Internal Control

CHAPTER 1

Abstract

This research focused on the existing interaction between internal control system and corporate governance at J Sainsbury Plc with due consideration on the impact of UK’s economic performance. The researcher gives due consideration to the effect of global economic slowdown and how the firm’s management respond to counter the market volatility. Therefore, the appropriate data collection method was utilized to gather data from the study participants that included the organization’s workforce, the management, and the customers. The researcher later analyzed and evaluated the gathered data and information thoroughly for a successful outcome and recommendations for future projects in a similar field.

Introduction

Purpose

The purpose of this study is to gather relevant information on J Sainsbury’s internal control and corporate governance and to compare the data with the UK’s economic prospects. In addition, the researcher shall consider how the corporate governance strategies and internal control tactics within the business environment affect the overall performance of the firm in the long run. The views of the shareholders, consumers and other stakeholders of the organization will be analyzed to paint a clear picture of the operations of the business entity. The study also calls for an understanding of the functionality of the board of governance, the number of executive directors and the role assigned to each of them (Hoitash et al., 2011). In addition, it is understandable that the firm has non-executive directors, thus a need to study how their commercial experiences contribute to the effectiveness of the internal controls in the organization. Moreover, the paper analyzes the cooperation that exists between the firm’s audit committee and the management especially in the formulation of risk mitigation and management strategies in response to economic changes (Shlefer and Vishny, 2012).

            The topic of this research was chosen after a lengthy deliberation and a careful consideration. Since 2008 financial crisis, the UK economy has slumped significantly. Even though there are signs of recovery, the pace is gradual, rendering the economy susceptible to market shocks. The impact of the economic crisis has been felt in all sectors. In fact, the operations of most businesses shrunk due to the closure of some of the branches as the consumers spend lesser (Beasley et al., 2013). However, J Sainsbury is one of the corporations that have exhibited resilience amidst the economic downturn. The survival of the firm and its positive performance is contributed by several factors, including excellent corporate governance and internal controls. In light of this, the research investigates these aspects to explore the tactics employed by the management and the staff to boost the organizational performance.

Statement of the Problem

Since 2008 financial crisis, the stability of organizations in the United Kingdom has become a core issue for organizational policy makers to tackle. Concerns on the stability of organizations in the retail sector have dominated the public debate not only in the UK but also in other parts of the world. The latest scandals in Europe and the United States renew interest in research with regards to internal control and corporate governance (Agrawal and Chadha, 2015). Formal studies on UK economy indicate that supermarkets and chain stores exert a strong impact on economic development because they are a source of employment to the citizens while others are shareholders in such firms. In addition, Sainsbury and other organizations are a source of government’s revenue which is mostly utilized in developmental projects. Therefore, it is easy to see the close relationship and the chain that binds the state, citizens, and the organization. In light of these, a study on Sainsbury’s internal control and corporate governance sheds lights on the condition of UK’s corporations in relations to economic performance hence an addition to the existing knowledge. Besides, the research outcome and recommendations will be useful to other organizations as well.

Numerous gaps exist in the studies on internal controls and corporate governance. For example, John and Senbet (2013) have focused their attention on studying the financial dimensions on organizational performance while Johnstone and Rupley (2011) are shifting their focus towards systematic performance. Moreover, business analysts pay lesser attention to the social dimension of the organizations such as the effect of the relationship of the board, the management, and the audit committee. Contradictions exist in the previous studies as researchers fail to agree on the contributions of the board members and the management on corporate governance, hence calling for a further research. So far, a handful of studies has established a link between insolvency, internal control and corporate governance with due consideration on their impact on the economy (Hay et al., 2008). Academic uncertainties such as these begs for a keener study of the moderating factors like unsuitable control activities, weaknesses of risk consciousness, and the existing defects in the control environment.

Objectives

The objective of this project is to assess and analyze the interaction between internal control and corporate governance in J Sainsbury Plc. The paper also aims to decipher the possible ways to enhance the existing control mechanisms in the organization with due consideration of the economic conditions (Lacker et al., 2015). In this way, it will be possible to recommend ways that frauds, corporate failures, and scandals can be minimized in UK firms. Furthermore, the research seeks to understand the distinct measures applicable in mitigating risks in corporations especially in the times of economic vulnerability (Ho and Wong, 2011).

