Thesis Chap 1 3 WITH PAGE

University of Perpetual Help System Laguna
Sto. Niño, City of Biñan, Laguna

College of Business and Accountancy
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EFFECTIVENESS OF INTERNAL CONTROL SYSTEM ON PROFITABILITY

OF SMES IN BIÑAN CITY
A Research Proposal
Presented to
The Faculty of the College of Business and Accountancy
In Partial Fulfillment of the

Requirements for the Degree of
Bachelor of Science in Accountancy
by
Aspa, Austin Lloyd M.

Escaño, Jerilyn C.
Valencia, Mae O.
Vinoya, Harly E.
March 2018
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TABLE OF CONTENTS
Page Number
Title Page i
Chapter 1 THE PROBLEM AND ITS SETTING
Introduction 1
Theoretical Framework 3
Operational Framework 4
Operational Model 5
Statement of the Problem 5
Statement of the Hypothesis 6
Assumption of the Study 6
Scope and Delimitation 7
Significance of the Study 7
Definition of Terms 8
Chapter 2 REVIEW OF RELATED LITERATURE AND STUDIES
State of the Art 12
Related Literature 12
Related Studies 16
Synthesis of the State-of-the-Art 25
Gap/s Bridged by the Present Study 27

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Chapter 3 RESEARCH METHODOLOGY
Research Design 28
Sources of the Data 28
Population of the Study 29
Instrumentation and Validation 30
Evaluation and Scoring 30
Data Gathering Procedure 31
Statistical Treatment of the Data 31
References 32
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Chapter 1
THE PROBLEM AND ITS SETTING
Introduction
Competition in today’s business world is increasingly tight. This is experienced
not only by large companies but also small and medium enterprises. Small and medium
enterprises (SMEs) are a very heterogeneous group. They are found in a wide array of
business activities, ranging from the single artisan producing agricultural implements for
the village market, the coffee shop at the corner, the internet café in a small town to a
small sophisticated engineering or software firm selling in overseas markets and a
medium-sized automotive parts manufacturer selling to multinational automakers in the
domestic and foreign markets. Statistical definition of SMEs varies in countries. Nikki
Natividad (2016) “In the Philippines SMEs are defined as any enterprise with 10 to 199
employees and/or assets valued from P3 million to P100 million.” Based on statistics
SMEs composed of 99.6% of the business registered in the Philippines and employ 70%
of the country's total workforce.
Every entity faces certain business risks ranging from the operational aspects to
financial aspects of the business causing it to fail in meeting its objectives. In order to
address business risks the entity establishes a system of internal control. Internal Control
is an essential element in achieving the objectives of an organization and it plays an
integral role in a company’s success.

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Giriunas (2015) “establishment of an efficient internal control system is one of the
main company management instruments at major companies; mastering and use of this
instrument under the modern economic conditions create preconditions for achieving
competitive advantage over other companies”. Competition in the business world does
not talk about only in the improvement of their products but also in the establishment of
efficient and effective Internal Control System.
Main objective of most of the profit oriented organizations established like SMEs
are to obtain profit or be profitable. They aim to maximize profit for them to grow and
expand their organizations. One of the ways in achieving this objective is the
establishment of Internal Control. Vitez (2017) "Profitability is not only achieved through
high sales and meeting consumer demand, but also from controlling costs and limiting
excessive spending". Internal Control helps promote strong daily operations at the lowest
possible cost. Hassan (2013) "Internal controls are put in place to keep the company on
course toward profitability goals and achievement of its missions and to minimize
surprises along the way". Internal Control System does not only prevent opportunities for
employees to misappropriate goods or money but also for achieving the objectives of an
organization, one of which is the maximization of profits that leads to the growth of
businesses.
This study aims to know the relationship of Internal Control System on the
profitability of an organization. The researchers will investigate the effectiveness of
Internal Control System on the profitability of various SMEs in the area chosen.
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Conceptual/ Theoretical Framework
The Systems Theory by Keraro (2014) as cited in Bertalanffy (1968) highlighted
that real systems interact with and were open to their environments and that they can
cultivate qualitatively new properties through emergence that results in ceaseless
innovation. He argued that Systems Theory centers on the arrangement of and
interrelationships between the parts which connect them into a whole rather than reducing
an entity or organization to the properties of its parts or elements. In such time, an entity
recognized a system that is independent of the concrete substance of the elements such as
various departments like accounting, human resources, financing, etc. as an example.
Hence, same principles and concepts of organization support the different disciplines,
which provide a basis for their unification. In applying the approach of Systems Theory,
the study determined that there are numerous feasible roles of governance in the strategic
management of companies.
Based on the aforementioned discussion of the study undertaken, this theory
helped the researchers to envision the fact that part of an interrelated network of
connected issues in internal control system is the isolated internal problem. Indeed this
theory supports corporate governance as one of the key role of management.
Internal Control is present in all organizations, standardized in large companies
and is often implemented in very small firms. It is important for an organization to
formalize an internal control system for it is the way in which the management
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maximizes their resources to reach their goals particularly with their financial
performance - profitability being one of its manifestation.
As stated in Muya & Gathogo (2016), profitability is the ability to make benefits
arising from the organization's business operations. It refers to money that an entity can
yield from its resources. Accordingly, it is the profit maximization that most companies
are aiming for as stated in Vinesh & Velnampy (2014). At some point, it is profitability
that captivates investors and the business is likely to survive for a long period of time
(Farah and Nina, 2016).
In Accounting Theory, profitability refers to the surplus of profit over expense for
a given period of time. Since profitability provides a clear interpretation of business
performance, it is vital to the manager of the firms and also with the owners and other
stakeholders who are associated or involved in the firm. Najed et al. (2012) ratios on
profitability such as return on assets or ROA and others are used to measure the earning
capacity of business entities and are considered as an indicator of firm's growth and
success. A high ROA ratio is a great pointer of a good performance or profitability of an
entity (Bentum, 2012).

