AN EXAMINATION OF GOVERNMENT INTERNAL

AUDITS ROLE IN IMPROVING FINANCIAL

PERFORMANCE

Stephen Kwamena Aikins, University of South Florida, USA

ABSTRACT

This research empirically examines how the work of government internal audits lead to
improvements in government financial performance. Periodic economic downturn and dwin-
dling state aid to local governments have left many public managers looking for ways to im-
prove financial oversight and operational efficiency. Although internal audit is one area with
the expertise to assess efficient utilization of financial resources and help improve oversight
and financial performance, public administration research has paid little attention to the role
of internal audit in the financial management process. A survey was sent to local government
Chief Auditors to learn of audits examination of government operations and financial man-
agement. Financial performance data were obtained from the Comprehensive Annual Finan-
cial Reports (CAFRs) of survey respondents local governments and analyzed with the survey
responses. Results show that in general, local government auditors perform more audits in
operational areas that deal with fiscal receipts and outlays. Additionally, auditors work sig-
nificantly influences local government financial performance both directly and indirectly
through improvements in internal controls and efficiency of operations.

Key Words: internal audit, financial management, financial performance, control adequacy,
control effectiveness, documented policies, procedural guidelines, government

1. INTRODUCTION

The financial challenges facing state and local governments across the
United States in recent years have resulted in the inability of resources to keep
up with citizens increasing need for government services. The property tax
accounted for 58.5% of tax revenue and 36.8% of own source revenue of all
American municipal governments (including townships) in 1992. These prop-
erty tax shares had fallen to 53.3 and 33.6%, respectively by 2007 (U.S. Cen-
sus Bureau 2009). In a recent study of city government chief finance officers
conducted by the National League of Cities (NLC), nearly 90% of respondents
reported their cities are less able to meet fiscal needs in 2010 than in previous
year, and 61% reported decreased state aid to cities as a leading factor affect-
ing their budgets (Hoene & Pagano 2010). According to the NLC survey re-
sults, city sales taxes declined in 2009 over previous year receipts by 6.6% in
constant dollars, and city finance officers projected further decline in 2010 by
4.9%. When asked about the most common responses to prospective shortfalls

Public Finance and Management

Volume 11, Number 4, pp. 306-337
2011
307 Aikins

in the 2010 fiscal year, by a wider margin the most common responses were
instituting some kind of personnel related cut (79%) and delaying or cancel-
ling capital infrastructure (69%). Two in five (44%) said their city is making
cuts in services other than public safety and human-social services that are in
higher demand during economic downturn.

The above stated situation has left many public administrators looking for
ways to improve financial oversight and operational efficiency within prevail-
ing budgetary constraints while providing reasonable levels of services to their
constituents. For this to happen, concrete measures should be put in place to
improve financial efficiency and performance. The internal audit function is
the key governmental unit with the expertise for assessing the effectiveness of
utilizing financial resources by identifying waste, inefficiencies and fraud in
budget items like the ones that the above referenced NLC survey respondents
like to cut or retain, and for making recommendations to enhance efficiency of
operations and improve financial performance. For this reason, understanding
audits role in the financial management process is essential.

The inability of resources to keep up with citizens increasing demand for

services can produce an expectation gap between what citizens expect and
what they receive from their government, and increase pressure on public offi-
cials to demonstrate a higher level of operational accountability over public
funds (Montondon 1995). Operational accountability is defined as the demon-
stration of responsibility for the efficiency and effectiveness of resource con-
version activities when measured against operating objectives (Henke 1992).
One way of ensuring operational accountability over public funds is through
effective use of internal monitoring mechanism like internal audit to improve
financial performance. Despite the importance of internal audit in the govern-
ment financial oversight process, public administration research has paid little
attention to the relationship between internal audits and efficient financial
management. Consequently, a scholarly investigation that examines the effects
of government internal audit on financial performance is greater than ever be-
fore.

The objective of this study is to investigate the extent to which internal

audits contribute to improvements in the adequacy and effectiveness of inter-
nal controls over government financial management, and to overall financial
performance. For the purpose of this research, internal controls refer to the
measures designed and implemented by the public sector manager to help ac-
complish the entitys financial goals and objectives, and to mitigate operation-
al and financial risks. Examples of these include the approval of invoices be-
fore payments, segregation of duties pertaining to the payment and recording
of financial transactions, and reviewing of recorded transactions for accuracy
and procedural compliance. Internal control adequacy means the design of the
control structure regarding the policies, procedural guidelines and related ac-
PFM 11/4 308

tivities, provide enough guidance and direction for acceptable practices and
the performance of task to ensure that the entitys goals are achieved. Internal
control effectiveness means the implemented controls are operating as intend-
ed by management. Financial performance in this instance refers to the per-
centage change in government-wide net assets, which is a reflection of the
change in the governments operating surplus or deficit.

Studies of government audits have focused on comparative accounting and

auditing for local governments (Giroux et al. 2002), compliance reporting de-
cisions in municipal audits (Kidwell 1999), the emergence of performance au-
diting as the activist auditor (Wheat 1991), determinants of audit quality in the
public sector (Deis & Giroux 1992), and comparison of internal audits in the
private and public sectors (Goodwin 2004). More recently, others have fo-
cused on ethical implications of independent quality auditing (Walters & Dan-
gol 2006), the timeliness of school district audit (Carslaw et al. 2007), and the
effectiveness of internal auditing in Israeli private and public sector organiza-
tions (Cohen & Sayag 2010). While these studies contribute to the literature
on audit quality and effectiveness, they do not investigate the effects of audits
on government financial performance. Dwelling on the theory of transaction
cost economics, the internal control framework of the Committee of Sponsor-
ing Organizations (COSO), and the literature on fiscal health, this research
extends the literature on internal audit by establishing a theoretical foundation
to explain how the work of government internal audit contributes to financial
performance through improvements in internal controls over financial man-
agement practices, and efficiency of operations.

2. INTERNAL AUDIT AND PUBLIC FINANCIAL MANAGEMENT

The broad objectives of public financial management are to achieve fiscal

discipline, efficient and effective provision of public services, and efficient
allocation of resources to reflect priority needs (Asare, 2008). Public financial
management includes the legal and organizational framework for supervising
all phases of the budget cycle, including the preparation of the budget, com-
parison of actual and budgeted revenues and expenditures, procurement, moni-
toring and reporting, as well as related internal controls and audits. Controls
systems play important role in enhancing accountability and transparency in
the governance process (Szymanski 2007; Baltaci & Yilmaz, 2006).

An audit helps to improve controls by discovering deviations from accept-

ed standards and instances of illegality, inefficiency, irregularity and ineffec-
tiveness in order to take corrective action, hold violators accountable, and take
steps to prevent further losses (Mikesell 2007). Internal audit is an independ-
ent, objective assurance and consulting activity designed to add value and im-
prove an organizations operations. It helps an organization accomplish its ob-
jectives by bringing a systematic, disciplined approach to evaluate and im-
309 Aikins

prove the effectiveness of risk management, control and governance process-

es (The Institute of Internal Auditors [IIA] 2006). Through the reviews and
reporting of the functioning of the internal control systems and offering of
recommendations for improvement, internal audit helps to enhance financial
accountability by providing governments and citizens much needed infor-
mation regarding the effectiveness and efficiency in the utilization of public
resources.

Government internal auditors bolster financial accountability through the

evaluation and improvement of internal control, risk management and govern-
ance processes. This role encompasses the policies and procedures established
to ensure the achievement of objectives (Asare, 2008). Government auditors
roles in financial accountability are also manifested by monitoring the effec-
tiveness of managements internal control structure to identify and reduce
conditions that breed corruption and misuse of resources by government offi-
cials. Therefore, as part of their financial oversight contributions, government
auditors detect and deter corruption, including misappropriation of funds, in-
appropriate or abusive acts and other misuses of power, to ensure judicious
utilization of public resources, efficiencies and cost savings. Internal auditors
also contribute to public sector governance by providing independent, objec-
tive assessment on the appropriateness of the organizations governance struc-
ture and operating effectiveness of specific governance activities, and by act-
ing as catalyst for change, advising or advocating improvements to enhance
the organizations governance structure and practices (IIA, 2006).

Government internal auditors contribute toward public sector risk man-

agement by assessing and monitoring organizational risks, recommending
controls to mitigate those risks, evaluating related trade-offs to enable the or-
ganization to accomplish its strategic and operational objectives (Asare, 2008)
thereby providing independent and objective assurance as to whether risks are
being mitigated to acceptable levels (Griffiths, 2006). For example, through
fraud risk evaluations, investigations and reporting of existing control practic-
es to mitigate fraud, internal auditors add value to the governance process
(Corain et al., 2007) by suggesting avenues for cost saving and improved fi-
nancial performance. For these reasons, there is the need for public adminis-
trators to recognize the value-added role of internal audit and to contribute to-
ward its effectiveness (Van Gansberghe, 2005) in order to help strengthen
public financial management.

