The audit function has become an integral part of organizational financial management and an instrument of improving performance in the mid- size manufacturing sector (Al-Shammari, 2010). Thus, the internal auditing function gauges the usefulness of manufacturing firms in accomplishing approved purposes and thereby stimulating resilient authority and responsibility in firms. The recommendations made by internal audit for improvement helps management in manufacturing sector entities to improve their risk management, control and governance processes (Van Gansberghe, 2005). The internal audit function offers an unfailing, objective and impartial service to the management, board of directors, and audit committee, while stakeholders are interested in return on investments, sustainable growth, strong leadership, and reliable reporting on the financial performance and business practices of a company (Ljubisavljević & Jovanovi, 2011). Hutchinson and Zain (2009) explored the relationship between internal audit quality (audit experience and accounting qualification) and firm performance (ROE) in Malaysia. The results showed a strong relationship between internal audit quality and firm performance with opportunities of high growth and that this positive link is decreased by the increasing independence of audit committee.
Locally, Gaturu and Ngahu (2015) did a study on the effect of computerized audit system on financial management at Water Resources Management Authority in Nairobi County. Their study found that computer-assisted audit techniques and internal controls influenced financial management in WRMA. Their main focus was on computerized audit system and its effect on financial performance of WARMA whose orientation in the sectors of economy is different from that of mid- size manufacturing firms in Kenya. Kiema, Ahmed and Ndirangu (2015) investigated the influence of internal audit independence on the financial performance of small and medium enterprises in the Construction Industry in Mombasa.
Kiema et. al., (2015) found that some construction companies within Mombasa County do not accord the internal auditors the independence they deserved to effectively give their opinion on the financial statements of the organizations. The study did not give a clear direction of the relationship between internal audit function as a whole with the financial performance of firms in the mid- size manufacturing sector. Ondieki (2014) conducted a survey of the effects of internal audit on financial performance of commercial banks in Kenya and found that internal audit standards, independence of internal audit, professional competency and internal control had a positive relationship with financial performance of commercial banks. Ondieki looked at internal audit in the context of banking firms and did not link the internal audit function to the financial performance of the banks and therefore could be interesting to link the internal audit function and financial performance in the mid- size manufacturing firms.
As evidenced from the foregoing studies, there is unanimous agreement that if left unexploited internal audit is most likely to affect the financial performance of mid- size manufacturing firms. There have been no published studies on the relationship between the internal audit function and financial performance of mid- size manufacturing sector organizations in Kenya hence the research gap. To this end the study sought to respond to the following research question: What is the relationship between the internal audit function and financial performance of mid-size manufacturing firms in Nairobi County?
The agency theory outlines the relationship or the dependency between an agent and a principal (Adams, 1994). The principal delegates responsibilities to the agent most often for a fee. It can also be postulated to mean the practice by which productive resources owned by one person or group are managed by another person or group of persons (Millichamp & Taylor, 2008). The agency theory is said to be one on the internal auditing theories. In the context of an organization, the agency theory argues that agents should act in the interest of their employers (shareholders). However, the aforementioned agents have been alleged to act in their own interest rather than on the behalf of the shareholders.
The foregoing is argued to beget mistrust between the two parties, particularly from the shareholders (employers). Consequently, the mistrust increases the inclination of enhanced monitoring of the agents’ (directors and managers) activities. Upon the foregoing principle lies the foundation of auditing profession (Millichamp & Taylor, 2008). The theory further expounds on the principle agent problem, that is, agency dilemma. The dilemma is said to be occasioned by the inclination of the agent’s inclination to act in his own best interest rather than those of the principal. There is a likelihood of moral hazard and conflict of interest arising in the corporate scene.
It is exemplified that, the principal (shareholders) may be sufficiently concerned that at the likelihood of being exploited by the agent (directors and managers) that a dilemma may arise in hiring the right agents. The foregoing is necessitated by the desire to minimize or get rid of agency costs (Bebchuk & Fried, 2004). According to Adams (1994), the agency theory can provide for richer and more meaningful research in the internal audit discipline. Agency theory contends that internal auditing, in common with other intervention mechanisms like financial reporting and external audit, helps to maintain cost-efficient contracting between owners and managers.