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Operational Framework
An operational framework sets out the relationship that exists between the
variables of the study. The study is in pursuit to determine the effectiveness of internal
control system on SMEs' profitability. Given this objective, the researchers came up with
various concepts and theories that are suitable to attain such goal.
In accordance with foregoing concepts and theories, the researchers came up with
an operational model for better understanding of the study. The model below depicts the
effectiveness of internal control system as the independent variable and profitability on
the other hand as the dependent variable.
Independent Variable Dependent Variable
Effectiveness of Internal Profitability

Control System
-Return on Assets
-Risk Assessment
-Return on Equity
-Control Environment
-Gross Profit Ratio
-Control Activities
-Information and
communication
-Monitoring
-
-
Figure 1.The Operational Model of the study showing the relationship of the variables.
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Statement of the problem
This study will determine the effectiveness of internal control system to the
profitability of the SME's. This topic will seek answers specifically to the following
questions:
1. What is the level of effectiveness of internal control system of SMEs in terms of:
- Risk Assessment
- Control Environment
- Control Activities
- Information and communication
- Monitoring
2. What is the level of profitability of SMEs in terms of:

- Return on Assets
- Return on Equity
- Gross Profit Ratio
3. Is there any significant relationship between the level of effectiveness of internal
control system and level of profitability of SMEs?
Statement of the Hypothesis
This study will be testing the null hypothesis.
H0: There is no significant relationship between the level of effectiveness of internal
control system and the level of profitability of SMEs.

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Assumptions of the study
The study will revolve around the following assumptions which are the given of
the problems.
1. Internal control of the company affects the profitability of SMEs.
2. Every SME has internal control.
3. The respondents will answer the questionnaires provided to the best of their
abilities.
Scope and Delimitations
This study focused on the relationship of internal control system and profitability
of entities, particularly SMEs (Small and Medium Enterprises). The respondents of this
research are SMEs within Biñan City. The study will cover the academic year 2017-2018.
This research only includes respondents that are located in Biñan City in the
province of Laguna. This study focused only on the profitability of an entity and does not
include other business performances. Moreover, this study talks about internal control
system of the business in general and does not specify particular control of an
organization.
The independent variable in this study is the effectiveness of internal control
system. On the other hand, profitability of SMEs is the dependent variable.

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Significance of the Study
The results of this study would be beneficial to the following:
SMEs will benefit in this study since they will know that effective internal control will
contributes to their profitability.
Managers will benefit in this study for it will inform them how essential and significant
internal control in a business.
Researchers of the present study will be benefited for they will be able to know the
relationship between the variables of the study.
Future researchers will benefit in this study for it will serve as their guide in doing
upcoming research connected to their study.
Definition of Terms
For a better understanding of the discussions of this paper, the following terms are
defined both conceptually and operationally.
Effectiveness is defined as producing a desired effect (Merriam Webster, 2015).
Operationally, the effectiveness of internal control to the profitability of SMEs will be
determined on the basis of the gathered data.
Internal Control as defined by COSO framework (2015) is a process designed
implemented and maintained by those charge with governance, management, and other
personnel to provide reasonable assurance regarding the achievement of objectives

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relating to effectiveness and efficiency of operations, reliability of reporting, and
compliance with laws and regulations.
- Control activities as defined by COSO Internal Control – Integrated
Framework (2013) are the activities built up through strategies and
methodology that assistance guarantee that administration's orders to alleviate
dangers to the accomplishment of goals are done. Control activities are
performed at all levels of the element, at different stages inside business
forms, and over the innovation condition
- Control Environment is the set of measures, procedures, and structures that
give the premise to doing internal control over the association. The top
managerial staff and senior administration set up the tone at the best with
respect to the significance of interior control including expected measures of
direct (COSO Internal Control – Integrated Framework, 2013).
- Information and Communication is the ceaseless, iterative procedure of
giving, sharing, and acquiring important data (COSO Internal Control –
Integrated Framework, 2013). Internal correspondence is the methods by
which data is dispersed all through the association, streaming up, down, and
over the element. It empowers work force to get a reasonable message from
senior administration that control duties must be considered important.
- Monitoring, according to COSO, refers to the operations that managers use to
observe processes or internal controls within the entity.