Background Information

Multiple financial scandals have shaken investors and financial markets globally. They contribute to the recognition of the fundamental role of the internal control system (ICS) in the governance plan of organizations such as J Sainsbury Plc. The concept of interaction between ICS and corporate governance covers the entire structure and process used in the management of business affairs to enhance corporate accounting and prosperity to realize the long-term value and interests of stakeholders. For more than a decade, internal control and corporate governance have gained prominence as topical and pertinent business issues due to a series of large corporate failures and scandals in The UK and USA (Ashbaugh-Skaife et al., 2012). Still, it is important to note that internal controls have existed since the era of ancient civilizations. For instance, in the Ancient Egyptian society, a dual administration existed and had a bureaucratic authority to supervise the collection of taxes.

Internal Control

Internal control refers to the process undertaken at multiple levels of the organization to provide a reasonable certainty on the attainment of effectiveness in operations, and to comply with the set rules and regulations (Chhaochharia and Grinstein, 2012). Specifically, ICS is effective if it provides sufficient protection against risks in the business environment that are detrimental to the attainment of corporate objectives. In addition, its effectiveness is judged by the availability of all of its functional components. Internal managerial processes form part of ICS, though they are unobservable from the external environment. Thus, the disclosure of ICS is imperative to enable investors to conduct independent assessments (Gillan and Starks, 2014). The latest trend in the UK’s business regulations shares this view because it asks for transparency in operations and disclosure of structural components and processes ICS with a focus on risk assessment, the control environment, information, monitoring, and communication.

Therefore, it is clear that J Sainsbury and other organizations cannot survive or succeed unless internal control systems are operational. Other business experts consider internal controls as a process influenced by the management, personnel, and board of directors. It is designed specifically to provide a reasonable assurance on the attainment of objectives such as reliable financial reporting, efficient operations, and compliance with business policies and regulations. Agency theory proposes that the independent directors are more likely to raise the board’s ability to monitor because they hardly align with the management and cannot encourage the organizations to disclose all the information to the stakeholders.

Corporate Governance

Corporate governance concerns ways to align the interests of managers and investors for the organization to operate in a beneficial manner to the shareholders and owners. It entails the relationship between the societal conceptions on the scope of accountability and the internal corporation mechanisms (Denis, 2015). Corporate governance is also defined as cultures, processes, and structures that build on the success of the business entity. Specifically, it is a set of measures endorsed in an enterprise in favor of the economic agents for regeneration and distribution of business surplus with consideration of partners’ contributions to the organization (Kirkpatrick, 2011). Simply put, it is a system where firms are controlled and directed. Given that corporate governance embodies legitimacy of accountability (because it defines the relationship between J Sainsbury Plc. and other fundamental corporate constituencies). Considering this, it is arguable that corporate governance is a mechanism to establish the control and ownership of J Sainsbury Plc. within the UK economy. Indeed, this economic and legal mechanism is alterable through a political process, especially in large corporations.

The interaction between Corporate Governance and Internal Control

In Theory, proper internal control system accelerates the level of corporate governance because it is a part of the managerial process. Firms with effective ICS ought to excel in performance given that the objectives are met in time, hence leading to good corporate governance. On the other hand, a business entity with a weak internal control system is most likely to experience poor corporate governance. In this research, some of the aspects of corporate governance examined are inclined towards the traits of the board of directors at J Sainsbury such as the board’s diligence, size, independence, and expertise of its members (Denis and Mc Connel, 2013). The board of governors is one of the most important body to monitor the internal control mechanisms like the activities of the managers. Besides, this body oversees the J Sainsbury’s overall performance and endorses the proposed policies for enactment and implementation. The roles of board members are centered on maximizing the value of the shareholder.

            When there is a separation of control and ownership, the managerial decisions are directly influenced by corporate governance mechanisms to improve efficiency, transparency and accountability. Eventually, this move will result in an enhanced financial reporting process. As a result of such a separation of management from corporate ownership, creation of informational gap is realized. Consequently, the realization necessitates the need for internal and external control mechanism through audit reports and board’s oversight.

