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 dwindling state aid to local governments have left many public managers looking for ways to improve 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 ma nagement. Financial performance data were obtained from the Comprehensive Annual Financial 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 significantly 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 property tax shares had fallen to 53.3 and 33.6%, respectively by 2007 (U.S. Census 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 affecting their budgets (Hoene & Pagano 2010). According to the NLC survey results, 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
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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 cancelling 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 prevailing 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 officials to demonstrate a higher level of operational accountability over public funds (Montondon 1995). Operational accountability is defined as the demonstration of responsibility for the efficiency and effectiveness of resource conversion 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 government 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 before. The objective of this study is to investigate the extent to which internal audits contribute to improvements in the adequacy and effectiveness of internal 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 accomplish the entitys financial goals and objectives, and to mitigate operational and financial risks. Examples of these include the approval of invoices before 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-

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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 intended by management. Financial performance in this instance refers to the percentage 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 decisions in municipal audits (Kidwell 1999), the emergence of performance auditing 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 focused on ethical implications of independent quality auditing (Walters & Dangol 2006), the timeliness of school district audit (Carslaw et al. 2007), and the effectiveness of internal auditing in Israeli private and public sector organizations (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 Sponsoring 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 management 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, comparison of actual and budgeted revenues and expenditures, procurement, monitoring 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 accepted standards and instances of illegality, inefficiency, irregularity and ineffectiveness in order to take corrective action, hold violators accountable, and take steps to prevent further losses (Mikesell 2007). Internal audit is an independent, objective assurance and consulting activity designed to add value and improve an organizations operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and im-

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prove the effectiveness of risk management, control and governance processes (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 information 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 governance 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 effectiveness of managements internal control structure to identify and reduce conditions that breed corruption and misuse of resources by government officials. Therefore, as part of their financial oversight contributions, government auditors detect and deter corruption, including misappropriation of funds, inappropriate 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, objective assessment on the appropriateness of the organizations governance structure and operating effectiveness of specific governance activities, and by acting 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 management by assessing and monitoring organizational risks, recommending controls to mitigate those risks, evaluating related trade-offs to enable the organization 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 practices to mitigate fraud, internal auditors add value to the governance process (Corain et al., 2007) by suggesting avenues for cost saving and improved financial performance. For these reasons, there is the need for public administrators to recognize the value-added role of internal audit and to contribute toward its effectiveness (Van Gansberghe, 2005) in order to help strengthen public financial management. As implied by the theory of transaction cost economics, operational efficiency 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.

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Internal audits role in improving public financial management can be explained using the theory of transaction cost economics (Williamson, 1975; 1985) and the COSO (1994) internal control framework. Transaction cost economics theory argues the superiority of internal audit for cost economization and outlines advantages, especially for hierarchical organizations. Additionally, it conceptualizes intra-organization production as a series of activities linked by transactions. An activity is the partial production of a good or service, 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 excluded 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 performance, and feedback from monitoring provides understanding of activities, thereby facilitating the adapting of internal organization to changing conditions (Spraakman, 1997). Directing and monitoring mechanisms are possible with in-house production because of control over resource allocation and access to better information about cost. When combined, directing and monitoring mechanisms form a system of internal control for managing in-house production and for reducing cost of activities (Spraakman, 1997). Transaction cost economics is based on bounded rationality and opportunism. Simon (1961) argues economic actors are intendedly rational, but only limitedly so. In accepting bounded rationality and the limit of the human ability 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 organization, receive crucial disclosures not available to external auditors, and able to obtain important information regarding cost efficiency practices of the organization. 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 resources effective? Through audit and reviews of internal controls aimed at answering these questions, government internal auditors reduce bounded rationality 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 costefficiency.