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- Risk Assessment includes a dynamic and iterative process for recognizing
and dissecting risks to accomplishing the entity's goal shaping a reason for
deciding how risks ought to be overseen. Management thinks about
conceivable changes in the external environment and inside its own particular
plan of action that may hinder its capacity to accomplish its objectives (COSO
Internal Control – Integrated Framework, 2013).
Profitability is the ability to yield a gain or profit (Business Dictionary). Hence,
the profitability of SMEs refers on its ability to earn profit with the assumption that every
SME have internal controls.
- Return on Assets Ratio (ROA), frequently called the return on total assets, is
a profitability ratio that measures the net pay delivered by add up to resources
amid a period by contrasting net income with the average total assets (My
Accounting Course). At the end of the day, the return on total assets or ROA
measures how effectively an organization can deal with its advantages for
create benefits amid a period.
- Return on Equity Ratio (ROE) is a profitability ratiothat measures the
capacity of a firm to produce benefits from its investors’ interests in the
organization. As such, the return on equity ratio indicates how much benefit
every dollar of basic investors' value creates. (My Accounting Course)
- Gross Profit Ratio is a profitability ratio that ascertains the level of offers
that surpass the cost of merchandise sold (My Accounting Course). At the end
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of the day, it quantifies how proficiently an organization utilizes its materials
and work to deliver and offer items beneficially. You can consider it the
measure of cash from item deals left finished after the greater part of the
immediate expenses related with assembling the item have been paid.
SME (Small and Medium enterprises) is by definition of Divestopedia, little; be
that as it may, they outnumber extensive firms by a wide edge. Despite the fact that they
don't have the assets of huge organizations, their substance is entrepreneurial and,
therefore, they are critical to the innovation and development of a nation's economy.
Committee of Sponsoring Organizations of the Treadway Commission
(COSO) is a joint activity of the five private segment associations specifically namely
American Accounting Association, American Institute of Certified Public Accountants,
Financial Executive International, The Association of Accountants and Financial
Professionals in Business and The Institute of Internal Auditors and is committed to give
thought initiative through the direction on advancement of systems and guidance on
enterprise risk management, fraud deterrence and internal control.
Efficiency implies a level of execution that portrays a procedure that uses the
most minimal measure of contributions to make the best measure of yields. It identifies
with the utilization of all contributions to delivering any given yield, including individual
time and vitality (Investopedia).
Level a position on a real or imaginary scale of amount, quantity, extent, or
quality (Investopedia).
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Chapter 2
REVIEW OF RELATED LITERATURE AND STUDIES
This chapter presents the related literature and research collected from both local
and international sources which enclose facts and information that are relevant to the
present study. This also includes a synthesis of the art and gaps bridged by the present
studies that were presented at the end of the chapter.
State of the Art
The study has been fulfilled by the researchers through summarizing different
related studies and research works of recognition, authorized and well-known locally and
internationally. It serves as a basis for better understanding of the study’s research
problem, research design, and research methodology. The following facts helped provide
concepts for significant investigation.
Related Literature
Accordingly, Accounting Tools (2016) identifies internal control as an
interlocking arrangement of exercises that are layered onto the ordinary operating
methods of an association, with the purpose of protecting resources, limiting errors, and
guaranteeing that tasks are led in an affirmed way. Another method of looking into the
perspective of at internal controls is that these exercises are expected to alleviate the
value and sorts of risk to which a firm is subjected.