Agency theory may not only help to explain the existence of internal audit in organizations but can also help explain some of the characteristics of the internal audit department, for example, its size, and the scope of its activities, such as financial versus operational auditing (Adams, 1994). Agency theory can be employed to test empirically whether cross-sectional variations between internal auditing practices reflect the different contracting relationships emanating from differences in organizational form.
2.2.2 Contingency Theory
The contingency theory of organization views organizations as rational entities capable and willing to make internal changes to achieve a technical fit between environment and structure. Contingency theory views effective organizations as those having structures that both support the unique nature of their production process and that are customized to complement their environment as argued by Byars & Rue (2004). The goal of an audit is to test the reliability of a company‘s information, policies, practices and procedures. Government regulations require that certain financial institutions undergo independent financial audits, but industry standards can mandate audits in other areas such as safety and technology. Auditors require access to documents, systems, policies and procedures to manage an audit.
According to Daft (2010), audit teams may begin the audit process with meetings where they gather risk and control awareness, after which the field work begins. During the audit process, auditors perform substantive procedures and test controls.
The audit sub processes, particularly in planning and field work, include contingencies such as business type, employee skill level, applicable laws, available audit workforce, available technology and systems, and deadline.
Daft (201) in his book wrote that contingency means one thing depends on other things and Contingency theory means: it depends. Audit functions are task-oriented and can be loosely structured. The functions also can vary considerably, depending on the area of a company under audit and the type of business model, so auditors must carefully manage their inspections and take variables into account to get the job done. The contingency theory also can be applied to an audit team‘s structure. Typically, audit team managers receive audit projects (Daft, 2010). They then create ad hoc audit teams for the projects, selecting auditors based on expertise and experience in the subject areas, and on auditor availability, all of which add up to contingencies for any given audit project. Audit teams use a mix of structure and contingency to get the output rolling quickly.
2.2.3 Stakeholder Theory
The stakeholder theory proposed by Freeman R. Edward (Freeman, 2004) is a theory of organisational management and business ethics that addresses morals and values in managing an organization. Stakeholder theory takes into account a wider group of constituents rather than focusing on shareholders. A consequence of focusing on shareholders is that the maintenance or enhancement of shareholders’ value is paramount whereas when a wider stakeholder group such as employees, providers of credit, customers, suppliers, government and the local community is taken into account the overriding focus on shareholder value become less self-evident.
Nonetheless many companies do strive to maximize shareholders value whilst at the same trying to take into account the interests of the wider stakeholder group (Kay & Silberston, 1995). One rationale for effectively privileging shareholders over other stakeholders is that they are recipients of the residual free cash flow (being the profits remaining once other stakeholders such as loan creditors have been paid) (Kay & Silberston, 1995). This means that the shareholders have vested interest in trying to ensure that resources are used to maximum effect, which in turn should be to the benefit of the society.
2.3 Determinants of Financial Performance
The financial performance of a firm which is described as a measure of an enterprise’s gains over its operative years is determined by several factors according to various empirical studies. Stierwald (2009) investigated the determinants of financial performance by considering a case of large firms in Australia. The study established that the financial performance of a firm is influenced by a number of variables which include lagged profit, productivity level and size. It was further indicated that the degree of concentration in a given sector influences firm behaviour and financial performance. More so, it was postulated that differences in firm-level characteristics such as efficiency, organizational structure and/or quality management may cause differences in financial performance of mid- size manufacturing firms.
The internal audit aspects that affect the financial performance of the firms include independence of internal audit (i.e. formalized principles, operations structure), professional competency (qualifications, auditors personnel, internal audit quality), internal control systems (reporting, management support of IA, advisory role) and internal audit standards (objectivity, accountability, discipline, risk management). In addition, working capital, firm characteristics and policies, capital structure, size of the firm and firm liquidity determine the financial performance of mid-sized enterprises.
2.3.1 Working Capital
Makori and Jagongo (2013) conducted an empirical analysis of environmental accounting and firm financial performance amongst selected firms listed in Bombay Stock Exchange, India. The study relied on data from annual reports of the selected firms. The major findings indicated that the relationship between environmental accounting and return on capital employed (ROCE) was significant and negative. Patel (2014) argued that net profit ratio (NPR) and working capital are related. The author opined that NPR is one of the best measures of the overall results of a firm particularly when it is included in the evaluation of how well a firm is using its working capital (Filbeck & Krueger, 2005). The authors established that there exist significant differences between industries in working capital practice over certain duration of time.
