The efficiency of internal audit as a tool to improve the financial performance of Microfinance Institutions (MFIs) in Buea

CHAPTER ONE

INTRODUCTION

This study looks at the efficiency of internal audit as a tool to improve the financial performance of Microfinance Institutions (MFIs) in Buea

Further reading: THE EFFECT OF INTERNAL CONTROL ON FRAUD DETECTION AND PREVENTION IN SMALL AND MEDIUM SIZE ENTERPRISES: THE CASE OF BUEA MUNICIPALITY

1.1 Background of the study

The growth and expansion of Microfinance Institutions (MFIs) in terms of the services and products they offer have necessitated the adoption of an effective risk management framework.

Nevertheless, the internal risk management systems of MFIs are often a step or two behind the scale and scope of their activities (Microfinance Network, 2000).

Strong internal capacities to identify and anticipate potential risks to avoid unexpected losses and surprises have been necessitated by the growth experienced by most MFIs.

The spurring growth of MFIs in our economy and the world over is evidence of their increasing importance and the demand for their products and services.

This increasing demand for the services of MFIs is backed by the large mass of poor and low-income people 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 [ABD] & African Development Fund [ADF], 2006).

These MFIs are spread across the country offering diverse products and services to the average Cameroonian including deposits, loans, payment services, leasing, money and remittance transfers, pensions, and insurance.

They are constantly penetrating the financial markets especially in the rural areas offering less stringent loan policies and conditions; a move which is believed will facilitate the attainment of Millennium Development Goals (MDGs) as access to financial services for all people underpins the attainment of the MDGs (ADB & ADF, 2006).

The growth of MFIs in Cameroon truly began to escalate in the early 1990s, but it has existed in the country for almost fifty years.

The provision of microcredit in Cameroon began in the 1950s when attempts were made in the country, as in other parts of the developing world, to promote small scale agriculture and enterprises undertaken by low-income people to raise their productivity and income (Lairap, 2004).

The first cooperative was created in 1963 by a Dutch catholic Father Alfred Jansen in Njinikom, in the North-West region. This cooperative is the founding-father of CAMCULL (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 and the resultant restructuring of the financial institutions were contributing factors to the development of the microfinance sector. During the economic downturn in the late 1970s, certain banks in the country began to suffer financially from a lack of available liquid funds.

By the 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 resources within the country.

This spurred the government to act in the late 1980s and there was a complete restructuring of financial institutions in the country causing many banks to close their doors while taking the savings of many Cameroonians with them.

It was out of the banking crisis that microfinance was born in Cameroon, as many citizens were still in need of banking services that were no longer readily available.

And the number of MFIs has been on the increase since then as they are proving to be able to provide these services via their operations.

However, the operations of a microfinance institution just like any other organization continuously expose it to a wide range of risks. This includes liquidity risk, credit risk, transaction risk, fraud risk, market risk, legal and compliance risk, and governance risks.

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).

Moreover, the result of a survey conducted by Audit Net in December 2009 reveals that weak internal control is still a recognized problem experienced by most organizations.

Most MFIs experience financial loss as a result of weak internal control systems leading to fraud at some point in their development.

Exposure to fraud risk is a normal part of operations for any financial institution, as is exposure to credit, liquidity, interest rate, and transaction risks.

The art of risk management is essential to the long-term sustainability of MFIs (Microfinance Network, 2000).

A company’s system of internal control has been attributed to a key role in the management of risks that are significant to the fulfilment of its business objectives.

In this light, there has been an increased interest in internal control systems and the fight against fraud over the past two decades.

As the business grew in size, scope, and complexity, a critical need for a separate internal assurance function that would verify the accounting information used for decision making by management emerged. In the 20th century, the establishment of a formal internal audit function became the logical answer to many problems.

It focuses initially was on the protection of the payroll against fraud, loss of cash, and other assets. This primary focus was quickly extended to the verification of almost all financial transactions. Reeve (1986), acknowledged that internal audit has gradually moved from audit for management to audit of management.

Nevertheless, the establishment of the internal audit function in MFIs is not enough but internal audit functions should be effective to the extent of contributing to the achievement of the overall organizational goal.

Internal auditing should not only serve basic functions of monitoring internal and financial control systems and making recommendations to management as its primary and initial focus but should be effective to contribute to the achievement of organizational profitability.

Sawyer (1995) stated that the internal auditor’s job is not done until defects are corrected and remain corrected.

