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.