In addition, Rehman (2006) examined the how WCM impacted on financial performance of Pakistani firms listed on Islamabad Stock Exchange (ISE). The study focused on the implication of average payment period and cash conversion cycle on the net operating profit of firms. An empirical study was conducted on working capital management as a financial strategy for Nestle Nigeria PLC. The firm under study was selected for a period of five years, that is, from 2004 to 2009. The study analyzed the effect of various constructs of WCM which included current ratio and collection days on gross profit movement coefficient.
The results obtained by Rehman (2006) indicated that there exists a negative correlation between current ratio and financial performance. The collection days were regressed against ROCE. The pertinent results showed that, the relationship between the two variables was negative. This implied that a reduction in collection days increased financial performance of the firm. Generally, therefore, the study revealed that WCM as a financial strategy not only affects firm liquidity but also its financial performance.
2.3.2 Firm Characteristics and Policies
Certain firm characteristics are associated with high performance of firm. These include size, growth rate, dividends, liquidity and sales (Love & Rachinsky, 2007). The forms that have better growth rate can afford better machinery, and then gradually the assets and size of the firm will increase. Large firms attract better managers and workers who in turn contribute to the performance of the firm. So, both firm and its people support each other’s goals. A study on Saudi’s cement manufacturing firms indicated that the firm size is directly proportional to firm’s financial performance (Almazari, 2013). These findings concurred with a previous study conducted in Pakistan where it was noted that firm size had a significant effect on the financial performance of the firm (Raheman, Afza, Qayyum & Bodla, 2010).
According to Berger and Bouwman (2012) the extent to which higher capital ratios increase the performance of commercial banks during the time of stress is determined significantly by the size of the bank. A study conducted in Nigeria BY Bassey, Aniekan, Ikpe and Udo (2013) indicated that the size of the firm was one of the firm characteristics that were significant with debt ratio of the firm. Moreover, when examining agro-based firms in Nigeria between 2005 and 2010, Bassey et. al., (2013) noted that the firm size was one of the major determinants of short-term debt ratio for the firms under study. A study on listed manufacturing firms in Ghana by Akoto, Awunyo and Angmor (Akoto et al., 2013) found that firm size significantly and positively influence financial performance.
Makori and Jagongo (2013) empirically analyzed working capital management (WCM) and financial performance of both manufacturing and construction firms listed on Nairobi Securities Exchange Kenya. The study found that the size of the firm has significant effect on the firm’s financial performance. Their study concurred with the findings of a previous study on the relationship between WCM and performance of small and medium enterprises (SMEs) in Pakistani, which revealed that firm size is positively associated with financial performance (Raheman et al., 2010).
2.3.3 Capital Structure
Capital structure plays an important role in determining corporate performance. Barton & Gordon (2008) suggest that entities with higher profit rates will remain low leveraged because of their ability to finance their own sources. On the other hand, a high degree of leverage increases the risk of bankruptcy of companies. Outsourced capital is perceived as a liability to a firm since such an enterprise relies on external financing for its operations and had to compensate the capital source later.
Kuang-Hua and Ching-Yu (2009) empirically studied capital structure and financing decisions as evidenced by cases in East Asian Tigers and Japan. Their study involved samples from Hong Kong, Japan, Korea, Singapore, and Taiwan. The authors argued that the aforesaid countries had homogenous level of economic development. They acknowledged that there exist several elements that temporarily impact on capital structure, yet firms from the aforementioned countries rebalance their leverage following equity issuances. The study further revealed that firms have their target capital structure determined by the marginal benefits of debt and costs associated with debt.
According to Yang and Chen (2009), the size of a firm is the amount and variety of production capacity and ability a firm possesses or the amount and variety of services a firm can provide concurrently to its customers. The size of a firm is a primary factor in determining the profitability of a firm due to the concept known as economies of scale which can be found in the traditional neo classical view of the firm. It reveals that contradictory to smaller firms, items can be produced on much lower costs by bigger firms. In accordance with this concept, a positive relationship between firm size and profitability is expected. Large companies enjoy Economies of scale since their cost of capital is lower than in small firms.