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It is important to note that despite the advantage of organizational cooperation and information disclosure internal auditors have over external auditors, the lack of independent reporting structure could hinder the formers effectiveness. In an analysis of the range of internal audit units in 258 local government entities in the United States, Friedberg & Lutrin (2001) found variations in organizational positions of the heads of audit units, and suggested actual position and status of the internal audit unit are among the main factors determining the measure of government internal audit independence. As argued 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 evidenced in the erstwhile Arthur Andersen and the Enron debacle, and by considerations 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 existing internal controls may be limited. Internal controls include financial accounting controls and operational controls (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 managed 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 financial transactions and operations and minimize losses to the public agency. The more internal auditors review the controls over financial transactions and operations, 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 reasonable assurance that financial information is accurate and reliable: that the organization 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 operations 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-

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tion of managements achievement of the internal control objectives, and recommendation 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 intended. 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 regard to policies and procedural compliance that assure management that objectives are achieved, and risk mitigation strategies are carried out effectively. COSO suggests that control activities relate to the policies and procedures pertaining 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 practices 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 financial management practices. If auditors review and recommend improvements in the existing policies and procedural guidelines to mitigate risks to the organization, 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 mechanism 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 operation, and to avoid further deterioration in financial condition. Thus, by comparing actual financial results against budgets to determine how well financial objectives have been achieved, public managers will be in a position to identify unreasonable variances and take corrective actions to improve financial performance. Most importantly, when public agency management realize that in-

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ternal auditors evaluate financial performance monitoring practices, they are likely to institutionalize those practices to enhance internal controls over financial transactions and operations. Therefore, I postulate that there is a positive 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 fiscal health is very important because it enables the jurisdiction to finance needed services, improves officials chances of re-election or bid for higher offices, influences homeowner and business location decisions and economic development, 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 downturn. Although various useful indicators (indices) have been developed by academics 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 conduct 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 financial analysis. The traditional monitoring role of internal audits regarding evaluation of the adequacy and effectiveness of financial and operational controls enables them to fill this gap by identifying any control weaknesses and recommending corrective actions. Therefore, we should expect a significant positive 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 analysis because they occupy the highest level of the audit function and are in a better position to provide professional assessment of the adequacy and effectiveness of local governments internal controls over financial management. A

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report of the initial results was generated using responses from 89 respondents and shared with ALGA members. Additional follow-ups increased total participation 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 represented, 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 respondents 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 midwest and 23% from the west. Therefore, it can be argued that the survey respondents 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 performance 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 financial performance. The survey questionnaires were designed to ascertain information pertaining to the areas audited, the years between audits, evaluation of internal control 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, revenue collection, cash management, cash and cash equivalents, investments, accounts receivable, inventory, fixed assets, procurements, expenditures, accounts payable, long-term debt, payroll, transportation, public safety, fire safety, public works, parks and recreation, health and human services, human resources, 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 information 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-

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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 respondents 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; compliance with applicable policies; following procedural guidelines; safeguard of assets; monitoring of financial performance indicators; monitoring of compliance 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 performed, their agreements or disagreements to the following statements: my department recommends improvements to budget policy manual; my department 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 procedures; my department recommends improvements to accounts receivable policy and procedures; my department recommends improvements in communicating policy and procedural updates. These variables were measured because 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 financial management, respondents were asked to consider a number of factors, including: their experience auditing the specific areas being rated, the extent of documented policies and procedures, and the guidelines provided in the procedures for the performance of control activities. In addition to these, respondents 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, adequacy of control design was measured by asking respondents to indicate the level

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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 control effectiveness was measured on the following 7 point scale: 1 = Completely 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 financial 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 percentage change in net assets of survey respondents local government calculated 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 figures 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 government-wide statement of net assets and statement of activities using full accrual basis of accounting, GASB Statement No. 34 also requires management discussion and analysis of financial condition. Thus, MD&A is particularly useful for highlighting important financial information and providing insight for further 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 respondents indicated their audits cover both governmental and business-type activities. Assets are the valuable resources owned by an organization and include current assets such as cash and accounts receivables, as well as noncurrent assets 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; positive net assets are often in the form of investment in an asset reserve. An asset

