Effects Of Internal Control Systems On The Performance Of Non-Governmental Organizations
Background of the Study
When organizations suddenly collapse, people usually ask the question “what went wrong?” A breakdown in internal control systems is usually the case. Internal control is therefore a process that guides such an organization to achieve its desired objectives. Any entity of whichever form or size should put in place its own system of controls in order to achieve its objectives (Mwindi, 2008). A system of internal controls is a critical component of NGO management and a foundation for the safe and sound operation of organizations.
Internal Control Systems
Effective internal control is important for an organization as it could plug the loopholes for corruption which often involves malpractice and fraud. Internal control is a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of an organization’s objectives in the effectiveness and efficiency of operations, reliability of financial and management reporting, compliance with applicable laws and regulations and protect the organization’s reputation (Kaplan,2008; Cunningham, 2004; INTOSAI, 2004; Committee of Sponsoring Organizations (COSO), 1992; Auditing Practices Board (APB), 1999). Effective internal control systems operate when some specific procedures are adopted by the management. ICS provide an independent appraisal of the quality of managerial performance in carrying out assigned responsibilities for better revenue generation (Beeler et al, 1999). Fadzil et al (2005) said that an effective ICS unequivocally correlates with organizational success in meeting its revenue target level (Ittner, 2003).
Most organizations no longer set up internal control system as a regulatory requirement but also because it helps in ensuring that all management activities are appropriately carried out (Kenyon and Tilton, 2006). Further, organizations are making it a point of duty to train, educate, and sensitize their employees on how to use these internal control systems since its effectiveness depends on the competency and dependability of the people using it. All these control actions ensure that any risks that may affect the organization’s ability to achieve its goals are appropriately avoided and should occur at all levels and in all functions of the organization ((Doyle et al, 2005). Using the analytical approach and focusing on control activities and monitoring, Barra (2010) investigated the effect of penalties and other internal controls on employees’ propensity to be fraudulent. Data was collected from both managerial and non-managerial employees. The results showed that the presence of the control activities, separation of duties, increases the cost of committing fraud. Thus, the benefit from committing fraud has to outweigh the cost in an environment of segregated duties for an employee to commit fraud. Further, it was established that segregation of duties is a “least-cost” fraud deterrent for non-managerial employees, but for managerial employees, maximum penalties are the “least-cost” fraud disincentives. The results suggest the effectiveness of preventive controls control activities such as segregation of duties is dependent on detective controls.
In order to align the activities with their objectives and to meet the donor accountability NGO’s need to measure and monitor performances of various groups. An NGO’s performance can be measured by how well it achieves the goals it has set itself and at what efficiencies. The two principal functions of performance measurement systems are first, to ensure that organizations are held accountable for their performance and actions; and second, to facilitate learning and improve performance. Such an integrated view would offer a comprehensive link between several units within an NGO (right from resource generation unit to program management unit). Such a comprehensive framework is highly recommended. (Epstein and McFarlan, 2011)
Financial Measures of Performance
A vital measure to evaluate the quantitative parameters is the financial statements of organizations. (Lewis, 2009) These statements provide the stakeholders with an insight on the financial situation of the organization and facilitate better planning and monitoring of activities.
With soliciting and using the donor funds comes the responsibility of being able to justify and provide clarity on the usage of funds and also plan for effective utilization of the limited resources. Therefore transparency is an essential condition for accountability. NGOs are striving to gain the confidence of their donors and internally create a committed organization. Many NGOs are proactively deciding what more can they inform their stakeholders. The disclosures in the financial statements are better and if any person from anywhere in the world is able to understand the financial statement then the objective of transparency is achieved (Lewis, 2009).