            In the United Kingdom, the quality of J Sainsbury’s board has increasingly attracted attention over the past 2 decades as the owners and shareholders emphasize on strong corporate governance. In essence, this is not an isolated case. The latest studies indicate that majority of states around the globe emphasize on proper corporate governance mechanisms as evidenced by the enactment of codes of practice and guidelines to strengthen internal control and corporate governance mechanisms. The rationale for this alertness is because of heightened concerns over the integrity of corporations and stock market officials. Investor’s confidence can hardly be impacted unless the board of directors exercises good corporate governance to positively influence the financial reporting. To improve the integrity of financial reporting, resources should be channeled towards periodic auditing activities for greater accountability and stronger internal control. Besides, rational and logical board decisions yield good corporate governance to boost the revenue and annual performance of organizations such as J Sainsbury Plc.

J Sainsbury Plc.

J Sainsbury Plc. is one of the major supermarket and public quoted convenient store in the United Kingdom. The organization was established in the year 1869 and currently has more than 1000 stores countrywide (Competition Commission, 2013). Approximately, the firm has 160, 000 employees. The vision of J Sainsbury is to provide excellent services to customers at fair prices. In return, the organization will provide the investors and other stakeholders with sustainable and strong financial return. Improving the performance of the supermarket chain in the United Kingdom is the core focus of the board, management, and staff. However, the strategic management unit in the organization shall continue to develop and explore growth opportunities in other European markets (Enriques and Volpin, 2010).

            Sainsbury’s board is composed of four and six executive and non-executive directors respectively. Two different persons carry out the roles of chief executive and chairman separately because their distinct roles are clearly defined in the company’s laws (Kiel and Nicholson, 2013). The independence of non-executive directors allows them to contribute their varied and wide experience to the board. Furthermore, the board adheres to the provisions of the FRC’s (Financial Reporting Council) corporate governance code in the United Kingdom in compliance with the government’s requirements. Economic experts in the UK widely regard Sainsbury’s adoption of best practices as a move to reassure investors to raise their confidence.

To ensure successful operations in the organization, the internal controls in place at Sainsbury are effective. Already, in the year 2009, the economic meltdown prompted the installation of mechanisms in the organization to safeguard against potential shocks and business risks. Moreover, on a quarterly basis, Sainsbury’s board and the audit committee review the effectiveness of the operational mechanisms for internal control. Yearly, The management and the board members work hand-in-hand with the audit committee to identify, analyze, manage and mitigate prevalent risks to maintain the positive performance of the corporation. Still, there is a risk policy in Sainsbury communicated in all the departments and is constantly reviewed by the internal audit committee in preparation of a report to be shared with the board (Gramling et al., 2014). The ability of the Sainsbury to survive the 2008 economic turbulence is a testament to the effective risk management and internal control systems coupled with good corporate governance. The demonstration of resilience serves as positive news for the shareholders because of the security of their investments. There is also an effective remuneration policy in Sainsbury, given that in most organizations, the director’s remuneration is linkable to their performance. However, it is important to note that the remuneration entitlement is variable based on the attainment of the annual targets. In this way, it is possible to align the interests of the shareholders to those of the management and organizational leadership.

The main responsibility of Sainsbury’s audit committee is to monitor the organizational integrity as reflected in the formal announcements and financial statements related to the firm’s performance. Besides, the committee reviews significant judgments in relation to finances as contained in the business documents (Bushman et al., 2014). They are entrusted to make sure that the organizational financial controls and the systems of risk management or internal control operate efficiently.  In case some weaknesses are identified, the committee propose detailed actions to be implemented to reverse the negative developments. Sainsbury’s committee acts to minimize overdependence of internal auditors on external firms such as PriceWaterhouseCoopers (PWC). For instance, during the second quarter of 2013, the committee implemented the firm’s policy that restricts the engagement of PWC in non-audit services of the organization. The design of this policy is intentional to limit influence.

