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CHAPTER ONEINTRODUCTION1.1 Background of Study For most of its
history internal audit has served as a simple administrative procedure
comprised mainly of checking documents, counting assets, and reporting to Board
of Directors, Management or External Auditors. In recent times, however, a
combination of different forces has led to a quiet revolution of the
profession. Organizations have to demonstrate accountability in the use of
shareholders money and efficiency in the delivery of services. Organizations
now demand great competency and professionalism from internal audit, and scarce
resources must be deployed more efficiently to minimize and manage risks.
Technological advancement makes it possible to track and analyse data with
continually increasing speed thus making it essential for organizations to be
well advised by the internal audit department. Internal audit varies from one
organization to another, and making change to modern internal audit can be a
substantial undertaking. The transition from merely ensuring compliance with
rules and regulations to truly delivering added value requires more than just
organizational changes. In many bank institutions staff is poorly paid and
unmotivated, ethical standards are weak, and governance practices are
ineffective leading to asset mismanagement (Ramamoorti, 2003). All
over the world there is a realization that the Internal Audit activity has the
potential to provide hitherto unparalleled services to management in the
conduct of their duties. This potential has been turned into a challenge and
embodied in the new definition of Internal Auditing from the Institute of
Internal Auditors (the IIA). Commercial banks have come to the realization that
internal audit is essential in improving management of assets in the banks
leading improved financial performance of banks (Basel Committee, 2002).Internal Audit According
to Robertson (1976) Internal Auditing may be defined in several ways depending
upon what purpose is to be served. Pickett (1976) stated that ?internal audit
is an independent, objective assurance and consulting activity designed to add
value and improve an organization’s operations. It helps an organization
accomplish its objectives by bringing a systematic, disciplined approach to
evaluate and improve the effectiveness of risk management, control, and
governance processes?. This definition actually seeks to demonstrate the depth
and breadth of the internal audit activity within an institution as against the
previous orientation of reviewing payment transactions over the years.Internal
Audit is an objective and independent appraisal service within an organization
on risk management, control and governance by measuring and evaluating their
effectiveness in achieving the organization’s agreed objectives. In addition,
internal audit’s findings are beneficial to the Board of Directors and line
management in the audited areas. The service applies the professional skills of
internal audit through systematic and disciplined evaluation of the policies,
procedures and operations that management put in place to ensure the
achievement of the organization’s objectives, and through recommendations for
improvement (Dumitrescu, 2004).The
Board of Directors of the Institute of Internal Auditors in June 1999 described
internal audit as an independent, material and consultancy activity, which adds
value and improves the functioning of an organisation. It helps the
organisation achieve its aims by means of a systematic, disciplined approach to
evaluating and improving the effectiveness of risk management, control and the management
process. Internal
audit has several aims and principles which it is necessary to adhere to. It is
the board of directors of the bank, however which bears final responsibility
that the bank’s management applies an appropriate and effective system of
internal audit, a system of evaluating banking activity risk and risks
concerning bank capital, appropriate methods of monitoring compliance with
laws, measures and internal procedures. Likewise, the bank’s management is
responsible for drawing up procedures which identify measure, monitor and
control the risks that the bank faces. Internal
audit is a part of the repetitive monitoring of the internal control systems of
the bank and its procedures for evaluating internal capital. As such, it
assists management and the board of directors in the effective performance of
their responsibility as outlined above (Gramling, 1997). Although
the need for objectivity and impartiality is of particular importance for the
internal audit department in a banking institution, this does not exclude the
possibility that this department, too, may contribute to advisory and
consultancy activity, if the independence of analyses and evaluations is
ensured. Some banks have also introduced a system of evaluating their activities,
which does not replace, but supplements the function of the bank’s internal
audit. This is a formal and documented process whereby management and employees
analyse their activities and evaluate the effectiveness of the related internal
control procedures (Hawkes, 1994). Financial Performance There
are many aspects of the performance of commercial banks that can be analysed.
Muga (2012) stated that the importance of bank profitability can be appraised
at the micro and macro levels of the economy. At the micro level, profit is the
essential prerequisite of a competitive banking institution and the cheapest
source of funds. It is not merely a result, but also a necessity for successful
banking in a period of growing competition on financial markets. Hence the
basic aim of every bank management is to maximize profit, as an essential
requirement for conducting business. At the macro level, a sound and profitable
banking sector is better able to withstand negative shocks and contribute to
the stability of the financial system. Bank profits provide an important source
of equity especially if re-invested into the business. This should lead to safe
banks, and as such high profits could promote financial stability. Schiuma
(2003) mentioned accounting- based performance using three indicators: return
on assets (ROA), the return on total equity (ROE) and Return on Investment
(ROI).These are widely used to assess the performance of firms, including
commercial banks. Bank regulators and analysts have used ROA and ROE to assess
industry performance and forecast trends in market structure—as inputs in
statistical models to predict bank failures and mergers—and for a variety of
other purposes where a measure of profitability is desired. The main purpose of
this study was to examine if internal audit can actually enhance banks
financial performance. Internal Audit and Financial
Performance Most
internal audit professionals argue that an effective internal audit function
correlates with improved financial performance. According to Beyanga (2011), an
effective internal audit service can, in particular, help reduce overhead,
identify ways to improve efficiency and maximize exposure to possible losses
from inadequately safeguarded company assets all of which can have a
significant effect on the financial performance of an organisation. He
also stated that internal audit is an ?invaluable tool of management for
improving performance?. Fadzil et al (2005) also noted that internal auditors
help run a company more efficiently and effectively to increase shareholders
value?. Finally Hermanson and Rittenberg (2005) argued that the existence of an
effective internal audit function is associated with superior organizational
performance. At
the empirical level, a survey conducted by KPMG (1999) found that the internal
audit function in organizations where it exists, contributes substantially to
performance improvement and assist in identifying profit evidence in corporate
disasters, particularly financial fraud consistently documents an association
between weak governance. Thus internal audit by acting as a watchdog could save
the organization from malpractices and irregularities thus enabling the
organization to achieve its objectives of ensuring high level of productivity
and profit. Commercial
Banks in SomaliaThe
banking sector in Somalia is regulated by the Central bank of Somalia (CBS). Commercial
banks are licensed under banking ACT 2011, CAP 130. For the year the ended 31st
December 2016 the sector comprised of sixteen commercial banks all of them
having their head office in Mogadishu ( Commercial
Banks are an institution which accept deposits, makes business loans and offers
related services. They also allow for a variety of deposits accounts, such as
checking, savings and time deposit. These institutions are run to make profits.