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reserve can be used to measure an organizations financial ability to withstand financial emergency (Wang 2006). Change in net assets is the difference between 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 performance. They argue the use of percentage change in total net assets indicators 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 government internal audit examinations on government financial performance. Specifically, once the change in net assets and the total net assets figures were obtained from the CAFRs, each years percentage change in net assets was calculated 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 number 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 Performance 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 population 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 attribute, an observed variable, in the study. By considering the extraneous variables in their own right, I was able to determine how they interact with the independent variables of interest and the extent to which they influence local

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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 income measures the relative wealth of a jurisdiction and may therefore influence 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 services, 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 inclusion 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, population, 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 Beginning Net Assets 1,828,520,061 2008 1,680,498,646 148,021,415 1,828,520,061 0.088081841 2007 1,585,380,190 95,118,456 1,680,498,646 0.059997253 2006 1,458,506,430 126,873,760 1,585,380,190 0.086988825 2005 1,380,259,050 78,247,380 1,458,506,430 0.056690358

Change in 12,776,717 Net Assets Ending 1,841,296,778 Net Assets Percentage 0.006987464 Change in Net Assets Average Demographic Data (2005-2009) Population Per Capita Income Unemployment Rate

392,788 31,793 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.

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5. RESEARCH FINDINGS An analysis of bivariate correlations among the independent variables revealed a few fairly high correlations (>0.30) among some independent variables. Since common diagnostic measures are not available in ordinal regression, 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 Control Adequacy and Internal Control Effectiveness. A closer review of Table 2 reveals that with the exception of investments and budgeting, the Years Between Audit mean scores of ten areas that engage in routine financial transactions 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 receivable = 3.92; inventory = 3.97; accounts payable = 3.98; payroll =3.99, and governmental 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 fiscal 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 appear 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 budgeting; 4.93 for investment; 4.74 for cash management; 4.72 for both revenue

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collection and cash and cash equivalent; and 4.64 for expenditures, suggesting a relatively more effective internal control over areas involved in financial receipts and outlays.
Table 2. Years Between Audits, Control Adequacy and Control Effectiveness
Control Effectiveness Std. DeviaMean tion 4.70 .897 4.97 .982 4.72 .988 4.72 1.087 4.74 1.028 4.93 1.095 4.28 1.097 4.30 1.142 4.21 1.210 4.44 1.261 4.64 .980 4.61 .973 4.67 .974 4.66 .916 4.49 .943 4.31 .777 4.38 .898 4.21 1.050 4.30 .922 4.38 .971 4.63 1.112 4.53 1.001 4.37 .897 4.18 .820 4.08 .801 4.46 1.108 4.46 1.108 4.22 1.042

Years Between Audits Audited Areas Range 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 1-7 Mean 3.98 4.56 3.71 3.53 3.56 4.54 3.92 3.97 4.30 3.29 3.27 3.98 5.89 4.89 5.69 5.36 4.71 4.75 5.38 4.88 3.99 5.15 5.83 5.67 6.71 4.57 4.76 6.13 Std. Deviation 2.644 2.254 2.520 2.467 2.471 2.074 2.323 2.530 2.336 2.043 2.380 2.325 1.896 2.142 1.780 2.052 2.070 2.016 2.133 1.857 2.278 2.007 1.765 2.026 1.002 2.357 2.417 1.626

Control Adequacy Std. Deviation .944 1.130 1.024 1.093 1.167 1.204 1.138 1.161 1.248 1.207 .997 .922 .944 .932 .906 .972 1.033 1.208 .970 1.167 1.020 1.078 .907 .873 .692 1.040 1.055 .983

Governmental funds Budgeting Revenue Collection Cash and Cash Equivalent Cash Management Investments Accounts Receivable Inventory Fixed Assets Procurement Expenditures Accounts Payable Long-Term Debt Public Safety Fire Safety Transportation Public Works Parks and Recreation Health & Human Services Human Resources Payroll Employee Benefits Economic Development Social Services Medicaid IT Operations Information Security E-Government