CHAPTER 2

Literature Review

There are multiple models of corporate governance employed in global organizations. The stark differences exhibited are as a result of the variety of capitalistic structure embedded in them. According to the study conducted by Hopt and Leyens (2014), the Anglo-American model emphasizes on the shareholder’s interests. On the other hand, the multi-stakeholder or coordinated model is associated with Japan and the European nations. Mainly, this model focuses on the interests of the managers, workers, the community, customers and the suppliers. Each of the models shows different relationship with the internal controls. Worth noting is that the interaction between the two is clear in all small organizations and often extends to non-economic and economic activities. Jackson (2011) explains the link between corporate governance and internal control but fall short of an in-depth explanation of their effect on the economy. Owing to this ambiguity, scholars interpret the interaction differently. However, grasping a better understanding of internal control and how its relationship with corporate governance can stabilize the economy calls for an understanding of the extent of influence of organizations such the United Kingdom’s Sainsbury (Forker, 2012). Still, owing to the vast nature of the influential factors in the UK, the models proposed in the literature can be flawed given that each research team formulates their concerns and scope.

Fontrodona and Dison (2016) argue that the agency theory is deeply rooted in economics and entails the relationship between the parties like the management and the shareholders. According to this theory, the shareholders expect the management and the organizational leadership to make decisions and act in the interest of the principal. Contrarily, it is not necessarily possible for the agent to meet the demands of the shareholders because they have personal goals and interests to pursue. A scenario such as this is mostly common in firms whose internal control mechanism is dysfunctional because of poor corporate governance.

Often, problems arise from the separation of control and ownership. If this is the case, the agents are more likely to focus on massive high-return projects with fixed wage and lacking the component of incentive. While it can serve as a fair assessment, separation of control and ownership cannot minimize or eradicate corporate misconducts that are detrimental to the economy. Cohen et al. (2012), observe that the enactors of corporate governance policies ought to utilize a positivist approach to control the agents using principal-made rules to maximize the investor’s value. Indeed, if a separation exists, the agency model is applicable in the alignment of the managerial goals with those of the corporate owners.

According to stewardship theory, stewards (Sainsbury’s leadership and management) maximize and protect the wealth of the shareholders by improving the organizational performance. In turn, the stewards optimise their utility functions (Davis et al., 2007; Muth et al., 2011). Stewardship theory stresses the role of the managers as stewards that integrate their goals to the organizational operations, unlike the agency theory that is based on individualist perspective. Lastly, the stakeholder theory is centered on an individual or a group of people that influence or are affected by the attainment of the firm’s objective. In the case of Sainsbury, the theory suggests that the top level management serves a network of business partners, employees, and the investors or shareholders.

The Mechanisms of Internal Control Systems

            There are multiple organizations in the UK that have wound their operations because of lack of properly functional internal controls. Root and Grumman (2011) observe that fraudulent activities due to selfish needs of the employees (or because of the collusion between the management and the board) siphon resources from the firm. In the end, the organization fails to meet its financial obligations and to honor the demands of the shareholders. The leadership of Sainsbury is well aware of this likelihood; that is why it demands of the employees to observe ethical standards and to conduct themselves with a high level of professionalism. However, Karpoff et al. (2013) note that the demands can hardly be realized if the internal control mechanisms are blunt. There is no conflict between ethical behavior and generation of financial resources for the shareholders and investors because small firms may decide to drop their standards of ethics to deliver unrealistic profits in the short-run, but in the long run, the organizational values will be diluted. Eventually, the firm will lose investors trust because of the damaged reputation as was the case for most of the business entities that failed after the economic crisis.

There are numerous dimensions of corporate governance in Europe. For example, the UK Code divides corporate governance according to the remuneration of directors and their roles, accountability, audit process, and the shareholders’ role. According to Karpoff et al. (2013), a convex association exists between the level of insider ownership and the proportion of the external board members in the UK corporate internal control process. Hanford et al., (2013) says that in most cases when there is no nominating committee or when a CEO is serving on the committee, numerous gray outsiders are appointed as compared to a handful of independent outside directors. In governance mechanism, the structure of the board is important.