Thus MFIs must develop their internal capacities to manage and monitor risk exposures (Campion, 2000).

Experience has demonstrated that MFIs cannot rely on external evaluations by donors, regulators, or external auditors to identify fraud or other problems, these evaluations are infrequent and often too shallow.

More so, internal controls can only support risk minimization if the MFI’s risk management strategies are effectively integrated into its policies and procedures (Campion, 2000).

As part of the risk management feedback loop, they play a significant role in identifying, evaluating, and monitoring risks facing institutions.

Also, the internal control system comprises internal auditing which is a very important tool for ex-post evaluations.

Similarly, Campion (2000) concludes that MFIs grow to operate more as regulated financial intermediaries, internal control becomes essential to long-term institutional viability.

Moreover, according to ABD & ADF (2006), financial intermediation designed to serve low-income groups must be addressed from a financial sector perspective and rely on the best-practice standards to succeed.

Thus, an effective system of internal control allows the MFI to assume additional risks in a calculated manner while minimizing financial surprises and protecting itself from a significant loss, hence making internal control an integral component of risk management.

The internal audit consists of four related components that are derived from how the management runs its business.

These components are internal audit standards, the independence of the audit department staff, professional competence, and internal control mechanisms.

These components of internal audit apply to all business entities though MFIs may apply them differently to large cooperation.

MFI’s internal audit could be less formal and unstructured but far more effective. They use the internal audit to make sure their financial statements show a true and fair view as laid down by guiding principles and procedures.

Everyone in an organization has the responsibility to ensure that the internal audit succeeds to some extent. Virtually all employees produce information used in the internal audit or take other actions needed to affect the audit.

The evolution towards financial inclusion is driven by MFIs who combine the credit cooperatives’ willingness to serve poor people with the commercial banks’ capacity and professionalism (Research Insight, April 2013).

MFFIs in Cameroon have been resilient despite local droughts and the high inflation rates that were experienced in the years 2008 and 2009.

MFIs have been projecting strong growth in borrowers in the recent past in line with the government’s over-emphasis on access to financial services as key to modernizing the economy.

The goal of MFIs as development organizations is also to service the financial needs of new markets as a means of meeting development objectives (Ledger Wood, 1999).

The innovativeness of MFIs and progressive government policies has enabled MFIs in Cameroon to be ranked as one of the most developed in central Africa.

One of the major contributors attributed to this success is the increased awareness by citizens, mobile banking, and the passing of the Finance Act of 2010 allowing agent banking is also known as branchless banking and the setting up of effective credit bureaus on the whole country.

With the mobile banking market continuing to grow and evolve, MFIs can look forward to increased efficiency and better client outreach.

The mobile money market is gradually drifting away from telecommunication companies and MFIs can now develop their applications to tie their client’s mobile money accounts to their MFI’s accounts considering Cameroon has more than 20 million mobile phone subscribers (Cameroon Post and Telecommunications, Statistics Report 2010). This together with a strong culture of saving shows MFIs are receiving more deposits compared to loan applications, overall the loans and deposits have both increased in equal measure since 2008 together with product line diversification, therefore, meeting customer needs in the process.

Despite the regulatory framework put in place by the Cameroon government over the years to regulate the activities of the microfinance industry, the industry could be characterized by a lot of challenges like poor internal controls. In light of this, it has become very imperative for firms in the microfinance industry especially savings and loan companies to establish proper internal audit functions.

For the past decade, many savings and loans companies have come to appreciate the importance of establishing internal audit functions.

In this light, savings and loan companies that have established an internal audit function operate it based on their internal audit charter.

The Institute of Internal Auditors (IIA), the international governing body for internal auditors brings some level of uniformity and consistency to internal audit functions.

The IIA provides general standards for performing internal audits and serves as a source for education and information. All internal audits in private institutions like savings and loans companies are conducted following the establishment, growth, and evolution of the contemporary internal auditing profession.

For the past sixty (60) years, the internal audit profession appears poised for continued dynamic growth and promises to become a profession for the 21st century.

This worldwide expansion, continuing relevance, and increasing influence and recognition of the IIA and the internal auditing profession over the last 60 years constitutes remarkable growth and progress.

Auditing, being an internal or external audit offers an independent verification to reduce record-keeping errors, asset misappropriation, and fraud in business, and this function of an audit goes back to times scarcely less remote than that of accounting.

Throughout European history, for instance, fraud cases such as the South Sea bubble of the 18th century, and the Tulip scandal justified exercising more controls over managers (Ramamoorti, 2003).