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Internal control includes some major disadvantages, which is that control
activities as often as possible back off the common procedure stream of a business, which
can lessen its general productivity as well as efficiency. Subsequently, the improvement
of a system of internal control expects management to maintain an equal proportion in
reducing risk with proficiency. This procedure can at times result in management
tolerating a specific measure of risk keeping in mind the end goal to make a key profile
that enables an organization to compete more successfully, regardless of whether it
endures intermittent losses since controls have been intentionally decreased.
A system of internal control tends to increment in exhaustiveness as firm
increments in estimate. This is required, in light of the fact that the original founders do
not have room schedule-wise to keep up total oversight when there are numerous workers
or potentially areas. Further, when an organization opens up to the public, there are extra
financial control prerequisites that must be executed, particularly if the company's offers
are to be listed on an open trade. In this way, the cost of controls tends to increment with
size. Internal control comes in numerous structures, which incorporate the following:
Board of directors supervises the whole organization, giving administration over the
management group.
Internal auditors routinely analyze all procedures, searching for failings that can
be rectified with either new controls or changes of existing controls;Procedures are
changed so in excess of one individual is associated with every one; this is done as such
that individuals can cross-check each other, decreasing fraud occurrences and the
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probability of errors;access to computer records is confined, with the goal that data is just
made accessible to those individuals who require it to lead particular errands or specific
tasks. Doing as such lessens the risk of data theft and the risk of asset theft through the
adjustment of ownership records; and resources are secured up when not in use, making it
harder to take or steal them. A key idea is that even the most thorough system of internal
control will not totally wipe out the risk of fraud or error. There will dependably be a
couple of occurrences, normally because of unexpected conditions or an exceedingly
decided exertion by somebody wants to commit misrepresentation.
Based on the article issued by the Emirates Chartered Accountants Group (2013),
business firms are in need to establish their own system of internal control due to the
gigantic development in the size and complexities of present day business endeavor.
They defined internal control as an essential prerequisite for efficient and effective
management of any association. The vast majority of the SMEs do not have the correct
system of internal control which brings about different fraudulent exercises. It has turned
into the center target of management to execute a viable internal control framework
suitable to the nature and size of the entity.Accordingly, management will not be
conceivable unless the entity has a viable internal control framework. Because of the
expansion in everyday exchanges of the business immensely, it has turned out to be
impracticable for the internal auditor to direct itemized vouch-and-post review or audit
during the internal audit method. An efficient and effective internal control system will
illuminate this issue of time constrain and make the review simpler and precise.
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The article issued by UHY Haines Norton Chartered Accountants (2014) provides
that the thought of an entity's control environment is regularly viewed as the domain of
huge firms, for example, publicly listed companies or government divisions. While the
control environment of a small or medium-sized entity (SME) may contrast from that of a
large organization, it is similarly essential that it is assessed consistently to guarantee
successful management of risks which may change with the business.
With regard to SMEs, the viability or effectiveness of the risk management in the
control environment is settled by the mentality, activities and attention to entrepreneurs
and management towards the internal control system and their apparent significance of it
to the SME's general targets. This will set the tone and culture of an organization.A
powerful control environment guarantees the following: viability and effectiveness of
activities or operations, dependability or reliability of financial reporting, consistence
with relevant laws and regulations, and protecting of assets. A review of an entity's
control environment commonly starts by playing out an assessment of risk. Risk
evaluation is the recognizable proof and examination of relevant risks which keep or
prevent an organization from accomplishing its targets. Risks ought to be considered as
far as their probability of occurrence and their effect on the organization in the event that
they happen.
As stated in the article issued by Financial Times (2015), the ratio of net profit to
investors' equity, communicated as a rate. A measure of how well an organization utilizes
investors' capital to obtain profit. Return on Equity (ROE), is a money related ratio that
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measures the return created on investors'/investors' equity, the book or bookkeeping
estimation of investors'/investors' equity which mirrors the accumulation after some time
of amounts got by the organization from stock/share issues in addition to the
profits/income held by the organization, i.e., not yet circulated in profits (bookkeeping
estimation of investors' equity is additionally equivalent to an organization's net
resources, i.e., assets less liabilities).
Related Studies
One of the essential elements in achieving the objectives of the organization is the
establishment of an Internal Control.Thus, it plays a vital role in a company’s success.
Debora et al. (2013) stated that in business organizations, Internal Control System is
essential and important for they play significant roles in achieving the organization’s
objectives. In addition, Patience (2013) stated that this system was established to achieve
appropriate management of business, to ensure faithfulness to administration policies,
and secure complete and accurate records. Moreover, as stated in Giriunas (2015)
establishment of an efficient internal control system is one of the main company
management instruments at major companies; mastering and use of this instrument under
the modern economic conditions create preconditions for achieving competitive
advantage over other companies. Competition in the business world does not talk about
only in the improvement of their products, attaining customers’ demand and getting the
trust of the public but also in the establishment of efficient and effective internal control
system.
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According to Beukes (2014) strong internal controls are very significant to
multinational organizations such as small, micro and medium enterprise because they
safeguard businesses against the risk that they will incur losses as a result of inaccurate
accounting and fraud. On the other hand lack of internal controls can be very dangerous
in an organization. And also a strong internal control system reduces the risks in
misappropriation of company funds and other resources, and is therefore needed in
controlling the balance between natural errors and fraud. Also emphasized by Beukes, it
is really an essential for an organization to invest in the establishment of internal controls
rather than to trust employees just to minimize the cost because in the long-run they will
benefit on it and regrets will be avoided. The saying that prevention is better than cure is
also relevant to internal controls. This system is very crucial to protect a company’s
assets, not only against fraud but also against physical damage, obsolescence and theft.
Based on the AICPA Employee Benefit Plan Audit Quality Centre’s literature
entitled “The Importance of Internal Control in Financial Reporting and Safeguarding
Plan Assets” (2015), effective internal control lessens the risk of loss of assets, financial
statements are trustable, guarantees that arrangement data or plan is finished and
accurate, and the operations of plans are directed as per the arrangements of appropriate
laws and controls. At the point when internal control is compelling, you have reasonable
affirmation that your plan is accomplishing its financial reporting destinations.
Consequently, when it is not effective, you have practically no such assurance. Moreover,
an effective internal control system secures your plans in two ways: by limiting open
doors for accidental mistakes or purposeful misrepresentation that may harm the
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arrangement. Preventive controls, which are intended to dismay errors or
misrepresentation, help achieve this goal; and by finding little errors before they turn out
to be enormous issues. Detective controls are intended to distinguish a fraud or error after
it has happened.
As stated in Marks (2012) an effective system of internal control provides
reasonable assurance regarding the achievement of an entity's objectives. Each of the five
components of internal control namely Control Environment, Control Activities, Risk
Assessment, Information and Communication, and Monitoring Activities must be present
to be able to have an effective system of internal control and they must function together
in a manner that reduces the risk of not achieving the objectives to an acceptable level.
Also in evaluating whether the internal control system is effective, senior management
and the board of directors determine to what degree the principles, in turn, the
corresponding traits related with each component are present and functioning. When the
principles are esteemed not to be present or working, deficiency on internal control
exists. Established criteria were set up against which effectiveness of internal control can
be evaluated. Internal control can be concluded effective if the operation objectives of the
entity are being met, financial reports are being prepared reliably, laws and regulations
were being complied with. While internal control is a process, its effectiveness is a state
or condition of the process at a point of time. In like manner the effective functioning of
segments of internal control provides reasonable assurance with respect to
accomplishment of at least one of the expressed classifications of objectives to ensure
high levels of organizational performance. Therefore the company's criteria for effective
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internal control and success of the entire organization efficiency and effectiveness of
operations have been taken to mean efficiency and effective use of its resources including
personnel, accurate information for decision making and safeguarding of assets and
records. In addition effective internal controls must fulfill three essential criteria a. They
must be appropriate (that is, the right control in the right place and commensurate to the
risk involved) b. They must function consistently as planned throughout the period (that
is, be complied with carefully by all employees involved and not bypassed when key
personnel are away or the workload is heavy) and c. They must be cost effective (that is,
the cost of implementing the control should not exceed the benefit) (Lemi and Ababa,
2015).
According to Ayagre, et al. (2014) the effectiveness of an internal control system
is subject to how liquid the system communicate with itself and how inserted it is into the
associations business forms. Again for an internal control system to be viable and give
that required affirmation to the board, there ought to be a few "agents of effectiveness".
These are a dynamic board, which does not hold up to be educated but rather a board that
comprehends the business and inquiries the present state of affairs, and a compelling, free
internal audit unit. Internal control is a procedure, yet its adequacy is a state or a
condition at purpose of the procedure. In this way it is vital for administration and the
board to assess and evaluate the adequacy of the internal control system intermittently.
The study of Paraskevi (2016) summarizes the findings that most of the banking
institutions nowadays are facing numerous risks including liquidity, financial and
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operational risks. The exposure of such institutions in a large battleground of competition
need a systematic and an efficient control necessary to determine the threat within the
entity so that appropriate actions may be done resulting in a stable functions. He
emphasized that banks are required to apply internal audit so that these ordinary
situations can be diminish and be able to continue its existence in the industry.
Furthermore, he also highlighted that the use of Internal Audit and Internal Control
System are effective in mitigating these problems given the fact that it is not possible for
banking institutions to overcome all the difficulties that they encounter simultaneously.
Profitability is the ratio to measure the performance of the company. It is the
entity’s ability to yield profit for a specific period at a rate of sales, assets and certain
capital stock. Profitability is one of the essential requisites for the firm’s long-term
survival and success. Margaretha and Supartika (2016) stated that there are several
factors that influenced profitability of SMEs; these factors include firm size, growth,
lagged profitability, productivities, firm’s age and industry affiliation. They concluded
that firm size, growth, lagged profitability, productivity and industry affiliation
significantly influenced the profitability of SMEs, while firm’s age has no significant
influence on it. They also added that productivity and firm size are the two most
influencing factors on SMEs profitability. Brush et al. (2000) as cited on Ciobanu and
Popa (2014) noted that internal factors and environment in which the company belongs
have an important influence on its profitability. Also underscore in this study that
limitation on financial access of SMEs affects its profitability. It is a great challenge for
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SMEs to access loans or to attract investments, due to this factors that slowdown their
growth, SMEs must use other methods to ensure their profitability.
The study conducted by Nishanthini and Nimalathasan (2013) says that one of the
indicators of profitability is the gross profit ratio. Gross profit ratio that can be earned
from the net deals. That is the connection between the sales and the gross profit. It
portrays the purchasing efficiency of an entity. The higher the gross profit ratio, the better
the purchasing efficiency of the entity and furthermore a high ratio of gross profit to sales
is an indication of good management as it infers that the cost of production of the
company is generally low. In any case, a relationship low gross margin is unquestionably
a peril flag.
There are a lot of problems and challenges businesses encounter in the business
world. Businesses face problems such as economic crisis, maximizing profits, hiring of
employees etc. but one of the greatest problems business firms deal with is the risk to
fraud. In Klein’s (2015) study, it was written that an organization have a yearly loss of
5% revenue because of fraud. This statistical data was from the most recent Report to the
Nation, a survey conducted by Association of Certified Fraud Examiners (ACFE2014).
On the same study, it is stated that when applied to the 2013 estimated world product, the
loss of 5% revenue is losing nearly $3.7 trillion. Every year, firm’s loss a great number of
money just because of fraud therefore fraud is considered as one of the major problems
businesses face today.