As implied by the theory of transaction cost economics, operational effi-

ciency and cost economizing can lead to better financial management if a
monitoring mechanism such as internal audit helps management to gain better
control over resource allocation and have better access to cost information.
PFM 11/4 310

3. THEORETICAL FRAMEWORK

Internal audits role in improving public financial management can be ex-

plained using the theory of transaction cost economics (Williamson, 1975;
1985) and the COSO (1994) internal control framework. Transaction cost eco-
nomics theory argues the superiority of internal audit for cost economization
and outlines advantages, especially for hierarchical organizations. Additional-
ly, it conceptualizes intra-organization production as a series of activities
linked by transactions. An activity is the partial production of a good or ser-
vice, e.g. procurement for service provision, while a transaction is that stage in
the activity series where one activity ends and another begins, e.g. invoice
payment for the procurement. This theory argues that when the market is ex-
cluded to the preference of in-house production, internal organization must be
developed to replace market forces (Spraakman, 1997). Internal organization
consists of directing mechanisms for contracting, planning, coordinating and
setting standards for accomplishing activities. Likewise, there are monitoring
mechanisms concerned with reporting actual against expected activity perfor-
mance, and feedback from monitoring provides understanding of activities,
thereby facilitating the adapting of internal organization to changing condi-
tions (Spraakman, 1997). Directing and monitoring mechanisms are possible
with in-house production because of control over resource allocation and ac-
cess to better information about cost. When combined, directing and monitor-
ing mechanisms form a system of internal control for managing in-house pro-
duction and for reducing cost of activities (Spraakman, 1997).

Transaction cost economics is based on bounded rationality and opportun-

ism. Simon (1961) argues economic actors are intendedly rational, but only
limitedly so. In accepting bounded rationality and the limit of the human abil-
ity to process information, comprehensive contracting is excluded, resulting in
incomplete contract, as well as the possibility and desirability of intra activity
interventions. In this regard, transaction cost economics is primarily concerned
with designing internal mechanisms like internal controls and audit to reduce
bounded rationality. As employees of government agencies, internal auditors
are more able to easily gain the cooperation of other members of the organiza-
tion, receive crucial disclosures not available to external auditors, and able to
obtain important information regarding cost efficiency practices of the organi-
zation. For example, government internal auditors are able to obtain answers
to questions such as: are the best deals being obtained for procurement? Are
financial resources being used efficiently? Are the operations using these re-
sources effective? Through audit and reviews of internal controls aimed at an-
swering these questions, government internal auditors reduce bounded ration-
ality by furnishing public managers with the description of the effectiveness of
existing internal controls, the shortcomings of internal controls over financial
management process, and recommendations for improvement to ensure cost-
efficiency.
311 Aikins

It is important to note that despite the advantage of organizational coopera-

tion and information disclosure internal auditors have over external auditors,
the lack of independent reporting structure could hinder the formers effec-
tiveness. In an analysis of the range of internal audit units in 258 local gov-
ernment entities in the United States, Friedberg & Lutrin (2001) found varia-
tions in organizational positions of the heads of audit units, and suggested ac-
tual position and status of the internal audit unit are among the main factors
determining the measure of government internal audit independence. As ar-
gued by Bou-Raad (2000), the strength of an internal audit department must be
assessed with respect to the level of independence it enjoys from management
and from operating responsibilities. Although external auditors independence
could be impaired by comingling of auditing and consulting activities, as evi-
denced in the erstwhile Arthur Andersen and the Enron debacle, and by con-
siderations of retention in subsequent years, they are generally not subject to
internal managerial manipulations as internal auditors. Therefore, depending
on the level of independence enjoyed by government internal auditors, their
ability to render objective opinions on the adequacy and effectiveness of exist-
ing internal controls may be limited.

Internal controls include financial accounting controls and operational con-

trols (Brown 1994). Examination of controls over financial accounting helps
to determine the validity of financial statements, and reviews of operational
controls over financial transactions determines whether operations are man-
aged and controlled as senior management and the audit committee expect
them to be (Sawyer & Vinten 1996, p. 196-9). Recommendations from these
audits give public managers the opportunity to strengthen controls over finan-
cial transactions and operations and minimize losses to the public agency. The
more internal auditors review the controls over financial transactions and op-
erations, the more able they are to provide information to management about
the control weaknesses and the needed improvements. Therefore, we should
expect a positive relationship between the frequency of audits and the overall
adequacy and effectiveness of operational and financial management controls.

Fadzil et al. (2005) argue that the primary objectives of an organizations

system of internal controls are to provide administrative management reasona-
ble assurance that financial information is accurate and reliable: that the or-
ganization complies with policies, plans, procedures, laws, regulations and
contracts; assets are safeguarded against loss and theft; resources are used
economically and efficiently; and established objectives and goals for opera-
tions or programs can be met. The COSO (1994) internal control framework
outlines three objectives of internal control as: effectiveness and efficiency of
operations; reliability of financial information; and compliance with applicable
laws and regulations. When these objectives are properly achieved, internal
control should be deemed effective (Agbejule & JokiPii, 2009). Audit evalua-
PFM 11/4 312

tion of managements achievement of the internal control objectives, and rec-

ommendation for improvements, help to minimize bounded rationality and
provide management the basis to put in place the mechanisms to ensure the
internal controls over financial management practices are operating as intend-
ed. Therefore, we should expect a positive relationship between auditors
evaluation of the internal control objectives and internal control effectiveness.

The five components of the COSO (1994) internal control framework are
control environment, risk assessment, control activities, information and
communication and monitoring. Control activities refer to the practices in re-
gard to policies and procedural compliance that assure management that objec-
tives are achieved, and risk mitigation strategies are carried out effectively.
COSO suggests that control activities relate to the policies and procedures per-
taining to the segregation of duties, information processing, physical control
and performance reviews (Arens et al., 2006). A typical government finance
department seeking to properly manage its financial operations should have
documented policy and procedural guidelines that spell out acceptable practic-
es and steps for budgeting, receivables, expenditures, accounting and financial
reporting, investments and cash management. Properly documented policies
and procedural guidelines in these areas help to determine not only how the
control activities are to be carried out but also provide thorough information
for auditors assessment of the overall adequacy of control design over finan-
cial management practices. If auditors review and recommend improvements
in the existing policies and procedural guidelines to mitigate risks to the or-
ganization, management is likely to respond in the affirmative. Therefore, I
posit that there is a positive relationship between auditors recommendations
to improve documented financial polices and procedural guidelines and the
adequacy of financial management control.

Government Internal auditors monitor control adequacy and effectiveness

by assessing the quality of controls. Monitoring covers ongoing and periodic
evaluations of external supervision of internal control by management or other
parties outside the process. It ensures that controls are operating as intended
and that they are modified appropriately to cater for changes in conditions
(Arens et al., 2006, p.283). Transaction cost economics also suggests that by
comparing actual against expected activity performance, a monitoring mecha-
nism facilitates the adaption of internal organization to changing conditions
and reduction of cost of activities. This view is also echoed by Wang (2006, p.
85) who argues that a government financial monitoring system provides an
ongoing check on the budget, helps to uncover inefficient practices in opera-
tion, and to avoid further deterioration in financial condition. Thus, by com-
paring actual financial results against budgets to determine how well financial
objectives have been achieved, public managers will be in a position to identi-
fy unreasonable variances and take corrective actions to improve financial per-
formance. Most importantly, when public agency management realize that in-
313 Aikins

ternal auditors evaluate financial performance monitoring practices, they are

likely to institutionalize those practices to enhance internal controls over fi-
nancial transactions and operations. Therefore, I postulate that there is a posi-
tive effect of audits evaluation of financial performance monitoring practices
on control effectiveness and financial performance.

In addition to feedback from financial performance monitoring, internal

audit evaluations pertaining to control adequacy and control effectiveness
could provide management with vital information about the fiscal health of
local governments and help improve financial performance. Knowledge of fis-
cal health is very important because it enables the jurisdiction to finance need-
ed services, improves officials chances of re-election or bid for higher offices,
influences homeowner and business location decisions and economic devel-
opment, local government organization flexibility and human resource quality,
local government competitiveness, quality of service provision, long-term
credit worthiness, and tax cost of local government on citizens (Honadle et al.
2004). A formal warning system for local financial condition and fiscal health
would help states and local governments to predict local fiscal distress and
help avert fiscal crisis. This is critical due to the severe fiscal constraints from
state imposed tax and expenditure limitations and periodic economic down-
turn. Although various useful indicators (indices) have been developed by ac-
ademics and practitioners to measure fiscal condition and fiscal health (Brown
1993, Kloha et al. 2005, Nollengerger 2003, Hendrick 2004) there are almost
no systematic studies that demonstrate whether state and local governments
regularly assess fiscal health, whether states require local governments to con-
duct fiscal health assessments, or how states monitor financial performance of
local governments (Jung 2008). This situation creates information gap as to
whether local management makes informed decisions based on prudent finan-
cial analysis. The traditional monitoring role of internal audits regarding eval-
uation of the adequacy and effectiveness of financial and operational controls
enables them to fill this gap by identifying any control weaknesses and rec-
ommending corrective actions. Therefore, we should expect a significant posi-
tive effect of adequate and effective controls over operational and financial
management, on local government financial performance.