Internal audit as such becomes an instrument and a means of risk control that helps the enterprise to achieve its goals and to perform its tasks.

Only an effective internal audit in the enterprise can help objectively assess the potential development and tendencies of the enterprise performance and thus to detect and eliminate the threats and risk in due time as well as to maintain a particular fixed level of risk and to provide for its reasonable security.

The system of control adopted in an economy greatly determines the development and growth of that economy to ensure optimization in money, material, machine, time, resources, and management of men. Controls are essential.

These controls are installed by many organizations including micro-financial institutions to check how effective and efficient they maximize their resources.

Internal control started to become significant to authors in the United States early in the 20th century [Staub, 1904,p.98; Vincent, 1952, p.3; Brown, 1962, p.699; Myres, 1985,p.69].

Its importance was associated with American audit procedures, which were beginning to develop independently from those used by the British profession. In particular, procedures became oriented to financial reporting rather than to fraud detection [Moyer, 1951,p.7; Brown, 1962].

MFIs are an important contributor to the Cameroon economy. The sector contributes to the national objective of creating employment opportunities, training entrepreneurs, generating income, and providing a source of livelihood for the majority of low-income households by financing the business that they run.

The general perception is that the enforcement of proper internal audit systems always leads to improved financial performance.

Nevertheless, available literature still points out that despite the elaborate system of controls organizations, financial performance has been elusive in most of these organizations (OAG, 2010).

Commercial banks traditionally lend to medium and large enterprises that are judged to be credit-worthy and tend to avoid doing business with the poor and the micro-enterprises because the associated cost and risks are considered to be relatively high.

MFIs have therefore become the main source of funding for micro-enterprises in Africa and other developing regions (Anyanwu, 2004).

Financial performance was measured in terms of liquidity. Stoner (2003), financial performance is the ability to operate efficiently, profitably, survive, grow and react to environmental opportunities and threats.

Most MFIs have not attained financial stability as a result of not putting in place sound financial cost control portfolios and are relying on subsidies as their source of funds.

A small number of MFIs are extending loans to individuals, at the same time most MFIs are taking deposits to cushion risks associated with non-repayment of loans. it was within this backdrop that there was seen a need to undertake this study.

1.2 Statement of the Problem

The African microfinance sector is a dynamic and growing marketplace. In general, since 2005 there has been a spurt of overall growth in microfinance activity in sub-Saharan Africa.

The region’s aggregate loan portfolio increased by 69 per cent from 2006 to 2007 and savings increased by 60 per cent in the same period (Africa Microfinance Action Forum [AMAF], 2009).

In 2007, sub-Saharan Africa experienced economic growth of 6.7 per cent and continued to accelerate progress in human development, improve the huge lack of infrastructure, and strengthen governance. Microfinance has been able to capitalize on these positive developments, experiencing strong growth in recent years.

This tremendous growth in MFIs across Africa has been attributed to the fact that they use savings mobilization as the main funding source (International Association of Microfinance investors, 2010).

Similarly, in Cameroon the numbers of institutions have accumulated by way of deposits, a sum amounting to over FCFA 258 billion from close to one million customers.

And ever since the first micro-financing sector has been moving steadily upwards offering the country more than FCFA 22 billion as capital, employment to over 15000 people, and loans that amount to more than FCFA 138.5 billion, thus offering worthwhile support to poor people who would not be eligible for traditional banking facilities (Cameroon today, 2011).

However, with over a decade of existence, even fewer microfinance institutions operating in Cameroon have reached the level of self-sufficiency.

The majority of MFIs in Cameroon are not-for-profit organizations registered as financial cooperatives and credit unions. As such, their main source of loanable capital comes from the savings of their members (Lairap, 2004).

Mismanagement of the savings of members and customers is becoming rampant.

Thus, many are not able to survive resulting in a decrease in the number of microfinance institutions over the last few years.

The number of MFIs decreased from 652 in 2000, to 481 in 2008 (COBAC Annual Report, 2000, 2008).

Besides, the development of the microfinance sector is hampered by a loose regulatory network and supervisory framework for MFIs.

There is a clear absence of governance in the management of most MFIs. Almost all microfinance institutions have at least one strong shareholder who tends to influence the smooth functioning of the institution especially when it comes to giving out loans.

Likewise, the president of ANAMCAM highlighted among other poor governance, loan delinquency, and incompetent staff as a major hurdle faced MFIs in Cameroon (Cameroon today, 2011).