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Small and medium firms are prone to fraud and corruption especially due to its
dishonest employees and lack of strong accounting system. Boateng et al. (2014)
described fraud as the act of dishonesty with the intention of gaining personal benefits, in
more precise meaning; fraud is the act of pretending to be something one is really not.
Fraud occurs when there is confusion, complex process or high volume of disorganized
transactions. (Dhitima, 2013; Ogunleye, 2004; Iyiegbuniwe, 1998) as cited in Boateng et
al. (2014) identified weak internal control system, policies and procedure as one of the
factors that cause fraud risk to a company. Therefore, in order to reduce fraud risks,
SMEs must have a strong internal control system and organized transaction. To avoid
losing such amount of revenue, internal control system is a necessity to SMEs.
Ali, et al (2012) study evaluated and analyzed the relationship between SMEs
performance and internal control. Lack of internal control incidence as disclosed by
proprietors is affecting the level of business inadequacy still at a very low level and the
total cost brought up is still within the assumption. Even so, there’s an uncertainty if the
disclosed rate of business failure is caused bythe appropriate precautionary stepsapplied
by owners, or if they are just unwilling to expose the fact in order to present the operating
of their business as effective and efficient. This study stated that there is significant
relationship between SME’s performance and internal control. Mostly, SMEs in Malaysia
are set to put internal control into effect but it is still in basic stage and they may be
lacking of knowledge on the internal control’s advantages to their businesses.