4. METHODOLOGY

This research utilizes mixed methodology that combines analysis of survey

data and data obtained from the Comprehensive Annual Financial Reports
(CAFR) of survey respondents. An online survey was sent to all the 387 audit
department heads of the Association of Local Government Auditors (ALGA)
as of June 2008. Heads of audit departments were chosen as the unit of analy-
sis because they occupy the highest level of the audit function and are in a bet-
ter position to provide professional assessment of the adequacy and effective-
ness of local governments internal controls over financial management. A
PFM 11/4 314

report of the initial results was generated using responses from 89 respondents
and shared with ALGA members. Additional follow-ups increased total partic-
ipation to 178, representing 46% response rate, which is typical for survey in
general and quite good for an online survey.

Among those who participated in the study, 89% were audit directors and
managers and the rest had other titles. Fifty percent had staffing level of up to
5 auditors, 32% had from 6 to 10 auditors and 18% had more than 10 auditors.
Of the returned surveys, 75% were from municipalities, 23% from counties
and 2% from other local governments. Jurisdictions of all sizes were repre-
sented, with 50% of the cities having population of less than 100,000 and 80%
of the counties having population of more than 500,000. Eighty percent of re-
spondents indicated their departments conduct performance and programmatic
audits, and 78% perform financial audits. Thirty percent of the responses came
from the north-ease census region, 20% from the south, 27% from the mid-
west and 23% from the west. Therefore, it can be argued that the survey re-
spondents were a good representation of the target population, jurisdictions
audited and types of audits performed.

The survey was conducted from early June 2008 through late October
2008. Once the online survey questionnaires were completed, financial per-
formance data for five fiscal years, 2005 through 2009, were obtained from the
CAFRs of survey respondents local governments and used in the analysis to
determine the impact of internal audit examinations on local government fi-
nancial performance.

The survey questionnaires were designed to ascertain information pertain-

ing to the areas audited, the years between audits, evaluation of internal con-
trol objectives and financial performance monitoring practices, the adequacy
and effectiveness of financial and operational controls, and recommendation to
improve documented financial policies and procedural guidelines.

Audited areas were measured by asking respondents to select the areas

they audit from a list of auditable areas. These areas include budgeting, reve-
nue collection, cash management, cash and cash equivalents, investments, ac-
counts receivable, inventory, fixed assets, procurements, expenditures, ac-
counts payable, long-term debt, payroll, transportation, public safety, fire safe-
ty, public works, parks and recreation, health and human services, human re-
sources, employee benefits, social services, Medicaid, economic development,
IT operations, information security and e-government. Years between audits
was measured on a seven point scale by asking respondents to provide infor-
mation on how often they audit each of the above-stated areas. The scale was
as follows: 1 = Audited Every Year; 2 = Audited Every 2 Years; 3 = Audited
Every 3 Years; 4 = Audited Every 4 Years; 5 = Audited Every 5 Years; 6 =
Audited Every 6 or more Years; 7 = Not Audited. The above areas were in-
315 Aikins

cluded in the measure because they help to shed light on whether areas that
involve fiscal outlays and cash inflows were audited more frequently than
non-financial areas.

Evaluation of internal control objectives was measured by asking respond-

ents to choose from a set of percentage ranges to indicate the extent to which
they include the various elements of the COSO internal control objectives, as
well as and monitoring activities in their annual audits. The elements and
monitoring activities are: efficiency of operations; effectiveness of operations;
integrity of financial records; compliance with applicable regulations; compli-
ance with applicable policies; following procedural guidelines; safeguard of
assets; monitoring of financial performance indicators; monitoring of compli-
ance with regulations, policies and procedures. These measures were included
because they provide the basis on which respondents could make judgment as
to the effectiveness of their entitys internal controls.

For the purpose of measuring recommended improvements in financial

policy and procedural guidelines, respondents were first asked whether they
review the following policies and related procedures: budget policy manual,
accounting policy manual, cash management policy, investment policy, rainy
day fund policy, and accounts receivable policy. Additionally, respondents
were asked to indicate, on a seven point Likert-scale, based on reviews per-
formed, their agreements or disagreements to the following statements: my
department recommends improvements to budget policy manual; my depart-
ment recommends improvements to accounting policy manual; my department
recommends improvement to cash management policy and procedures; my
department recommends improvements to investment policy and procedures;
my department recommends improvements to rainy day fund policy and pro-
cedures; my department recommends improvements to accounts receivable
policy and procedures; my department recommends improvements in com-
municating policy and procedural updates. These variables were measured be-
cause they provide guidelines and acceptable practices for the performance of
control activities pertaining to financial management.

This study measured three dependent variables of interests. The first two
dependent variables are Adequacy of Internal Control and Effectiveness of
Internal Control. In determining the adequacy of internal control over finan-
cial management, respondents were asked to consider a number of factors, in-
cluding: their experience auditing the specific areas being rated, the extent of
documented policies and procedures, and the guidelines provided in the pro-
cedures for the performance of control activities. In addition to these, respond-
ents were asked to consider their audit findings, from evaluation of how well
control objectives were being achieved, in deciding the extent of effectiveness
of controls over financial transactions. Based on these considerations, adequa-
cy of control design was measured by asking respondents to indicate the level
PFM 11/4 316

of adequacy on the following seven point scale: 1 = Completely Inadequate; 2

= Very Inadequate; 3 = Inadequate; 4 = Somewhat Adequate; 5 = Adequate; 6
= Very Adequate; and 7 = Completely Adequate. Likewise, the extent of con-
trol effectiveness was measured on the following 7 point scale: 1 = Complete-
ly Ineffective; 2 = Very Ineffective; 3 = Ineffective; 4 = Somewhat Effective;
5 = Effective; 6 = Very Effective; and 7 = Completely Effective.

Descriptive statistics were used to analyze the relationships between years

between audits, control adequacy and control effectiveness. Ordinal regression
was used to measure the relationships between recommended improvements in
financial policies and procedures, and the adequacy of financial management
controls; between auditors evaluation of the achievement of internal control
objectives and internal control effectiveness; and between evaluation of finan-
cial performance monitoring practices and control effectiveness.

The third and the key dependent variable of interest is local government
financial performance. This variable was operationalized by the average per-
centage change in net assets of survey respondents local government calculat-
ed over the five year period, from fiscal year 2005 through fiscal year 2009.
The financial performance data obtained from the CAFRs for this purpose
were the government-wide total net assets and change in total net assets fig-
ures for each of the above fiscal years. These were taken from the statements
of changes net assets in the management discussion and analysis (MD&A)
section of the CAFRs. The figures were chosen from this section of the
CAFRs because the section provides financial overview of the government, is
compiled from the independently audited financial statements in the CAFRs,
and is based on the GASB 34 required accrual basis of accounting, which
makes it useful for evaluating overall fiscal performance of government. In
addition to the requirement that state and local governments report govern-
ment-wide statement of net assets and statement of activities using full accrual
basis of accounting, GASB Statement No. 34 also requires management dis-
cussion and analysis of financial condition. Thus, MD&A is particularly useful
for highlighting important financial information and providing insight for fur-
ther analysis of the information in the financial report (Jung 2008).

Another reason for using government-wide net assets and changes in net
assets to calculate the dependent variable is that most of the survey respond-
ents indicated their audits cover both governmental and business-type activi-
ties. Assets are the valuable resources owned by an organization and include
current assets such as cash and accounts receivables, as well as noncurrent as-
sets such as buildings and equipment. Liabilities are what an organization
owes to others and include current liabilities such as accounts payable and
wages payable, as well as noncurrent liabilities such as long-term debt
(Wang2006). Net assets are the difference between assets and liabilities; posi-
tive net assets are often in the form of investment in an asset reserve. An asset
317 Aikins

reserve can be used to measure an organizations financial ability to withstand

financial emergency (Wang 2006). Change in net assets is the difference be-
tween total revenues and total expenses for the current year of an organization,
and it can be seen as organization-wide operating surplus or deficit. A positive
figure indicates an increase in total net assets, and a negative figure eats up the
assets reserve (Wang 2006).

Chaney et al. (2002) recommend percentage change in total net assets

(change in net assets/total net assets) as an indicator to measure financial per-
formance. They argue the use of percentage change in total net assets indica-
tors enables the user to appreciate the effect of current years surplus or deficit
on total net assets. They also suggest since the change in net assets in a single
year may not be representative of the governments overall performance, a
trend analysis over at least five years should be performed. This study follows
the recommendation of Chaney et al. (2002) by using the average of a five
year trend of percentage change in net assets to analyze the effects of govern-
ment internal audit examinations on government financial performance. Spe-
cifically, once the change in net assets and the total net assets figures were ob-
tained from the CAFRs, each years percentage change in net assets was cal-
culated for all the 176 county and municipal governments and, the values were
summed up to obtain the total percentage change in net assets for all the local
governments in the five year period. The totals were then divided by the num-
ber of years to obtain the average percentage change in net assets, which was
then used as the key dependent, financial performance, variable of interest in
the study. Ordinal regression was used to determine the extent to which Years
Between Audits, Control Effectiveness, Control Adequacy, and Financial Per-
formance Monitoring influence Financial Performance. Additionally, linear
regression was used to determine the extent to which audits performed in each
operational area contributes to Financial Performance.