            In the contracting environment, key variables explain the managerial ownership that includes the unobserved heterogeneity of the firm (Hoskisson et al., 2012). Given that the audit committee are specialists in management control, the internal audit committee system plays a significant role in the oversight practices in the internal environment. Some of the activities handled by internal audit committee include the appraisal of control system effectiveness by correcting the managerial actions in line with the planned outcomes. As Walsh and Steward (2015) conclude, there is a striking similarity between its role and the management control. Furthermore, the internal auditors play an intermediary role between the audit committee and the senior management, especially in discharging the oversight duties (Krishnan and Visvanathan, 2013). The absence of this function mandates the management to apply other regulations to assure the board members of the functionality of internal control system. In such circumstances, Sainsbury’s board must assess if the applied process provide objective and sufficient assurance. Otherwise, regular appraisal and review on the competency and functionality of internal control systems in the firm should be considered.

CHAPTER 3

Method and Executive

The researcher adopted a descriptive research design to investigate the existing relationship between the governance of J Sainsbury Plc. and the internal control system. Descriptive research (also referred to as statistical research) describes characteristics and data on the phenomenon or population being analyzed (Ramsey and Schafer, 2012). The structure classifies the phenomena as systematic, accurate, or factual. The researcher surveyed J Sainsbury plc to identify the benefits of implementation of the internal control system as well as its role with regards to the economic prospects in the United Kingdom. By using the descriptive research design, it is possible to analyze the elements naturally without making adjustments to them. Besides, this structure offers an explanation to the existent relationship between the listed research variables.

The study participants were sampled from the organizational workforce, consumers, shareholders and the stakeholders. Both quantitative and qualitative secondary and primary data were applied in the research. Regarding the primary data, the researcher gathered information directly from the study subjects using structured questionnaires. The choice of a questionnaire was considered because it can be administered easily (Marshall, 2005). Further, there was a need to include close-ended and open-ended questions. The drop-and-pick method was used in self-administration of the questionnaires. Moreover, the questionnaire contained questions on corporate governance, internal control, and UK’s economic prospects.

 Content validity is used to test the accuracy and validity of research data collected. It is a logical analysis process that entails a critical and careful examination of research items in the questionnaire. The researcher sampled 5 managers from Sainsbury to fill in the questionnaires to make sure that the content carried is valid. Reliable information used in decision making was provided in the questionnaire, implying that it can produce similar results if utilized by other scholars. Data reliability was confirmed by conducting a pre-test from other small firms in the UK.  

CHAPTER FOUR

Analysis of the Results

 The researcher employed descriptive statistics to assess the data and to establish the interaction between corporate governance and internal controls with regards to the UK economy. A comparison of the J Sainsbury plc performance over years was analyzed as well. To aid the analysis process, Version 17 SPSS software (Statistical Package for Social Sciences) was employed. The data analyst preferred SPSS because of its multiple features and utilities that analyze graphical information and data to produce a systematic outcome. Furthermore, the use of multiple regression models was necessitated by the need to determine the correlation between corporate governance and internal controls (Ott and Longnecker, 2015).

Some of the independent variables considered in the study include the board structure (BC), the size of the board members (NX), the audit committee (AUC), and multiple directorships (CEOD). On the other hand, the dependent variables included the economic conditions (EC) in the UK, control environment (CE), monitoring (M) accounting information and communication (AIC), and risk assessment (RA).

The regression equation for internal controls is:

IC= fn{RA, EC, CA, M, AIC}

The regression equation for corporate governance is:

CG=fn{AUC, NX, BC, CEOD}

The researcher issued a total of 45 questionnaires. For consistency and completeness, the survey questionnaires were counter-checked and edited. Only 42 questionnaires out of 45 used in the sample were returned for analysis, a representation of 93% response rate. On the other hand, the 3 questionnaires that were not returned represented 7% rate of non-response. Standard deviations, means, frequency distributions and percentages are used to present the study outcome. The mean for corporate governance was 52.91 whereas average internal control natural log was 6.5748

Table 1: Descriptive statistics for J Sainsbury Plc.