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According to Olumola (2014), the effectiveness of internal control system bolster
productivity and development of an association by securing the general resources and
assets subsequently turning away instances of misfortune. Control measures are set up to
limit loss of the organization's benefits, properties and assets. Security measures,
resources and properties taking care of methodology and strategies are arranged and
executed to hinder misfortune. Effectiveness of internal control system thinks about the
distinguishing proof of forthcoming dangers, evaluating, estimating and dealing with the
hazard to a worthy point which the association is inclined to. The general financial,
political, ecological, and common and group hazards that can impede on the activities of
the organization are investigated by the internal control framework and are averted,
limited, exchanged or disposed of to have a profitable operation. And also according to
Nyakundi, et al. (2014) it is inferred that internal control systems as bolstered by the
research discoveries altogether affects the financial performance of SMEs.
Notwithstanding, there are challenges in the usage of internal controls particularly
considering that the inner review work which is the foundation of inside controls isn't
enough prepared by the specialized labor required, which unmistakably has influenced
their productivity as uncovered by this ponder. Insufficient budgetary assets have
likewise quickened to their wastefulness, reflected by sporadic review exercises and also
nonattendance of standard reports.
The study of Monday (2015) determines the effects of internal controls on the
profitability of the small businesses in the Lagos Metropolis. Questionnaires were given
to the 200 small businesses chosen for accessible sampling to gather primary data. Based
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on Committee of Sponsoring Organization Treadway Commission (COSO) there are six
determinants of internal control these includes, control environment, control activities,
risk assessment, information and communication, monitoring and information technology
affects the financial and operational performance of small business. The results showed
that these determinants affect significantly the profitability of the small businesses. The
study concluded that these determinants affect the profitability and survival of the
organizations positively.
Research by Ali et al., (2015) says that despite the fact that the Internal control
system was observed to be viable in the private banks furthermore an acceptable level of
financial performance is accomplished, there is still space for efforts to be heightened by
the administration and workers of the bank to build up their control system to accomplish
more prominent performance. The control environment can be further reinforced by the
top management to give a solid base to better working of the other four components. To
the extent the Public area is concerned, banks having a place to this specific part did not
have an adequately working control systems and had a direct level of financial
performance, consideration should be given to the two components i.e. control activity
and monitoring, that were observed to be frail. These banks ought to implement work
turn as it recognizes any shrouded wasteful aspects and mistakes and uncovered any
potential shortcoming in the control framework. Besides, the management must guarantee
that intermittent evaluations are done frequently to report any hidden inefficiencies and
errors and exposes any potential weakness in the control system.

28
Stated in the study of Ayyasht (2017) that all components of internal control
including control environment, control procedures, information and communication and
monitoring had positive associations with profitability. Notwithstanding, hypotheses
testing demonstrated that there are a few contrasts in the essentialness of the connection
between internal control parts and profitability.The dissection of the principal component
of internal control discovered that there is a noteworthy positive connection between
internal control system (control environment) and financial performance. This is the same
with the other components like risk assessment, data or information, control activities,
communication, and monitoring. These whole have appositive association with financial
performance. The study has come to a few outcomes that the high level of consistence
with internal control prerequisites helps in the accomplishment of internal control targets
or objectives. It gives a strong ground to upgrade profitability. The other outcome say on
the off chance that the execution of an effective internal control activity will not always
lead to a good financial performance in all directions.
Synthesis of State of the Art
From the review of related literature and studies done, it has been found out that
realization of affirmative financial performance and profitability depends on whether
firms implement internal control system or ICS. Accounting Tools (2016), UHY Haines
Norton Chartered Accountants (2014), Emirates Chartered Accountants Group (2013),
Patience (2013), Debora, et al. (2013), Giriunas (2015), Beukes (2014), AICPA
Employee Benefit Plan Audit Quality Center (2015), Marks (2012), Paraskevi (2016),
29
and Ayagre, et. al. (2014) discussed the definition of internal control system, its
importance and effectiveness. Accordingly, ICS is intended to safeguard assets, limit
errors, and ensure that tasks are led in an affirmed way, also ICS is a prerequisite for
effective and efficient management. Moreover, ICS is also considered as an essential
element to operate in good practices and is vital for good financial accounting. But then,
the implementation of internal control system must also be cost effective that is it should
not exceed the benefit as stated in the study of Demi and Ababa (2015).
On the other hand, the existence of relationship between ICS and SMEs was
portrayed in the study Ali, et al. (2012), Boateng, et al. (2014), Nyakundi, et al. (2014),
Monday (2015), Ayyasht (2017), Margaretha and Supartika (2016), Ciobanu and Popa
(2014), Olumola (2014), and Ali et al. (2015). It was discovered that the five components
of ICS together with information technology affects not just the financial but also the
operational performance of SMEs which are both keys in achieving firm’s profitability.
To determine an entity’s profitability, Nishantini and Nimalathasan (2015) and Financial
Times (2015) issued their view on how to measure profitability. It was indicated that both
Gross Profit ratio and Return on Equity and Return on Assets are all indicators of
profitability. It was also found out that the effectiveness of ICS bolster productivity and
development of an organization by securing the general assets in which will subsequently
turn away instance of issues within the entity. By then, it can be concluded from the
literature that ICS and profitability of SMEs are related with each other.
30
Gaps that will be bridged by the present study
The researchers seek to reveal the effectiveness of internal control system to the
profitability of SMEs. The following are the gaps that will be bridged:
1. There were no other studies yet conducted about the effectiveness of internal control to
the profitability of SMEs within Biñan City.
2. There were no other studies yet conducted about the effectiveness of internal control
system of SMEs within Biñan City.
3. There were no other studies yet concerning the relationship of internal control to the
profitability of SMEs within Biñan City.
In the view of the gaps identified, the researchers decided to determine the
relationship between Effectiveness of Internal Control System and Profitability of SMEs.