Commercial banks are licensed and regulated by the central banks of their
jurisdiction (countries) in which they operate. The Somali financial sector has mainly
been market based as compared to bank however, for the last five years the
trend has rapidly changed and the sector is dominated by commercial banks that
are mainly owned by the private sector. The banks have almost 40% stake in the
Somali economy and the vital role played by the banks in financing economic
development bring to forth the need to study the funding structure of the commercial
banks. The banking sector in Somalia has undergone many revolutions from pre
independence to the current day.Somali banking sector has witnessed many
changes since the beginning of e-banking. Today, customers of banks have
efficient, fast and convenient banking services delivered through technological
innovations such as ATMS, Online Banking, and Mobile banking. Research ProblemRecent corporate accounting scandals and
the resultant outcry for transparency and honesty in reporting have given rise
to two disparate yet logical outcomes. First, Internal Auditing skills have
become crucial in untangling the complicated accounting manoeuvres that have
obfuscated financial statements. Second, public demand for change and
subsequent regulatory action has transformed corporate governance.
Increasingly, company officers and directors are under ethical and legal
scrutiny. Both trends have the common goal of responsibly addressing
investors’concerns about the financial reporting system. However there has been
laxity in implementation of internal audit findings and recommendations. The
financial statement audit is an important tool for reducing information
asymmetries and maintaining an efficient market environment, also it improves
financial performance (Musa Adeiza Farouk. & Shehu Usman Hassan, 2014)Internal
Audits are an essential management tool to be used for verifying objective evidence
of processes, to assess how successfully processes have been implemented, for
judging the effectiveness of achieving any defined target levels, to provide evidence
concerning reduction and elimination of problem areas to improve overall
financial performance (Mahzan, N.S. & Binti Hassan,N.A, 2015).As
organizations pursuing objectives in an economic environment, the company is
the meeting place of a wide range of stakeholders interested in its
performance. They can be the directors of the company as shareholders and other
third parties. This complex situation has prompted us to seek to understand
more precisely.Internal
audit can contribute to financial performance, it can also help employees keep
their place in the company the state to consider recovery of taxes, commercial
banks take steps to recover their debt, the shareholders or partners should
ensure the profitability of their investment. It could help all the actors of
the company in every level to make the company get better and themselves in the
same way. Internal audit is a method of controlling which allows different
business partners such as shareholders, personnel, commercial banks the state
to ensure the quality and reliability of the information provided. (Saud,
to the study of (Ojongo, 2014) internal auditing serve as an important
connection in the business and financial reporting processes of financial
institutions and not-for-profit organizations.Internal
auditors play a key role in monitoring a company’s risk profile and identifying
areas to improve risk management.The
aim of internal auditing is to improve financial performance. Although
commercial banks practice internal audit but still they does not performing
well according literature commercial banks practice internal audit but how
practicing internal audit effect financial performance of commercial banks. So
this study would investigate the effect of internal audit on financial
performance of commercial banks in Mogadishu, Somalia. Research Objective The objectives of the study are classified as general
and specific objectives as follows:General ObjectiveThe objective of this study will be to
establish the effect of internal audit on financial performance of commercial
banks in Mogadishu, Somalia. Specific objectives?
To evaluate the effect of control environment on financial performance.?
To assess the effect of risk assessment on financial performance.?
To explore the effect of control activities on financial performance. Research
Questions? What is the
effect of control environment on financial performance?? What is the
effect of risk assessment on financial performance??
How control activities effect in the financial performance? Significance
of the studyThis study will help in increasing the
role and image of internal audit in commercial banks to make it more effective
and professional. It will help the shareholders appreciate the role of the
internal audit as one of the most important managerial control systems in an
organization required to safeguard their interests. The management of
banks will be able to look for ways of making Internal Audit a completely
independent function from the management thus making it more effective. By
implementing recommendations given on the internal audit reports management
will be able to enhance performance of the bank. For scholars it will help them to
appreciate and enhance their knowledge of internal audit so as to adhere to the
professional ethics as required by the IAS.         Conceptual Framework The figure 1.1
explains how the independent and dependent variables affect one another. The independent
variables are Internal Audit Standards, Independence of
Internal Audit,Professional Competency,
Internal ControlsTheses independent
variables have an effect on dependent variables of financial performance of the bank such as Profitability,
and Return on assets. The extraneous
variables have an effect on Financial Performance through Intervening
variables, Bank policy, Legal frame work, Society. See Next Figure for Further



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