Correlations

Using the natural log to measure internal control indicated a positive correlation to the control environment log (CE) at 0.6 with the significance of 1%. This conforms to the previous study that suggested the negative correlation between the risk assessment and internal control’s natural log with the significance of 5%. The implication of the negative correlation is that internal controls (IC) accelerated as risk assessment value decreased. Additionally, the natural log of IC was positively correlated with all the independent variables in the study, while fewer governance variables were related. However, their correlations are not indicative of multicollinearity as a significant issue.

The corporate governance variable indicated negative correlation (-0.078 natural log) as per the attributes of corporate governance. Besides, it was insignificant at 1% or 5% level. Early studies applied corporate governance in explanation of internal control variations. However, it is important to note that a risky organization has higher chances of running the risk of audit failure (Solomon et al., 2013). Resultantly, increased audit control will require intensive testing of the audit.

Conclusion

From the study, it can be concluded that Sainsbury Plc incorporated multiple parameters for use in gauging corporate governance and internal controls. The majority of the respondents agreed that the organization (as indicated by the averaged obtained from the inquiry) had instituted a stronger internal control system and excellent corporate governance measures. It is undeniable that there are numerous shortcomings in the previous research, hence a need for cautious interpretation of the research outcome on the role of the board of directors in corporate governance and their attributes (Baysinger and Hoskisson, 2011). Besides, this study confirms that a greater focus is directed towards the financial dimensions of the organizational performance, with little attention given to the formulation of strategies to minimize the impact of economic recessions on the performance of the organization.

According to the opinions of the respondents, it is true that the management gives lesser attention for the social dimensions of the corporate performance. In this area of study, many researchers in previous works offer conflicting information regarding the emphasis laid on business performance while social, cultural, and religious issues remain unexplored. Therefore, it is arguable that there is a wider area in the field for collaborative researchers to explore and to bridge the existing gaps. In a context such as this, corporate governance is amplified through economic and legal institutions alterable through political processes.

It is safe to conclude that Sainsbury complies with the provisions as recommended by the UK’s corporate governance code, hence indicating that the business entity has proper mechanisms in place to protect shareholder’s interests. Actual financial reports and data from the respondent are in support of this claim (Doyle et al., 2007). Furthermore, the firm executes its operations in a socially responsible and transparent manner, thus sending a positive signal to the potential investors and the existing shareholders.

The management of Sainsbury Plc. pays adequate attention and recognizes the independence of internal and external auditors for effective internal control. The recognition is important especially in improving the corporate governance and boosting the annual performance in terms of profitability and sales revenue. Moreover, it is the best way to make sure that the management represents the profits accrued by the shareholders. The study participants’ voluntary disclosure indicates that Sainsbury’s reputation is highly regarded by the workforce, the management, and the board. It is because of this reason that the firm performs positively even in times of economic crisis.

The leadership should neither sustain nor consider internal control and organizational governance independently because a business entity that lacks efficient internal control mechanisms and effective long-term leadership view is not sustainable. The findings of this study further challenge the academics and managers given its practical and theoretical implications. In retrospect, this research represents a step forward in the business and economic field. Despite the fruitful insight of this research, especially on the link between internal controls and corporate governance interfaces in the UK with respect to the economy, the paper admittedly has several limitations. Therefore, the future researchers should focus on internal control and the impact of the economic performance in a banking sector because of its sensitivity.

Recommendations

From the study, Sainsbury practices good corporate governance because of the enhanced internal control system. However, it will be more interesting and beneficial if this practice is linked directly to the corporate performance index and the economic conditions. While the study emphasizes on the internal control measures for corporate governance, it is unclear how other small firms in the sector should monitor the operations exclusively to avoid overindulgence on corporate governance to a level where the organizations start exhibiting instances of negative efficiency.

Corporate governance is good for medium size corporations and start-ups, though most of them reconsider the policies only when the firm is on a brink of collapse due to economic shocks. Beyond the organization, it is recommendable that the UK government should create a central regulatory organ to enhance internal control and corporate governance guided by specified code of ethics to prevent instances of shareholder uncertainties in the case of poor economic performance (Jensen, 2013).

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