In addition to the financial performance data, average population, average

per capita income and average unemployment rate for the five year period
were calculated from the demographic information provided in the CAFRs,
and included in the analysis as control variables. These were included in the
analysis as independent extraneous variables because they potentially could
influence the change in net assets of government organizations and therefore
confound the research results. For instance, the size of a jurisdictions popula-
tion may impact not only the level of revenues generated but also the level of
resource consumption in terms of expenditures for a particular year, thereby
having significant effect on changes in net assets. Kerlinger (1986) notes that a
potential extraneous variable can be controlled by including it as another at-
tribute, an observed variable, in the study. By considering the extraneous vari-
ables in their own right, I was able to determine how they interact with the in-
dependent variables of interest and the extent to which they influence local
PFM 11/4 318

government financial performance, either individually or in combination with

the independent variables of interest.

As indicated by Wang (2006 p. 160), population increase can provide

more revenues through taxes and fees but may also lead to increased spending
to support more public services. As the income per head, the per-capita in-
come measures the relative wealth of a jurisdiction and may therefore influ-
ence the level of government operating surplus or deficit. Increases in income
may suggest increase in tax base that results in improved solvency but such
increases may also suggest an increased demand for high quality public ser-
vices, which leads to higher spending and potentially deteriorating financial
condition. A higher unemployment rate may suggest a bigger need for public
assistances and services, which could negatively impact budget solvency
(Wang 2006) and hence financial performance. For these reasons, the inclu-
sion of the three as control variables helped to strengthen the data analysis.
Table 1 shows the average figures for net assets, changes in net asset, popula-
tion, per-capita income and unemployment rates calculated from the CAFRs
for all the 176 local governments.

Table 1. Average Financial and Demographic Figures of Research Sample (N = 176)

2009 2008 2007 2006 2005

Beginning 1,828,520,061 1,680,498,646 1,585,380,190 1,458,506,430 1,380,259,050
Net Assets
Change in 12,776,717 148,021,415 95,118,456 126,873,760 78,247,380
Net Assets
Ending 1,841,296,778 1,828,520,061 1,680,498,646 1,585,380,190 1,458,506,430
Net Assets
Percentage 0.006987464 0.088081841 0.059997253 0.086988825 0.056690358
Change in
Net Assets
Average Demographic Data
(2005-2009)
Population 392,788
Per Capita Income 31,793
Unemployment Rate 6.3
Source: Authors Calculation Based on Information Obtained from Comprehensive Annual Financial
Reports (CAFR) for 5 Year Period (2005-2009).
Note: All figures shown are the averages for all the 176 municipal and county governments included in
the analysis.
319 Aikins

5. RESEARCH FINDINGS
An analysis of bivariate correlations among the independent variables re-
vealed a few fairly high correlations (>0.30) among some independent varia-
bles. Since common diagnostic measures are not available in ordinal regres-
sion, the Wilk-Shapiro statistic and variance inflation factors for each model
were estimated using Ordinary Least Square. Results did not reveal problems
with non-normality of residuals or collinearity.

5.1 YEARS BETWEEN AUDITS AND INTERNAL CONTROLS

Table 2 shows the audited areas as well as the mean scores (and standard
deviations) measured on 7 point scale for Years Between Audits, Internal Con-
trol Adequacy and Internal Control Effectiveness. A closer review of Table 2
reveals that with the exception of investments and budgeting, the Years Be-
tween Audit mean scores of ten areas that engage in routine financial transac-
tions as well as fiscal outlays and inflows fall between 3.00 and 4.00 (mean
score for procurement = 3.29; expenditures = 3.27; cash and cash equivalent
=3.53; cash management = 3.56; revenue collection = 3.71; accounts receiva-
ble = 3.92; inventory = 3.97; accounts payable = 3.98; payroll =3.99, and gov-
ernmental fund = 3.98), suggesting audit cycles between every three years and
four years. Table 2 also shows that the Years Between Audit mean scores for
nine of the remaining 18 areas examined fall between 4.00 and 5.0, and the
mean scores of the other nine areas fall between 5.0 and 7.0, suggesting that
on the average, these areas are audited somewhere between every four and
five years, and at least every five years respectively. With the years between
audits being between three and four years for the areas that deal more with fis-
cal receipts and expenditures compared with the more years between audits for
the other areas, we can conclude from the analysis that our survey respondents
perform frequent audits in operational areas that deal more with fiscal receipts
and expenditures.

Table 2 also indicates that the Control Adequacy mean scores for all the
areas audited fall between 4.00 and 5.00, with the majority falling below 4.50.
These suggest our respondents rate the controls for these areas as between
Somewhat Adequate and Adequate. However, a closer look reveals the
mean scores are above 4.50 for those areas that are either involved with direct
financial transactions or with forecasting and recording receipt and outlays.
(e.g. mean scores for investments = 4.93; payroll = 4.88; budgeting = 4.87;
cash and cash equivalent = 4.82; cash management = 4.81; governmental
funds = 4.80; accounts payable = 4.70; expenditures =4.67). The findings ap-
pear to suggest that based on their experience auditing these areas, the local
government auditors believe the design of internal controls over areas that deal
with finances are relatively more adequate than other areas. A similar pattern
is noted for the Control Effectiveness mean scores which show 4.97 for budg-
eting; 4.93 for investment; 4.74 for cash management; 4.72 for both revenue
PFM 11/4 320

collection and cash and cash equivalent; and 4.64 for expenditures, suggesting
a relatively more effective internal control over areas involved in financial re-
ceipts and outlays.

Table 2. Years Between Audits, Control Adequacy and Control Effectiveness

Control
Years Between Audits Control Adequacy Effectiveness
Audited Areas Std.
Std. Devia- Std. Devia- Devia-
Range Mean tion Mean tion Mean tion
Governmental funds 1-7 3.98 2.644 4.80 .944 4.70 .897
Budgeting 1-7 4.56 2.254 4.87 1.130 4.97 .982
Revenue Collection 1-7 3.71 2.520 4.65 1.024 4.72 .988
Cash and Cash Equivalent 1-7 3.53 2.467 4.82 1.093 4.72 1.087
Cash Management 1-7 3.56 2.471 4.81 1.167 4.74 1.028
Investments 1-7 4.54 2.074 4.93 1.204 4.93 1.095
Accounts Receivable 1-7 3.92 2.323 4.44 1.138 4.28 1.097
Inventory 1-7 3.97 2.530 4.25 1.161 4.30 1.142
Fixed Assets 1-7 4.30 2.336 4.26 1.248 4.21 1.210
Procurement 1-7 3.29 2.043 4.51 1.207 4.44 1.261
Expenditures 1-7 3.27 2.380 4.67 .997 4.64 .980
Accounts Payable 1-7 3.98 2.325 4.70 .922 4.61 .973
Long-Term Debt 1-7 5.89 1.896 4.71 .944 4.67 .974
Public Safety 1-7 4.89 2.142 4.64 .932 4.66 .916
Fire Safety 1-7 5.69 1.780 4.65 .906 4.49 .943
Transportation 1-7 5.36 2.052 4.26 .972 4.31 .777
Public Works 1-7 4.71 2.070 4.34 1.033 4.38 .898
Parks and Recreation 1-7 4.75 2.016 4.13 1.208 4.21 1.050
Health & Human Services 1-7 5.38 2.133 4.30 .970 4.30 .922
Human Resources 1-7 4.88 1.857 4.34 1.167 4.38 .971
Payroll 1-7 3.99 2.278 4.88 1.020 4.63 1.112
Employee Benefits 1-7 5.15 2.007 4.51 1.078 4.53 1.001
Economic Development 1-7 5.83 1.765 4.20 .907 4.37 .897
Social Services 1-7 5.67 2.026 4.18 .873 4.18 .820
Medicaid 1-7 6.71 1.002 4.10 .692 4.08 .801
IT Operations 1-7 4.57 2.357 4.31 1.040 4.46 1.108
Information Security 1-7 4.76 2.417 4.28 1.055 4.46 1.108
E-Government 1-7 6.13 1.626 4.15 .983 4.22 1.042

With the above analysis revealing relatively high frequent audits in areas
that are involved in fiscal outlays and receipts, and auditors relatively high
rating of these areas for control adequacy and effectiveness, the researcher
sought to determine whether there are statistically significant relationships be-
tween Years Between Audits and a) Internal Control Adequacy, as well as b)
Internal Control Effectiveness. Tables 3 and 4 show cross tabulations between
Years Between Audits and Internal Control Adequacy, as well as between
Years Between Audits and Internal Control Effectiveness respectively. Ac-
cording to both Tables 3 and 4, the highest number of respondents (52) indi-
cated audits are averagely performed in 4 year cycles. As illustrated Table 3,
64% or 114 [24 +52 +38 = 114] of 178 respondents indicated on the average,
audits are performed every 3 to 5 years. Based on audits performed within the
same 3 to 5 year audit cycles, 63% or 112 of the respondents rated the internal
controls of the areas audited as between Somewhat Adequate and Very Ade-
quate. With the Pearson Chi-Square showing a significance value of 0.001, we
321 Aikins

can conclude that there is a statistically significant relationship between Years

