CHAPTER I
INTRODUCTION
Background of the Study
There is a dominating challenge in creating the appropriate organizational
confidence at present if efficiency of internal control is taken into consideration.
Appropriate internal control systems are to be considered in order to minimize errors,
fraud and identity mistakes, as management are the one to take corrective actions if
the system will fail to lessen possible losses (Odita et al., 2022). According to
Anantadjaya et al. (2021) owners and managers are key players in establishing
effective control environment within the organization because this is part of their
responsibility over the use of resource of the organization. Because internal control
systems are flexible considering its multiple component purposes, the call for better
internal control systems is vital. At present banks continue to face threats and risks
which can impact financial performance. Koch & MacDonald (2014) stated that these
risks can be categorized into six (6) and these are: credit, liquidity, reputational,
operational, market and legal risks which can directly impact the liabilities, market
valuation, equity and profitability of banks. According to Caruso et al. (2021) one of
the most significant threats that a bank may face in the conduct of its operations is
credit risk. Credit risk as defined by Buchory (2021) refers to the tendency of partial
or total loss due to inability to repay the loan on a particular time. Research have
shown that credit risk and bank performance are related positively (Dunyoh et al.,
2022). However, results suggest inconsistency on the research findings on the impact
of credit risk on bank performance, and therefore give more room for additional
analysis. Furthermore, Channar et al. (2015) stated that even with the control systems
put in place by banks, banks still face problems relating to liquidity, delay in
preparation of financial reports, inefficient allocation of resources, malfunctioning
and fraud in the use of the bank’s assets which ultimately affects the bank’s financial
performance.
Detailed evaluation and understanding of the effectiveness of internal control
systems and its components provide vital insights to managers and employees on what
key points on the current system has to be improved to achieve higher levels of
operational and financial performance (Channar et al., 2015). Internationally,
Chogawana (2017) studied the effect of internal controls on the financial performance
of commercial banks in Kenya and the study findings revealed that better financial
performance was achieved by commercial banks which effectively implement the
elements of internal control. Based on the regression analysis of the study, it was
proved that there exists a significant positive relationship between internal controls
and financial performance of banks in Kenya, which further suggests that in the
absence of effective internal controls, financial performance is compromised. This
was in alignment with the results from the research conducted by Channar et al.
(2015) in which findings suggests that internal control effectiveness has a positive
relationship with financial performance of banks in India. Results also concluded that
private banks possess the strongest internal control effectiveness followed by public
banks and weakest in Islamic banks which further translate into high level of financial
performance in private banks, moderate level of financial performance on public
banks and low level of financial performance on Islamic banks.
Rural banks in the Philippines also face threats of credit risk on its financial
performance. A study conducted by Mendoza & Rivera (2017) found out that credit
risk has a significant negative impact on profitability of rural bank in the Philippines.
It suggests that banks must have an understanding to which risk factors pose the
greatest impact on their financial performance and would be highly beneficial to use
better risk-adjusted performance measurement to support the strategies the bank is up
to. Rural banks should consider creating effective credit risk management plans that
define the process from initiation to approval of loans. They are highly encouraged to
take into consideration the credit risk management practices by regulatory bodies. To
ultimately improve financial performance, rural banks must minimize risks and this
would be possible if banks take actions to enhance its internal control measures to
ensure strict implementation of internal processes on its operations (Mendoza &
Rivera, 2017).
The limited local studies gave the impetus to the researcher to get a better
understanding towards the importance of internal control systems on the financial
performance of banks in North Cotabato. Therefore, only little evidence does exist on
the effect of internal control systems on financial performance in the banking sector.
To add up to the context, Onuonga (2014) stated that impact of determinants of the
performance of banks leads to no conclusion or definite result. This study aims to fill
the gap in the literature about the impact of internal control systems on financial
performance of banks in the local setting.
Statement of the Problem
Generally, the purpose of the study is to determine the impact of internal
control systems on financial performance of banks in North Cotabato.
Specifically, it seeks to answer the following questions:
1. What is the demographic profile of the respondents in terms of age and
gender?
2. What is the level of internal control system in terms of control environment,
internal audit, and control activities?
3. What is the level of financial performance in terms of profitability,
liquidity, and efficiency?
4. Do internal control systems significantly influence the financial
performance of banks in North Cotabato?
5. Is there a significant relationship between internal control systems and
financial performance of banks in North Cotabato?
Theoretical Framework
This study is anchored on the Efficiency Structure Theory (Demstz, 1973).
This suggests that higher profits are product of a firm’s specific advantage. This
theory suggests that banks that can earn high profits have higher levels of efficiency
than other banks. Higher level of efficiency results to lower operational costs which
lead to profitability. This theory also aims to know the relationship between bank size
and profitability. Banks with weak internal control are prone to inefficiency which
gives more room for fraud and mismanagement. Such activities increase operational
costs which lead to poor level of financial performance.
The researcher believes that this theory is important in the discussion of the
particular study to get an understanding on how efficiency brought by the internal
control systems at hand can help banks to gain specific advantage in the course of its
operations and to ultimately achieve better financial performance. This is vital
because one of the main objectives of internal controls is to ensure efficiency and
effectiveness of operations.
Conceptual Framework
Figure 1 shows the conceptual framework of this study. Both independent and
dependent variables are shown. The independent variables of the study are internal
control systems which are: control environment, internal audit, and control activities.
The dependent variable is financial performance which is consists of: profitability,
liquidity, and efficiency.
As indicated by the arrow pointing from the independent variable to the
dependent variable, internal control systems impact financial performance of banks in
North Cotabato.
Conceptual Framework
Independent Variable Dependent Variable
Internal Control Systems Financial Performance
Control Environment Profitability
Internal Audit Liquidity
Control Activities Efficiency
Figure 1. Schematic Diagram of the Conceptual Framework
Hypotheses
H01: Internal control systems have no significant impact on financial
performance of banks in North Cotabato.
Based on the internal control systems presented, the sub-hypotheses are the following:
H01.1: Control environments have no significant impact on financial
performance of banks in North Cotabato.
H01.2: Internal audit have no significant impact on financial performance of
banks in North Cotabato.
H01.3: Control activities have no significant impact on financial performance of
banks in North Cotabato.