The majority of the MFIs in Cameroon, similar to most in Africa, struggle with sound leadership which is believed to be the primary condition for success as successful MFIs on the continent have a strong board of directors. Therefore their internal controlling environment is seemingly lagging.

The control environment is weakened by the absence of a policy guideline regarding the protection of savings clients among the COBAC regulations (Ndiaye, 2005).

With a majority of the MFIs relying on savings mobilized from their members and customers, as funding for capital for their operations, the protection of the savings and its efficient utilization becomes paramount.

Moreover, transparency and accountability are increasingly being required from all financial institutions including MFIs. Currently, as investors are more and more demanding regarding financial accountability and transparency, internal audit has acquired the utmost importance.

On the other hand, fraud has continued to be an issue of concern owing to its nature and the large losses reported from several cases. According to the fraud survey released in 2003, 75% of the respondents reported losses due to fraud as against 62% in 1998 (singleton et al., 2006).

Furthermore of the frauds reported, 36% incurred $ 1 million or more in cost, up from 21% in 1998.

The Association of Certified Fraud Examiners (ACFE) reported an estimated $660 billion in losses due to fraud in 2004.

Disturbing as the figures may be, the occurrence of fraud is a major problem for corporate organizations and institutions.

Thus, prompting the search for techniques and risk management frameworks that effectively mitigate fraud.

However, most MFIs have not been able to come to terms with the benefits of an effective internal audit due to their inability to analyze the impact of effective internal audit and how much they could save financially. In this light, management of most MFIs simply ignores the need to put in place simple yet efficient internal audit control systems to safeguard assets, ensure reliable financial reporting and compliance with laws and regulations especially as the regulating of these institutions has not been comprehensibly developed.

This financial crisis which affected mainly the developed countries have equally been felt by developing countries including Cameroon as was the case of the closure of several microfinance such as the collapse of the major player CONFINEST that affected customers and members confidence negatively, in early 2011, the government announces the official closure of CONFINEST with major shareholders arrested for mal-practices and management in the market. This sparked fear within depositors and non-depositors who rushed in other microfinance to withdraw their deposits. Such a situation would not have risen if CONFINEST had an efficient system of internal audit.

The internal audit function gauges the usefulness of Microfinance firms in accomplishing approved objectives and implementing recommendations made by internal audits for improvement of their risk management, control, and governance processes (Van Gansberge, 2005).

The internal audit function offers an unfailing, impartial, and objective service to the directors of the board, management, and the audit committee, whereas the stakeholders are more concerned on Return On Investment (ROI), growth, sustainability, leadership, and the reporting that can rely on the financial performance.

Despite all the above findings, MFIs struggle with liquidity problems, operating and financial expenses are relatively high for MFIs and on average, and revenues from MFIs remain lower than in other global regions.

There are also cases of alleged corruption and financial practices. Effectively in terms of cost per borrower is also low to provide for the potential loss from defaulted loans.

Furthermore, the ability of management to override internal audit raises doubts as to the impact internal audit has on the incidence of fraud principally because they have been charged with the responsibility of establishing the internal audit in the first place.

More so, a system of internal audit cannot, however, protect with certainty against a company failing to meet its business objectives or all material errors, losses, fraud, or breaches of laws or regulations.

Therefore, it becomes imperative to examine internal auditing efficiency as a tool for improving the financial performance of MFIs in Buea. This research is therefore structured to provide answers to the following questions:

1.3. Research Questions

• To what extent do MFIs in Buea adopts internal audit standards?
• How does professional competence or efficiency influence the financial performance of MFIs in Buea?
• How does the internal control mechanism affect the financial performance of MFIs in Buea?

1.4. Objectives of the Study

The main objective of this study is to examine the efficiency of internal audits as a tool to improve the financial performance of MFIs in Buea.

The specific objectives are;

• To determine the level of adoption of internal audit standards by MFIs in Buea.
• To evaluate the impact of professional competence or audit efficiency on the financial performance of MFIs in Buea.
• To assess the impact of internal control mechanisms on the financial performance of MFIs in Buea.

1.5. Hypothesis of the study

HO₁– internal audit standards statistically have no significant effect on the financial performance of MFIs.

HO₂– professional competence or internal audit efficiency statistically has no significant effect on the financial performance of MFIs.

HO₃– internal control mechanism statistically has no significant effect on the financial performance of MFIs.