Between Audits and the Internal Control Adequacy of the areas of audited.
The cross-tabulation in Table 4 paints almost identical picture as that of Table
3, with 112 (63%) of respondents indicating audits are performed in 3 to 5
year cycles, and 108 (61%) rating internal controls as between Somewhat Ef-
fective and Very Effective. With the significance value of the Pearson Chi-
Square being 0.000, we can also conclude that there is a statistically signifi-
cant relationship between Years Between Audits and Internal Control Effec-
tiveness.
Table 3. Relationship Between Audit Years Between Audits and Internal Control Adequacy

Internal Control Adequacy

Years
Be- Completely Very Somewhat Very Completely
Inadequate Adequate
tween Inadequate Inadequate Adequate Adequate Adequate Total
Audits
1
Year
0 0 2 2 0 0 0 4
2
Years 0 0 0 2 2 2 0 6
3
Years 0 0 2 6 14 2 0 24
4
Years 0 0 0 20 28 4 0 52
5
Years 0 0 0 28 8 2 0 38
6
Years 0 0 0 28 8 6 0 42
Not
Au- 0
dited 0 0 8 4 0 0 12
Total
0 0 4 94 64 16 0 178
Pearson Chi Square Value, 37.133 ; df, 15; Assymp. Sig. (2 Sided) = 0.001

5.2 POLICIES, PROCEDURES AND ADEQUACY OF FINANCIAL CON-

TROLS

A key goal in this research was to determine whether auditors recom-

mended improvements in documented financial policies and procedural guide-
lines do impact the adequacy of internal controls over financial management.
In the public sector, policy and procedural compliance have wider regulatory,
operational, and financial implications that need to be managed to ensure suc-
cessful accomplishment of overall goals. Therefore, the need for documented
financial management policies and procedures that provide adequate frame-
work for acceptable practices and related controls to help accomplish stated
missions and goals is critical. Respondents were asked in the survey to indi-
cate whether they review listed policies and procedures. Results reveal 78%
perform review of the documents. The key issue, however, is whether audits
PFM 11/4 322

recommendations from these reviews help to strengthen managements design

of internal controls over financial management.

Table 4. Relationship Between Years Between Audits and Internal Control Effectiveness

Internal Control Effectiveness

Years Completely Very Somewhat Very Completely

Between Ineffective Ineffective Effective
Ineffective Effective Effective Effective Total
Audits

1
Year 0 0 0 2 0 0 0 2
2
Years 0 0 2 2 0 2 2 8
3
Years 0 0 2 10 8 2 0 22
4
Years 0 0 0 16 32 4 0 52
5
Years 0 0 2 24 8 4 0 38
6
Years 0 0 0 28 10 4 0 42
Not
Au- 0
dited 0 0 10 4 0 0 14
Total
0 0 6 92 62 16 2 178
Pearson Chi Square Value, 56.677; df, 20; Assymp. Sig. (2 Sided) = 0.000

Table 5 shows the internal control adequacy model estimated by ordinal

regression. The Likert-scale data from our survey results are ordinal but can-
not be assumed continuous or equal interval (Borooah, 2002), hence the use of
ordinal regression to measure relationship between the recommendations for
policy and procedural improvements, and the adequacy of financial manage-
ment controls. Borooah (2002) argues Likert scale data are ordinal but cannot
be assumed continuous or equal-interval, implying the appropriateness of the
use of ordinal regression to analyze data measured on the Likert scale. As a
linear regression-like model, ordinal regression is appropriate for attitudinal
responses measured on an apparently continuous ordinal scale (McCullagh &
Neider, 1989). The model is also amenable to the pooling of adjacent catego-
ries and allows for the interpretation of model parameters even if the variable
is not truly continuous (McCullagh, 1980), or if there is limited justification
for category assignment (SPSS, 2003). Thus, ordinality is assumed and the
imposition of an arbitrary scoring system for the categories is thereby avoid-
ed (McCullagh, 1980, p.110).
323 Aikins

Table 5. Ordinal Regression Model Effects of Financial Policy Improvement Recommendations

(Dependent Variable is Adequacy of Financial Internal Controls) (N = 176)

Coefficient Wald-
Estimate Standard Error Statistics P Value*
Threshold 5.295 1.149 21.245 0.000
Budget Policy Manual
0.968 1.491 0.421 0.516
Accounting Policy Manual 3.257 1.423 5.239 0.022

Cash Management Policy 3.887 1.731 5.040 0.025

Investment Policy 4.822 1.960 6.052 0.014

Rainy Day Fund Policy 0.973 1.192 0.666 0.414

Accounts Receivables Policy 11.733 4.736 6.137 0.013

Communication of policy and proce-

6.953 3.210 4.691 0.030
dural updates

Model Chi-Square Statistics 174.818

Probability (Chi-Square Statistics) 0.000

Pseudo R-Square:

Cox and Snell

0.860
Nagelkerke
0.992
McFadden 0.975

Note: All variables have an expected positive sign.

Link Function: Complementary Log-log
* 1 tailed tests.

Ordinal regression requires a predicted function of the actual cumulative

probabilities underlying the regression model. This predicted function is a link
function selected according to the research issue and the characteristics of the
data. Based on the distribution of the dependent variables, I chose the compli-
mentary log-log link-function. As shown in Table 5, the model shows positive
and significant relationships between our dependent variable Internal Con-
trol Adequacy and recommendations for improvements of accounting policy
manual (p = 0.022), cash management policy and procedures (p =0.026), in-
vestment policy and procedures (p = 0.014), accounts receivable policy and
procedures (p = 0.013), as well as communication of policy and procedural
updates (p = 0.030). The Cox and Snells pseudo R-square (Cox and Snell,
1989) is based on the log likelihood for the model compared to the log likeli-
hood for a base line model. However, with categorical outcomes, it has a theo-
retical maximum value of less than 1, even for a perfect model. The Nagel-
kerkes R-square (Nagelkerke, 1991) provides an adjusted version of the Cox
and Snell R-square that adjusts the scale of the statistic to cover the full range
from 0 to 1. The McFaddens R-square (McFadden, 1974) is another version,
PFM 11/4 324

based on the log-likelihood kernels for the intercept-only model and the full
estimated model.

As indicated in Table 5, the Cox and Snell, Nagelkerke, and McFadden R-

square statistics indicate that the model is capturing at least 86% of the vari-
ance in Internal Control Adequacy. The probability of the chi-square statistic
(0.000) indicates that the model gives a significant improvement over the
baseline intercept-only model. Therefore, we can conclude that, auditors rec-
ommended improvements in documented financial policies and procedures do
significantly impact the adequacy of internal control over financial manage-
ment.

5.3 CONTROL EFFECTIVENESS AND FINANCIAL PERFORMANCE

While improvements in policy and procedural guidelines do directly im-

pact the adequacy of internal control design, the control activities in compli-
ance with these policies and procedures are the practices that help to determine
whether the internal control objectives are being achieved and the controls are
operating as intended. As argued by many scholars, when internal control ob-
jectives pertaining to efficiency of operations, integrity of financial records
and compliance with law and regulations are achieved, and when assets are
safeguarded and performance monitored, then internal controls can be deemed
effective. Given these arguments, the question that comes to mind is from the
standpoint of auditors perceived contribution to the financial management
process, do the evaluations of managements accomplishment of these objec-
tives result in control effectiveness, i.e. result in controls operating as intend-
ed?

Table 6 presents results of the Control Effectiveness model estimated by

ordinal regression. As illustrated by the Table, there is statistically significant
positive relationships between our dependent variable Control Effectiveness
and evaluation of regulatory compliance (p = 0.050); procedural compliance
(p = 0.000); efficiency of operations (p = 0.000); integrity of financial records
(p = 0.021) and financial performance monitoring (p = 0.040). The Cox and
Snell, Nagelkerke and McFadden R-square indicate that at least 88% of the
variation in Internal Control Effectiveness is explained by the variation in the-
se five variables. With the probability of the chi-square statistic (0.000) indi-
cating the model gives a significant improvement over the baseline intercept-
only model, we can conclude that auditors evaluation of managements
achievement of control objectives and financial performance monitoring prac-
tices do significantly impact the Internal Control Effectiveness.
325 Aikins

5.4 AUDIT INTERVALS, CONTROLS AND FINANCIAL PERFORMANCE

The research results so far indicate statistically significant relationships

between years between audits, internal control adequacy and internal control
effectiveness; between auditors recommendations for improvements in finan-
cial policies and the adequacy of financial management controls; and between
auditors evaluation of managements achievement of control objectives, fi-
nancial performance monitoring and internal control effectiveness. However,
it is fair to say that when evaluating ones performance, there is the possibility
of one not making an objective assessment. Therefore, it is not surprising that
there are statistically significant relationships between years between audits,
evaluations, as well as recommendations and our dependent variables. In order
to verify these results with the independent data obtained from the CAFRs,
ordinal regression was used to determine the effects of years between audits,
control adequacy, control effectiveness, and evaluation of financial perfor-
mance monitoring on Financial Performance.