Many NGOs are adopting the IFRS (International Finance Reporting Standards) system of reporting to increase the quality of information. These financial statements prepared using common accounting standards across the globe would help the donors and other stakeholders better understand and analyze the financial condition of the organization. Financial statement analysis offers insights into: Where has the money come from or any organization to smoothly function and sustain would require funds. The source of funds for NGOs could be primarily donations, interests, rents or dividends; for what purpose has it been received? It is essential to define the objective of the organization and the purpose for which the funds are generated. For any other company the objective would be profit but for an NGO the objective would be to serve the society and expand its reach in uplifting the weaker sections of the society; how has it been spent? To know and summarize at the end of each financial year what has been the application of funds; what are the outcomes of the operation? To provide information internally as well as externally about the projects funded, intangible benefits to the project beneficiaries and the impact that the organization could create with the activities.
The aim in analyzing and interpreting financial results is to assess the financial health of the organization, compare the performance over the years or with other organizations, effective decision making and better planning for the future. Financial statement is also an important source of assessing the risk in the organization and taking appropriate measures to mitigate them. The risks associated with an NGO could be that of fraud, theft, volatility in costs, exchange risk etc. These risks could be mitigated through appropriate internal checks, constant review of the financial records and updated information and timely action. The financial measures present three dimensions of the NGO (Lewis, 2009): First dimension is financial Sustainability in which for an NGO would mean the long term support that these organizations provide to their beneficiaries. Hence, to support these activities the NGO must have sufficient funds to function and service not just today but also in the future. This financial sustainability would be a result of good financial management which would include planning to foresee and predict, organizing to work as per the plan, monitoring the activities to compare and match to the original plans and reviewing the activities performed. Second dimension is efficiency of an organization which is assessed by measuring the organization’s capability to serve as many people as possible with its resources at the lowest cost and good service. Lastly, effectiveness is another dimension which is the capability of an organization to achieve desired results by managing the limited resources and consistent performance.
The most common financial measures NGOs could use according to Lewis, 2009 are: Ratio Analysis which is a quantitative analysis of information in the financial statements to evaluate relationships among financial items. These ratios are used to analyze over time, individually or in comparison to similar organizations. Some of the ratios to understand the Financial Sustainability of the organization could be: Donor Dependency Ratio: Donor Income/Total Income: This ratio is a measure of the organization’s donor income to the total income generated during the year. The usual norm followed is that if the ratio is high then the donor dependency would be high and if the ratio is less, the organization is independent and there is less reliance on the donors to generate income. Accordingly, there is another view point to this. Considering the donor income it becomes very essential to analyze the number of donors contributing to that income. The donor mix is an indicator of the concentration of donations through limited donors which poses a risk to the organization. To de-risk the organization it becomes important to dilute the donor income or have a dispersed donor mix which reduces the risk of dependency on limited donors. This would be a true indicator of donor dependency and a measure to increase donors. Secondly, use of Survival Ratio: (General Reserves/Total Income)*52or 365, which is a hypothetical ratio which is an indicator of how long an organizations survive if all its funds are dried up and there are no donations received during the year. In simple terms it would mean if with the total income generated the organization can survive for 52 weeks or 365 days assuming all activities constant and income generated is spent then how many weeks or days would the organization sustain with its reserves. The General reserves here would mean the unrestricted funds/reserves.
Thirdly, use of Current Ratio (Current Assets/ Current Liabilities): This ratio in profit making companies indicates the liquidity position of the company. In NGOs too it determines the ability of the organization to pay off its immediate debts (within 12 months). A ratio of 2:1 is considered satisfactory. This ratio signifies the effective management of resources by the organization.
Income Utilization Ratio: Total Expenditure/Total Income: This ratio is basically to understand how much has the organization incurred in expenditure as a percentage of total income generated. This ratio can be further broken down into sub ratios such as the ratio between Programme expenses to Total Income or Administration Expenses to Total Income. These ratios help the organization to ascertain the efficiency to handle expenses with the generated income and prioritize expenses on the basis of need and original plans.
Resource Generation Ratio: Resource Generation Expenditure/Resource Generation Income: This ratio emphasizes on the efficient utilization of the available funds to generate more funds. It is an indicator of the real value of the income generated and the outflow to generate that income. If the expenditure to generate the income is high then there would be very little margin that could be used in the future.