31
CHAPTER 3
RESEARCH AND METHODOLOGY
This chapter includes the overall method that will be used by the researchers in
determining the relationship between SMEs’ internal control system and its profitability.
Explained in details are the research design, the population of the study, the source of
data, instrumentation and validation, data gathering and statistical treatment of data.
Research Design
The study sought to examine the effectiveness of internal control system on
SMEs’ profitability. The researchers will apply the descriptive-correlation method of
research that will try to prove the significance of the relationship between the
effectiveness of internal control system and the profitability of the chosen respondents.
Correlational design looks for the variables that seem to interact with each other, so when
one of the variables moves, the others will follow.
Source of Data
The study will consider two sources of data namely; primary and secondary
sources. The primary sources of data are the responses of the respondents on the
questionnaire provided by the researchers. Secondary sources of data were the internet,
journals, articles, books and research of others deemed necessary to gather the needed
information for the study.

32
Population of the Study
Population entails all people or items with similar characteristics that a researcher
intends to study and draw statistical inferences or conclusions. The population will be
comprise of Small and Medium enterprises (SMEs) operating within the area of Binan
City. Based on the record taken from the City Government Office of Binan the total
population of SMEs in the city as of 2018 is 68 and 58 out of the total population will be
used as the respondents of this survey. The study arrived in determining the number of
respondents using the Slovin’s Formula which will be portrayed below. Also, random
sampling technique was used. 29 respondents make up small enterprises and another 29
from the medium enterprises. This is to ensure that the data gathered representing SME
as a whole were weighted equally from its division.
Slovin’s Formula:
𝑁
𝑛=
1 + 𝑁𝑒 2
considering that:
𝑛 represents the sample size
𝑁 represents the total population
𝑒 represents the margin of error which is equivalent to 0.05 or 5%
33
Instrumentation and Validation
The researchers provide self-made survey questionnaires in conducting the study.
These were distributed to the respondents for them to answer. The self-made
questionnaires were composed of two parts. The first part covered the level of
effectiveness of internal control system among SMEs located within Biñan City. Second
part dealt with the level of profitability of SMEs. Each part was composed of ten (10)
items which are answerable by four-option corresponding scale.
The instruments will undergo content and surface validity. The instrument will be
assessed by the panel of experts; one in research, one in statistics, and one in the field of
accountancy. They will evaluate and critique the survey questionnaires. After that all the
suggestions and recommendations will be incorporated in the final draft.
Evaluation and Scoring
To measure the respondents’ effectiveness of internal control system and
profitability, the following points will be used.
Assigned Numerical Categorical Verbal

Points Ranges Responses Interpretation
4 3.51 ˗ 4.00 Strongly Agree (SA) Very High
3 2.51 ˗ 3.50 Agree (A) High
2 1.51 ˗ 2.50 Disagree (D) Low
Strongly Disagree
1 1.00 ˗ 1.50 Very Low
(SD)
34
Data Gathering Procedure
The researchers prepare letters for the management of SMEs to ask permission on
conducting the survey. Actual visit to the respondents’ location was made by the
researchers to personally conduct the survey to the management of the company. Then
the researchers ensured the 100% retrieval of the answered questionnaires. Afterwards,
the gathered data were tallied and tabulated by the researchers subject to statistical
treatment.
Statistical Treatment of Data
1. Weighted Mean will be used to determine the level of (a) effectiveness of
internal control system and (b) profitability of SMEs.
2. Pearson r will be used to determine if there is a significant relationship between
the respondents; level of effectiveness of internal control system and their level of
profitability.
35
REFERENCES
Accounting Tools (2016), https://www.accountingtools.com/articles/internal-control.html

UHY Haines Norton Chartered Accountants
(2014)https://www.uhyhn.co.nz/2014/05/12/smes-the-important-role-of-internal-
control-reviews/
AICPA Employee Benefit Plan Audit Quality Center (2015) “The Importance of Internal
Control in Financial Reporting and Safeguarding Plan Assets”
Ali et al. (2015) “EFFECTIVENESS OF INTERNAL CONTROL SYSTEM IN THE
GREEK BANK SECTOR”
Ayagre, P., Gyamerah, I., &Nartey, J. (2014) “The Effectiveness of Internal Control
Systems of Banks: The Case of Ghanaian Banks”
Ayyasht, M. Y. (2017) “The impact of internal control requirements on profitability of
Palestinian shareholding companies”
Beukes, T. D. (2014) “Assessment of Internal Control Effectiveness in Selected
Ethiopian Public Universities”
Boateng, et al. (2014) “EFFECTS OF INTERNAL CONTROLS ON FINANCIAL
PERFOMANACE OF TECHNICAL TRAINING INSTITUTIONS IN KENYA”
Ciobanu, O. and Popa, O. (2014) EFFECT OF INTERNAL CONTROLS ON THE
FINANCIAL PERFORMANCE OF MANUFACTURING FIRMS IN KENYA
Debora, et al. (2013) “Effectiveness of the internal audit function”
Divestopedia https://www.divestopedia.com/definition/5158/small-and-medium-
enterprises-smes
Emirates Chartered Accountants Group (2013)
Financial Times - Lexicon http://lexicon.ft.com/Term?term=return-on-equity--roe
Giriunas, Y. L. (2015) “Impact of sources of finance on the growth of SMEs: Evidence
from Pakistan”
Jabnoun, D. A.(2012) “An Assessment of the Effectiveness of Internal Audit Unit at
Local Government Level in Adamawa State”
Paraskevi, B. G.(2016) “EFFECTS OF INTERNAL CONTROLS ON REVENUE
COLLECTION: A CASE OF KENYA REVENUE AUTHORITY”
Margaretha and Supartika (2016)
Marks, N. (2012) “How to Assess the Effectiveness of Internal Control”
36
Monday, C. (2015) “The Impact of Internal Control on the Performance of Small and
Medium Enterprise Malaysian Evidence”
My Accounting Course https://www.myaccountingcourse.com/financial-ratios/return-on-
assets
My Accounting Course https://www.myaccountingcourse.com/financial-ratios/return-on-
equity
My Accounting Course https://www.myaccountingcourse.com/financial-ratios/gross-
profit-margin
Nishanthini A. and Nimalathasan B. (2013) “Determinants of profitability: A case study
of listed manufacturing companies in Sri Lanka”
Nyakundi, D. O., Nyamita, M. O. &Tinega, T. M. (2014) “EFFECT OF INTERNAL