Table 7 shows the financial performance model estimated by ordinal re-

gression. The results in the Table depicts statistically significant positive rela-
tionships between Financial Performance and population (p = 0.000); per capi-
ta income (p = 0.034); years between audits (p = 0.001); internal control effec-
tiveness (p = 0.001) and financial performance monitoring (p = 0.24). The Cox
and Snell, Nagelkerke and McFadden R-square all indicate that at least 99% of
the variation in Financial Performance is explained by the variation in these
four variables. Given that the probability of the chi-square statistic (0.000) in-
dicates the model gives a significant improvement over the baseline intercept-
only model, we can conclude that years between audits, evaluation of financial
performance monitoring and internal control effectiveness do actually influ-
ence Financial Performance in a significant way. Thus, more frequent audits,
evaluation of financial performance monitoring and the resulting effective in-
ternal controls lead to higher financial performance through higher positive
percentage change in net assets.

Table 8 contains the frequency distribution showing the percentages of re-

spondents who indicated the yearly intervals of audits performed in each oper-
ational area, and Table 9 shows the model coefficients for the linear regression
analysis performed to determine the extent of contribution of audits in each
operational area to financial performance. As illustrated in Table 8, higher
percentages of respondents indicated operational areas that deal with fiscal
receipts and outlays are audited within one year intervals, audits are consist-
ently performed in these areas and smaller percentages of these areas are not
audited. Comparatively, the other operational areas are mostly audited within
6 year intervals, with higher percentages of them not audited.
PFM 11/4 326

Table 6. Ordinal Regression Model - Effects of Control Objectives Evaluation (Dependent Varia-
ble: Effectiveness of Internal Control) (N = 176)

Coefficient Wald-
Estimate Standard Error Statistics P Value*
Threshold
3.334 0.675 24.380 0.000
Regulatory Compliance
3.867 0.554 3.369 0.050
Policy Compliance 5.137 2.760 3.463 0.063

Procedural Compliance 1.785 0.475 14.125 0.000

Efficiency of Operations 2.744 0.554 24.526 0.000

Effectiveness of Operations 2.283 0.319 2.996 0.083

Integrity of Financial Records 3.005 1.306 5.295 0.021

Safeguard of Assets 2.841 2.096 1.837 0.175

Financial Performance Monitor-

3.820 0.184 3.061 0.040
ing

Compliance Monitoring 3.547 2.736 1.681 0.195

Model Chi-Square Statistics 185.922

Probability (Chi-Square Statis-

0.000
tics)

Pseudo R-Square:

Cox and Snell 0.876

Nagelkerke 0.988

McFadden 0.958

Note: All variables have an expected positive sign.

Link Function: Complementary Log-log
* 1 tailed tests.

Table 9 also shows Financial Performance is a function of audits per-

formed on long-term debt (p = 0.020); public works (p = 0.017); health and
human services (p = 0.030); economic development (p = 0.050); and IT Oper-
ations (p = 0.018), suggesting audits in these areas have significant positive
influence on financial performance. The R Square value of 0.759 implies that
75.9 % of the variation in financial performance is explained by the variation
in audits performed in these 14 areas. Therefore, we can conclude that there
are statistically significant positive relationships between audits performed in
the above areas and local government financial performance. Thus, the analy-
sis using an independent financial performance indicator calculated from local
governments CAFRs does confirm the earlier results regarding the impact of
327 Aikins

internal audit activities on improvements in government financial manage-

ment.

Table 7. Ordinal Regression Model -Effects of Years Between Audits and Internal Controls (De-
pendent Variable: Financial Performance [2005-2009] (N = 176)

Coefficient Wald-
Estimate Standard Error Statistics P Value*
Threshold 4.886 1.240 15.524 0.000

Population
4.156 1.151 13.038 0.000
Per Capita Income 2.262 1.068 4.489 0.034

Unemployment Rate -1.960 1.061 3.409 0.065

Years Between Audits 3.914 1.132 11.952 0.001

Internal Control Adequacy 1.745 1.057 2.725 0.099

Internal Control Effectiveness 3.538 1.110 10.165 0.001

Financial Performance Monitoring 2.425 1.072 5.122 0.024

Model Chi-Square Statistics 479.625

Probability (Chi-Square Statistics) 0.000

Pseudo R-Square

Cox and Snell

0.987
Nagelkerke
1.000
McFadden 1.000

Note: All variables except unemployment rate have an expected positive sign.
Link Function: Complementary Log-log
* 1 tailed tests.

As illustrated in Table 9, financial performance is a function of population

(p = 0.001) as well as audits performed in the areas of governmental funds (p
= 0.048); budgeting (p = 0.023); cash management (p = 0.013); accounts re-
ceivable (p = 0.038); inventory (p = 0.043); procurement (p = 0.007); expend-
itures (p = 0.012); and revenue collection (p = 0.047). It is interesting to note
that, as indicated in Table 8, most of these areas are the same fiscal receipts
and outlays areas where the survey responses showed smaller number of years
between audits, and Table 2 showed the ratings for control adequacy and ef-
fectiveness are relatively high. Therefore, these results are very consistent
with the survey findings.
PFM 11/4 328

Table 8. Frequency Distribution for Responses Regarding Areas Audited

percentages Indicating Yearly Intervals of Audits Performed

1 Year 2 Years 3 Years 4 Years 5 Years 6 Years Not Audited Total
Governmental Funds 39.3 5.2 6.7 7.9 8.1 17.4 15.4 100
Budgeting 16.9 1.1 5.6 1.1 4.5 42.3 28.5 100
Cash Management 43.8 6.6 14.5 9.0 6.3 9.0 10.8 100
Investments 13.5 5.0 9.0 1.0 14.2 20.7 36.6 100
Accounts Receivable 41.6 5.5 6.7 5.6 13.5 12.0 15.1 100
Inventory 36.0 5.5 7.9 11.2 6.3 21.6 11.5 100
Fixed Assets 24.7 3.4 15.7 3.4 13.5 14.5 24.8 100
Procurement 28.1 13.5 25.8 5.4 7.9 7.6 11.7 100
Expenditures 43.8 7.7 11.2 5.5 11.9 10.3 9.6 100
Accounts Payable 27.0 7.9 13.6 8.7 13.2 16.6 13.0 100
Long-Term Debt 9.0 2.2 5.6 2.2 5.7 20.6 54.7 100
Public Safety 11.2 7.9 13.5 9.0 11.2 11.1 36.1 100
Fire Safety 3.4 5.6 9.0 9.0 7.9 14.5 50.7 100
Transportation 4.5 7.9 15.7 7.9 9.0 13.4 41.7 100
Public Works 9.0 13.5 12.4 7.9 13.5 13.9 30.0 100
Parks and Recreation 7.9 9.0 18.0 12.4 7.9 11.0 33.8 100
Health & Human Services 11.2 5.6 7.9 5.6 6.7 15.6 47.3 100
Human Resources 7.9 5.6 15.7 13.5 16.9 10.1 30.3 100
Payroll 22.5 11.2 12.4 8.7 11.2 13.8 20.2 100
Employee Benefits 9.0 6.8 11.2 4.5 15.7 16.9 35.9 100
Economic Development 5.6 2.2 9.0 4.5 7.9 16.8 54.0 100
Social Services 5.6 7.9 7.9 1.1 10.1 15.6 51.8 100
Medicaid 1.1 2.2 1.1 4.5 2.2 87.8 1.1 100
IT Operations 19.1 12.4 5.6 6.7 7.9 17.9 30.4 100
Revenue Collection 40.8 5.7 14.5 12.0 2.2 13.0 11.8 100
E-Government 3.4 4.5 5.6 2.2 5.6 3.4 75.3 100
329 Aikins

Table 9. Overall Model Coefficient: Effect of Area Audits on Financial Performance

Standardized
Unstandardized Coefficients Coefficients
B Std. Error Beta t Sig.
(Constant) .112 .093 1.198 .240
Population 1.000 .282 .405 3.550 .001
Per Capita Income .272 .261 .139 1.043 .305
Unemployment Rate -.125 .113 -.125 -1.104 .279
Governmental Funds .529 .256 2.797 2.066 .048
Budgeting .032 .013 .692 2.400 .023
Cash Management .049 .019 .531 2.649 .013
Investments -.023 .012 -.437 -1.890 .069
Accounts Receivable .054 .025 .543 2.166 .038
Inventory .023 .011 .566 2.124 .043
Fixed Assets -.053 .029 -.557 -1.808 .081
Procurement .047 .016 .448 2.882 .007
Expenditures .043 .016 .993 2.698 .012
Accounts Payable .006 .021 .065 .298 .768
Long-Term Debt .036 .015 .682 2.459 .020
Public Safety .027 .015 .526 1.844 .076
Fire Safety .002 .020 .013 .086 .932
Transportation -.002 .021 -.014 -.092 .927
Public Works .042 .016 .372 2.530 .017
Parks and Recreation .002 .023 .018 .088 .930
Health & Human Services .058 .025 .501 2.284 .030
Human Resources .007 .019 .055 .348 .731
Payroll .010 .020 .101 .490 .628
Employee Benefits .002 .017 .015 .099 .922
Economic Development .045 .022 .316 2.108 .050
Social Services -.005 .025 -.033 -.191 .850
Medicaid .048 .031 .237 1.531 .137
IT Operations .039 .015 .861 2.524 .018
Revenue Collection .063 .029 .546 2.119 .047
E-Government -.009 .022 -.059 -.398 .693
a. Dependent Variable: Financial Performance
R = 0.871; R Squared = 0.759; Adjusted R Squared = 0.526