The financial determinants of economies of scale occur due to size where large firms enjoy better interest and discount rates due to buying in large quantities (Pervan & Visic, 2012). There is a limit as to how big an organization can grow in order to achieve the economies of scale. After attaining a certain size the diseconomies of scale sets in as it becomes expensive to manage large organizations due to complexity, inefficiencies and bureaucracy. The hierarchy in small firms puts them in strategic position to counter the disadvantages arising from their size. They experience less agency problems and are more flexible in a changing environment. Serrasqueiro and Nunes (2008) found a positive relationship between size and performance in SMEs but not for large firms.
Liquidity refers to the available cash for the near future, after taking into account the financial obligations corresponding to that period. It is the amount of capital (Cash, credit and equity) that is available for investment and spending (Pradhan & Shrestha, 2016). Liquidity therefore, not only helps ensure that a person or business always has a reliable supply of cash close at hand, but it is a powerful tool in determining the financial health of future investments as well. Under critical conditions, lack of enough liquidity even results in firm\’s bankruptcy (Khidmat & Rehman, 2014). Sound and prudent liquidity policies set out the source and amount of liquidity required to ensure it adequate for the continuation of operations.
The policies must be supported by effective procedures to measure, achieve and maintain liquidity. According to Deloof (2003) less profitable companies wait longer to pay their debts. The negative relationship between liquidity and profitability is also established by Dong (2010) where it was found that decrease in the profitability occurs due to increase in cash conversion cycle. Mahmood and Qayyum, (2010) pointed out that to increase profitability of a company and ensuring sufficient liquidity to meet short term obligations as they fall due are two main objectives of working capital management. To measure firm liquidity, the study considered liabilities, debt management and cash flow.
Ebrahim, Abdullah and Faudziah (2014) did a study titled “The Effect of the Internal Audit and Firm Performance: A Proposed Research Framework.” The study was based on secondary data/desk search. The study attempted to propose a structure of the relationships between the internal audits characteristics (IAC); such as professional qualifications of the chief audit executive of the Internal Audit (IA), size, experience, and qualification; and firm performance. They revealed there is a paucity of studies exploring the association between internal audit characteristics (IAC) and firm performance whether conceptual or empirical. The study established that internal audit is a crucial part of corporate governance structure in an organization and corporate governance (CG) covers the activities of oversight conducted by the board of directors and audit committees to ensure credible financial reporting process.
Ewa and Udoyang (2012) carried out a study to establish the impact of internal design on banks’ ability to investigate staff fraud and staff life style and fraud detection in Nigeria. Data was collected from 13 Nigerian banks using a Four Point Likert Scale questionnaire and analyzed using percentages and ratios. The study found that internal control design influences staff attitude towards fraud such that a strong internal control mechanism is deterrence to staff fraud while a weak one exposes the system to fraud and creates opportunity for staff to commit fraud. The study therefore recommended that banks in Nigeria should upgrade their internal control designs and pay serious attention to the life style of their staff members as this could be a red flag to identifying frauds.
Chunlan (2009) examined the relationship between internal audit control and enterprise value. 75 listed companies in Shanghai and Shenzhen Stock Exchange were selected as sample. The researcher established that total asset turnover and return on equality have significant effect to raise the level of internal control; while internal control has significant effect to promote enterprise value. The model proves positive correlation between internal control and enterprise value.
Peursem (2004), undertook a study in New Zealand on internal auditor‘s role and authority. In this study, internal auditors were asked to come to a view on whether functions they perform in connection with audit engagements are essential, and to what degree they feel they enjoy the authority over, and independence from, management that is expected of a professional. A very high percent (73%) response rate was achieved over the original and follow-up survey. The study found that characteristics of a true profession exist but do not dominate.
Olumbe (2012) conducted a study to establish the relationship between internal controls and corporate governance in commercial banks in Kenya. The researcher conducted a survey of all the 45 commercial banks in Kenya. It was concluded that most of the banks had incorporated the various parameters which are used for gauging internal controls and corporate governance. This was indicated by the means which were obtained enquiring on the same and this showed that the respondents agreed that their banks had instituted good corporate governance with a strong system of internal controls and that there is a relationship between internal control and corporate governance.
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