CONTROL SYSTEMS ON FINANCIALPERFORMANCE OF SMALL AND
MEDIUM SCALE BUSINESSENTERPRISES IN KISUMU CITY, KENYA”
Olumola, O. J. (2014) “EFFEECTIVE INTERNAL CONTROL SYSTEM; ATRIGGER

TO SUSTAINED PROFITABILITY AND GROWTH”
Patience, M. K. (2013) “Internal Control System and Activities - a Study with Albanian
Companies”
37
QUESTIONNAIRES
Effectiveness of Internal Control
1. The separation of duties is adequate.
2. Documentation of every sale of goods or services with a cash register entry, a pre
numbered receipt form, an invoice, etc. Customers are issued a duplicate.
3. Accounting for pre numbered forms.
4. Cash receiving and refunding cash duties are separated and refunds are
independently authorized.
5. Restricting access to assets.
6. Cash receipts are controlled at the earliest point of receipt.
7. Duties for key employees of the organization are defined.
8. Deposits are made daily.
9. Guidelines for controlling expenditures.
10. Collection and deposit preparation functions are segregated from accounting
functions.
38
Profitability
1. During the past years, the company has been profitable.
2. The company is stable.
3. The company still manages to be competitive.
4. During the past years, the company has been continuing to improve.
5. Compared to other manufacturing companies, the company is generally much
more profitable.
6. Increasing sales due to better management team.
7. Over the past years, the company grow an average of over 20% per year.
8. Increasing customer base or number of clients.
9. Target profits are always achieved.
10. Identify which team provides the greatest growth aspect.

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University of Perpetual Help System Laguna

Sto. Niño, City of Biñan, Laguna

EFFECTIVENESS OF INTERNAL CONTROL SYSTEM ON PROFITABILITY

In Partial Fulfillment of the

Aspa, Austin Lloyd M.

Chapter 1 THE PROBLEM AND ITS SETTING

Statement of the Problem 5

Statement of the Hypothesis 6

Assumption of the Study 6

Scope and Delimitation 7

Significance of the Study 7

Chapter 2 REVIEW OF RELATED LITERATURE AND STUDIES

State of the Art 12

Synthesis of the State-of-the-Art 25

Gap/s Bridged by the Present Study 27

Chapter 3 RESEARCH METHODOLOGY

Sources of the Data 28

Population of the Study 29

Instrumentation and Validation 30

Evaluation and Scoring 30

Data Gathering Procedure 31

Statistical Treatment of the Data 31

THE PROBLEM AND ITS SETTING

Competition in today’s business world is increasingly tight. This is experienced

small sophisticated engineering or software firm selling in overseas markets and a

medium-sized automotive parts manufacturer selling to multinational automakers in the

of the country's total workforce.

is an essential element in achieving the objectives of an organization and it plays an

integral role in a company’s success.

efficient and effective Internal Control System.

profitability of an organization. The researchers will investigate the effectiveness of

The Systems Theory by Keraro (2014) as cited in Bertalanffy (1968) highlighted

cultivate qualitatively new properties through emergence that results in ceaseless

innovation. He argued that Systems Theory centers on the arrangement of and

various departments like accounting, human resources, financing, etc. as an example.

Based on the aforementioned discussion of the study undertaken, this theory

theory supports corporate governance as one of the key role of management.

Internal Control is present in all organizations, standardized in large companies

and is often implemented in very small firms. It is important for an organization to

performance - profitability being one of its manifestation.

(Farah and Nina, 2016).

a given period of time. Since profitability provides a clear interpretation of business

success. A high ROA ratio is a great pointer of a good performance or profitability of an

entity (Bentum, 2012).

effectiveness of internal control system as the independent variable and profitability on

the other hand as the dependent variable.

Independent Variable Dependent Variable

Effectiveness of Internal Profitability

2. What is the level of profitability of SMEs in terms of:

3. Is there any significant relationship between the level of effectiveness of internal

control system and level of profitability of SMEs?

Statement of the Hypothesis

This study will be testing the null hypothesis.

H0: There is no significant relationship between the level of effectiveness of internal

control system and the level of profitability of SMEs.

1. Internal control of the company affects the profitability of SMEs.

2. Every SME has internal control.

Scope and Delimitations

The independent variable in this study is the effectiveness of internal control