6. DISCUSSION

The findings from this study reveal that by their own assessment, local
government internal auditors play significant roles in public financial man-
agement and governmental operations. Further analysis performed using inde-
pendent data from the CAFRs confirms these assessments and also indicate
audits in individual areas contribute significantly to government financial per-
formance. The findings reveal that in general, auditors perform more frequent
audits, as reflected in fewer years between audits, in areas that deal with fiscal
outlays and receipts, and that frequent audits lead to improvements in financial
performance. Given the nature of transactions that take place in these areas,
there are risks pertaining to fraud and misappropriation of funds, of which
PFM 11/4 330

public managers may not be aware until after the fact. The findings suggest
this type of managements bounded rationality is addressed through internal
audits evaluations and recommendations which lead to improved control ef-
fectiveness and hence mitigation of misappropriation risks. In this regard, the
findings confirm the argument of Corain et al. (2007) that through risk evalua-
tions, investigations and reporting of existing control practices to mitigate
fraud, internal auditors add value to the governance process. Improvements in
financial control effectiveness do not only address managements bounded
rationality but are also consistent with the arguments of Szymanski (2007)
and Baltaci & Yilmaz (2006) that controls systems play important role in en-
hancing accountability and transparency in the governance process.

An important observation from this study is that on the average, the local
government auditors audit financial areas every 3 to 4 years, and perform
more annual audits in these areas than other operational areas. The findings
also show years between audits and internal control effectiveness have signifi-
cant effect on financial performance. In general, more areas with fewer years
between audits contribute significantly to local government financial perfor-
mance. Based on the research findings, one can argue that frequent audits in
the financial areas, as reflected in the fewer years between audits, enables au-
ditors to provide feedback that helps public managers enhance operational ef-
ficiency and cost economization. This argument is supported by the findings in
Table 6 which show evaluation of control objectives has significant impact on
the effectiveness of controls over efficiency of operations and integrity of fi-
nancial records. Thus, the research results suggest local government internal
audits lead to the identification of potential savings from operational efficien-
cies and reporting of findings to management to enable them allocate re-
sources efficiently to reduce overall operational costs.

As indicated above, the research findings reveal a statistically significant

relationship between auditors evaluation of managements achievement of
internal control objectives and control effectiveness. As argued by Fadzil et al.
(2005), some of the primary objectives of an organizations system of internal
controls are to provide administrative management reasonable assurance that
financial information is accurate and reliable, and policies, procedures, appli-
cable laws and regulations are complied with. This implies in order for chief
administrators to know whether established control objectives are being
achieved, there is the need for periodic independent evaluation and reporting
to management. With the research results showing years between audits and
control effectiveness significantly influence financial performance in a posi-
tive manner, we can conclude that local government internal auditors inde-
pendent evaluations result in significant contributions to the financial over-
sight process. Thus, by providing senior management audit reports on the ac-
curacy and reliability of financial information to enable them rectify control
deficiencies, auditors help to make administrators accountable to citizens
331 Aikins

through improved controls and financial performance. The results lend some
credence to the views of Sawyer & Vinten (1996, p. 196-9) that reviews of
operational controls over financial transactions determines whether operations
are managed and controlled as senior management and the audit committee
expect them to be.

The research findings also indicate that auditors recommended improve-

ments in documented financial policies and procedures significantly impact
the adequacy of internal controls over financial management. Documented fi-
nancial policies provide broad guidelines regarding the accepted practices for
the accomplishment of an entitys mission and financial goals. Documented
procedures provide step by step guidelines for the performance of tasks to en-
sure accuracy of financial records, and serve as source of reference in times of
staffing changes. Although the analysis shows adequate internal control over
financial management does not significantly influence financial performance,
the existence of such control adequacy is important for financial governance
and accountability because it provides assurance to senior management that
the existing financial policies and procedures provide the needed guidelines to
help achieve organizational goals and manage performance risks.

An important aspect of this research was to determine the role, if any, that
government internal auditors evaluations of managements financial perfor-
mance monitoring activities plays in enhancing the effectiveness of financial
management controls and financial performance. The research findings in Ta-
bles 6 and 7 reveal that auditors evaluation of financial performance monitor-
ing practices has significant effect on control effectiveness and financial per-
formance respectively. Considering the fact that the results in Table 7 also
show a statistically significant positive relationship between control effective-
ness and financial performance, we can safely conclude that in addition to di-
rectly influencing financial performance, auditors evaluation of manage-
ments performance monitoring practices does indirectly influence financial
performance by ensuring that internal controls over financial monitoring are
operating as intended. Therefore, the result is consistent with the arguments of
Arens et al., (2006, p. 283) that monitoring ensures that controls are operating
as intended and that they are modified appropriately to cater for changes in
conditions. For control effectiveness to result from evaluations of financial
performance monitoring activities any identified and reported weaknesses and
inefficiencies ought to have been addressed by management. Therefore, the
findings are consistent with the arguments of Wang (2006, p. 85) that a gov-
ernment financial monitoring system helps to uncover inefficient practices in
operation, and to avoid further deterioration in financial condition. Further-
more, they support a key argument of transaction cost economics theory,
which suggests that by comparing actual against expected activity perfor-
mance, a monitoring mechanism facilitates the adaption of internal organiza-
tion to changing conditions and reduction of cost of activities.
PFM 11/4 332

This research focused on the role of government internal audit in improv-

ing public financial performance through enhancements of internal controls
over financial management processes. Consequently, the impacts of public
managers actions, independent of internal audit, were not included in the
study. The 46% response rate does not reflect the majority of the population
from which the sample was drawn, although the description of the respond-
ents profile provided in the methodology section reveals the survey respond-
ents were a good representation of the target population, jurisdictions audited
and types of audits performed. Despite these limitations, the results are useful
because internal audits role in financial management, accountability and
oversight is an area with little empirical research. Further study is required to
empirically review the role of public managers, independent of audits, in
strengthening internal controls to enhance financial performance, and to de-
termine whether a larger sample will make a difference in the research results.

7. CONCLUSION

The results from this study have empirically demonstrated that government
internal audits make significant contributions to financial performance through
internal control enhancements over the financial management processes. In
general, the local government auditors surveyed perform frequent audits in
areas that deal more with fiscal receipts and outlays. By the auditors own as-
sessments, frequent audits lead to improvements in the adequacy and effec-
tiveness of internal controls, thereby contributing toward public accountabil-
ity. Their work also helps to ensure internal controls are operating as intended
through improvements in operational efficiency and financial performance
monitoring. The evidence from further analysis using independent data from
CAFRs confirm the auditors assessments because it shows that more frequent
audits and the resulting effective internal controls lead to higher financial per-
formance by positively impacting the percentage change in net assets. The ev-
idence suggests this is made possible through auditors identification of poten-
tial savings from operational efficiencies that enable senior management allo-
cate resources efficiently and reduce overall operational costs.

These research findings have theoretical and practical implications for

public administration. From theoretical perspective, the examination of the
impact of audits on percentage change in net assets, to determine internal au-
dits contribution to government financial performance, represents a funda-
mental shift in focus from prior research on government internal audits. There-
fore, the findings from this research may open the door for further research to
design rigorous models that apply real world numbers to help explain the val-
ue added contributions of government internal audits to overall government
financial performance. From practical perspective, the implication for public
administration is that with the right resources, government internal audits can
333 Aikins

help make meaningful improvements in financial management. Given the lo-

cal government financial constraints due to dwindling state aid and periodic
economic downturns among others, internal audits should be viewed as part-
ners with the capability to help improve efficiency and effectiveness of opera-
tions, cost savings and the overall financial management process. This will be
fruitful only if the internal audit function is adequately resourced.

REFERENCES

Agbejule, A. & Jokipii, A. (2009). Strategy, control activities, monitoring and

effectiveness. Managerial Auditing Journal, 24(6): 500-522.

Arens, A., Elder, R. & Beasley, M. (2006). Auditing and assurance services:
An integrated approach.Uppers Saddle River, NJ: Pearson Education.

Asare, T. (2008). Internal auditing in the public sector: Promoting good gov-
ernance and performance Improvement. International Journal of Government
Financial Management. pp. 12-27.

Baltaci, M. & Yilmaz, S. (2006). Keeping an eye on sub national govern-

ments: Internal control and audit at local levels, World Bank Publications, pp.
7-15.

