibility now being provided to customers have, unfortunately, also been exploited by those seeking to gain an advantage through dishonest behaviour.” Hence people are becoming more creative and providing for themselves new opportunities to perpetrate fraud almost daily.
This increased interest in internal controls is partly as a result of significant losses incurred by several banking organizations (Basel, 1998). In the mid-1990s, after several “surprise” bank failures, US regulators shifted the focus of reviews to place greater emphasis on an institution’s internal risk management capabilities in every area of operations, since those are better predictors of the bank’s ability to withstand internal or external uncertainties (Microfinance Network, 2000).
Fraud and mismanagement were at the center of the over 200 bank failures that occurred in the US. The Basle Committee analyzed the problems related to the losses incurred by banks and concluded that they probably could have been avoided had the banks maintained effective Internal Control Systems.
In addition, a review of traditional banks asserted that the implementation of effective Internal Control Systems played an important role in reducing bank failures throughout the 1990s as such, MFIs must develop their own internal capacities to manage and monitor risk exposures (Campion, 2000).
Experience has shown that Microfinance Institutions cannot rely on external evaluations by donors, regulators or external auditors to identify fraud or other internal problems. More so, internal controls can only fully support risk mitigation if the MFI’s risk management strategies are effectively integrated into its policies and procedures (Campion, 2000).
Risk management plays a significant role in preventing, detecting, evaluating, and mitigating risks facing institutions. Also internal audits are integrated in to the Internal Control System which is a very important tool for ex-post evaluations. In addition, internal auditors are expected to have sufficient knowledge to assess the risk of fraud and the manner in which it is managed by the organization as stated in the Institute of Internal
Auditors’ (IIA) International Professional Practices Framework (IPPF) Standard 1210.A2. Nevertheless, small Microfinance institutions rarely find it profitable to employ qualified internal auditors as full time staff. Rather, they outsource their internal audit services from the firms of their external auditors.
In most cases, the external auditors send a junior staff to carry out the internal audit at the microfinance institutions on a regular basis and his work is later supervised by one of the firm’s senior auditors. But with fraud on the rise, MFIs must set up their own in built systems of control to safeguard the shareholders’ investment and the company’s assets.
Effective internal control systems are said to reduce the occurrence of fraud; by closing the gaps otherwise referred to as the opportunity for employees to commit fraud thereby discouraging them from committing fraud and doing away with company assets. Sound internal controls equally provide a working environment in which good employees are not tempted to do something they would not ordinarily do.
In this light the performance of highly successful MFIs has been attributed to the integrity of their Internal Control Systems which detects problems early enough and calls for action by management in order to prevent small problems from exploding into larger ones (Microfinance Network, 2000).
Similarly, Campion (2000) concludes that as MFIs grow and more operate as regulated financial intermediaries, Internal Control becomes essential to long-term institutional viability. Moreover, according to the ADB & ADF (2006), providing intermediary financial services designed to help and serve low-income groups and earners must be addressed from a financial sector perspective and rely on best practice standards in order to succeed.
Hence, an effective Internal Control System allows MFIs to assume additional risks in a calculated manner while minimizing unexpected financial setbacks and protecting themselves from significant financial loss; thus making internal control an integral component of risk management.
The occurrence of fraud in society is increasing, especially in financial institutions. This act is driven by greed and the desire to have more and accumulate wealth even at the expense of society James Skeen (2004). The fact that many people live below the poverty line has weighed on their morals and they give up on their culture, ethical values and norms in an attempt to achieve personal targets before meeting organizational goals (Microfinance Network 2000).
This surely has led to the designing and implementation of Internal Control Systems in most organizations. They are to be an integral part of any organization since their task is to prevent risks from occurring, minimize their impact should they occur and prevent/detect fraud in an organization.
For this purpose organizations give much importance to the Internal Control function which is generally a feature of large companies. It is a function provided either by employees of the entity or sought from an external organization to assist management in another organization to achieve its objectives.
It becomes imperative therefore to investigate the Effect(s) which Internal Control Systems have on fraud mitigation in Microfinance Institutions. The questions below will guide me through the study; how does the control environment influence fraud mitigation in MFIs? How do control activities influence fraud mitigation in MFIs?
1.3 Objectives of the Study
This study has as main objective “To determine the Effect of Internal Control Systems on fraud mitigation in Microfinance Institutions.” Specifically, the study seeks to address the following specific objectives;
- Examine the extent to which integrity and ethics as a variable of the control environment influences fraud mitigation in MFIs?
- Examine the extent to which internal checks and internal audits as variables of the control activities influence fraud mitigation in MFIs?