Borooah, V.K. (2002). Logit and probit: Ordered and multinomial models.
Newbury Park, CA: Sage Publications.

Bou-Raad, G. (2000). Internal auditors and a value-added approach: The new

business regime. Managerial Auditing Journal, 15: 182-186.

Brown, P.R. (1994). Independent auditor judgment in the evaluation of inter-

nal audit functions. Journal of Accounting Research, Autumn, pp. 444-455.

Brown, K.W. (1993). The 10 point test of financial condition: Toward an easy
to use assessment tool for smaller cities. Government Finance Review (De-
cember): 21-26.

Carslaw, C., Mason, R. & Mills, J. R. (2007). Audit timeliness of school dis-
trict audits. Journal of Public Budgeting, Accounting and Financial Manage-
ment, 19(3): 290-316.

Chaney, B., Meade, D. & Shermann, K. (2002). New governmental financial

reporting model. Journal of Government Financial Management (Spring): 25-
31.
PFM 11/4 334

Cohen, A. & Sayag, G. (2010). The effectiveness of internal auditing: Exami-

nation of its determinants in Israeli organizations. Australian Accounting Re-
view, 54(20): 297-307.

Corain, P.J.; Ferguson, C. & Moroney, R.A. (2007). Internal audit, alternative
internal audit structures, and the level of misappropriation of assets fraud.
Retrieved, March 4, 2010 from http://ssrn.com/abstract=1021611

COSO. (1994). Committee of Sponsoring Organization of Treadway Commis-

sion. Internal Control-Integrated Framework. New York, NY: AICPA.

Cox, D.R. & Snell, E.J. (1989). The analysis of binary data. London, UK:
Chapman and Hall.

Deis, D.R. & Giroux, G.A. (1992). Determinants of audit quality in the public
sector. The Accounting Review, 67(3): 462-479.

Deller, S.C., Hinds, G.D. & Hinman, D.L. (2001). Local public services in
Wisconsin: Alternatives for municipalities with a focus on privatization. De-
partment of Agricultural and Applied Economics Staff Paper Series No. 441,
University of Wisconsin-Madison/Extension.

Deller, S.C. & Stallmann, J.J. (2007). Tax expenditure limitations and eco-
nomic growth. Marquette Law Review, 90(3): 497-554.

Fadzil, F., Haron, H. & Jantan, M. (2005). Internal auditing practices and in-
ternal control system. Managerial Auditing Journal, 20(8): 844-866.

Giroux, G., Jones, R. & Pendlebury, M. (2002). Accounting and auditing for
local governments in the U.S. and the U.K. Journal of Budgeting, Accounting
and Financial Management, 14(1): 1-26.

Goodwin, J. (2004). A comparison of internal audit in the private and public

sectors. Managerial Auditing Journal, 19(5): 640-650.

Griffiths, D. (2006). Risk-based internal auditing. An introduction. Retrieved

April 16, 2010 from www.internalaudit.biz

Florida Department of Revenue. (2009). Comparison of taxes levied by county

and municipal Governments. Fiscal Year 2007-2008 and 2008-2009. Re-
trieved January27, 2009 from
http://dor.myflorida.com/dor/property/cmtable1/statewide_table1.pdf
335 Aikins

Friedberg, A. & Lutrin, C. (2001). The internal audit in U.S. local govern-
ments in the 1990s: A status report and challenges. Journal of Public Budget-
ing, Accounting and Financial Management, 13(3): 326-344.

Hoene, C.W. & Pagano, M.A. (2010). City fiscal conditions in 2010, Research
brief on Americas cities,Washington, DC: The National League of Cities.

Hence, E. (1992). Introduction to nonprofit organization accounting, 4th Ed.,

p. 13. Cincinnati, OH: Southwestern Press.

Hendrick, R. (2004). Assessing and measuring the fiscal health of local gov-
ernments: Focus on Chicago Suburban municipalities. Urban Affairs Review,
40 (1):78-114.

Honadle, B.W., Costa, C. & Cigler, B. (2004). Fiscal health of local govern-
ments. Boston: Elsevier Academic Press.

Institute of Internal Auditors (UK) (1988). Standards and guidelines for the
professional practice of Internal auditing. Institute of Internal Auditors, Lon-
don.

Institute of Internal Auditors. (2006). The role of auditing in public sector

governance. Altamonte Springs, FL: Institute of Internal Auditors.

Johnson, N., Oliff, P. & Williams, E. (2009). An update on state budget cuts.
Center on budget and policy priorities. Retrieved, January 6, 2011 from
http://www.cbpp.org/cms/index.cfm?fa=view&id=1214

Jung, C. (2008). Practices of assessing financial conditions and fiscal health

in local governments in the United States. Retrieved January 28, 2011 from
http://www.kaga21.or.kr/admin/sub04/kagafile/04_%EC%A0%95%EC%B0%
BD%ED%9B%88.pdf

Kerlinger, F.N. (1986). Foundations of behavioral research. Third edition.

New York: CBS.

Kidwell, L.A. (1999). Compliance reporting decisions in municipal audits:

The impact of budget variance and employment sector. Journal of Budgeting,
Accounting and Financial Management, 11(3): 325- 356.

Kloha, P., Weissert, C.S. & Kleine, R. (2005). Developing and testing a com-
posite model to predict local fiscal stress. Public Administration Review,
65(3):313-323.
PFM 11/4 336

Kornhauser, M.E. (2002). Legitimacy and the right of revolution: The role of
tax protests and anti-Tax rhetoric in America. Buffalo Law Review, 50 (Fall).

Maher, C. & Deller, S. (2004). The fiscal health of Wisconsin cities and vil-
lages and policy responses. Retrieved March 9, 2009 from
http://www.aae.wisc.edu/pubs/misc/docs/deller.misc.extension.2004.pdf

Maher, C. & Deller, S. (2007). Fiscal health of Wisconsin Municipalities: An

update for 2007.Retrieved, March 11, 2009 from
http://www.aae.wisc.edu/pubs/sps/pdf/stpap511.pdf

McCullagh, P. (1980). Regression models for ordinal data. Journal of Royal

Statistical Society, 42(2): 109-142.

McCullagh, P. & Neider, J.A. (1989). Generalized linear models (2nd ed.).
New York: Chapman and Hall.

Mikesell, J.L. (2007). Fiscal administration: Analysis and applications for the
public sector. Belmont, CA: Thomson Wadsworth.

Mullins, D.R. and Wallin, B.A. (2004). Tax and expenditure limitations: In-
troduction and overview. Public Budgeting and Finance, Winter, pp. 2-15.

Montondon, L. (1995). Accountability in municipalities: The use of internal

auditors and audit committees. American Review of Public Administration,
25(1): 59-67.

Nagelkerke, N.J.D. (1991). A note on the general definition of the coefficient

of determination.Biometrika, 78(3): 691-692.

National Conference of State Legislators (NCSL)

http://www.ncsl.org/programs/fiscal/tels2005.htm

Nollenberger, K. (2003). Evaluating financial condition. Washington, DC:

ICMA.
Sawyer, L.B. & Vinten, G. (1996). The manager and the internal auditor.
Wiley, Chichester.

Simon, H.A. (1961). Administrative behavior. New York, NY: Macmillan

Spraakman, G. (1997). Transaction cost economics: A theory for internal au-

dit. Managerial Auditing Journal, 12(7): 323-330.

SPSS. (2003). SPSS for Windows (Release 12.0.0). Chicago, IL: Author.
337 Aikins

Szymanski, S. (2007). How to implement economic reforms: How to fight cor-

ruption effectively in public Procurement in SEE Countries. OECD Publica-
tion.

The Institute of Internal Auditors (2006). The role of auditing in public sector
governance. Retrieved January 6, 2011 from, www.theiia.org

U.S. Census Bureau. (2009). Census of governments, [selected years], State

and local government finances by level of government and state, Washington,
DC: Cen sus Bureau.

Van Gansberghe, C.N. (2005). Internal audit: Finding its place in public fi-
nancial management, public expenditure and fiscal accountability program.
Washington, DC: World Bank.

Walters, J.E. & Dangol, R. (2006). Ethical implications of independent quality

auditing. Asian Journal of Information Technology, 5(1): 107-110.

Wang, X. (2006). Financial management in the public sector: Tools, applica-

tions and cases. New York, NY: M. E. Sharpe.

Wheat, E.M. (1991). Activist auditor: A new players in state and local politics.
Public Administration Review, 51(5): 285-392.

Williamson, O.E. (1975). Markets and hierarchies. New York, NY: Free
Press.

Williamson, O.E. (1985). The economic institutions of capitalism. New York,

NY: Free Pres.

AUTHOR BIOGRAPHICAL SKETCH

Stephen Kwamena Aikins holds a PhD from the University of Nebraska at

Omaha and is an Assistant Professor in the Department of Government and
International Affairs at the University of South Florida, Tampa, USA. His
teaching and research interests include e-government, public financial man-
agement, government auditing and political economy. He has published in var-
ious scholarly journals, including International Public Management Review,
and State and Local Government Review. His recent publications have been
on Internet-based citizen participation and financial regulatory governance.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.