Mean 4.80 4.87 4.65 4.82 4.81 4.93 4.44 4.25 4.26 4.51 4.67 4.70 4.71 4.64 4.65 4.26 4.34 4.13 4.30 4.34 4.88 4.51 4.20 4.18 4.10 4.31 4.28 4.15

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 between 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. According to both Tables 3 and 4, the highest number of respondents (52) indicated 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 Adequate. With the Pearson Chi-Square showing a significance value of 0.001, we

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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 Effective and Very Effective. With the significance value of the Pearson ChiSquare being 0.000, we can also conclude that there is a statistically significant relationship between Years Between Audits and Internal Control Effectiveness.
Table 3. Relationship Between Audit Years Between Audits and Internal Control Adequacy
Internal Control Adequacy Years Between Audits 1 Year 2 Years 3 Years 4 Years 5 Years 6 Years Not Audited Total

Completely Very Inadequate Inadequate

Inadequate

Somewhat Adequate

Adequate

Very Adequate

Completely Adequate Total

0 0 0 0 0 0 0

0 0 0 0 0 0 0

2 0 2 0 0 0 0

2 2 6 20 28 28 8

0 2 14 28 8 8 4

0 2 2 4 2 6 0 16

0 0 0 0 0 0 0 0

4 6 24 52 38 42 12 178

0 0 4 94 64 Pearson Chi Square Value, 37.133 ; df, 15; Assymp. Sig. (2 Sided) = 0.001

5.2 POLICIES, PROCEDURES AND ADEQUACY OF FINANCIAL CONTROLS

A key goal in this research was to determine whether auditors recommended improvements in documented financial policies and procedural guidelines 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 successful accomplishment of overall goals. Therefore, the need for documented financial management policies and procedures that provide adequate framework for acceptable practices and related controls to help accomplish stated missions and goals is critical. Respondents were asked in the survey to indicate whether they review listed policies and procedures. Results reveal 78% perform review of the documents. The key issue, however, is whether audits

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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 Between Ineffective Ineffective Audits 1 Year 2 Years 3 Years 4 Years 5 Years 6 Years Not Audited Total Somewhat Effective Very Effective Completely Effective Total

Ineffective

Effective

0 0 0 0 0 0 0

0 0 0 0 0 0

0 2 2 0 2 0

2 2 10 16 24 28

0 0 8 32 8 10

0 2 2 4 4 4

0 2 0 0 0 0

2 8 22 52 38 42

10

0 16

0 2

14 178

0 0 6 92 62 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 cannot 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 management 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 categories 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 avoided (McCullagh, 1980, p.110).

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Table 5. Ordinal Regression Model Effects of Financial Policy Improvement Recommendations (Dependent Variable is Adequacy of Financial Internal Controls) (N = 176)
Coefficient Estimate 5.295 0.968 3.257 3.887 4.822 0.973 11.733 6.953 174.818 0.000 WaldStatistics 21.245 0.421 5.239 5.040 6.052 0.666 6.137 4.691

Threshold Budget Policy Manual Accounting Policy Manual Cash Management Policy Investment Policy Rainy Day Fund Policy Accounts Receivables Policy Communication of policy and procedural updates Model Chi-Square Statistics Probability (Chi-Square Statistics) Pseudo R-Square:

Standard Error 1.149 1.491 1.423 1.731 1.960 1.192 4.736 3.210

P Value* 0.000 0.516 0.022 0.025 0.014 0.414 0.013 0.030

Cox and Snell Nagelkerke McFadden

0.860 0.992 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 complimentary log-log link-function. As shown in Table 5, the model shows positive and significant relationships between our dependent variable Internal Control Adequacy and recommendations for improvements of accounting policy manual (p = 0.022), cash management policy and procedures (p =0.026), investment 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 likelihood for a base line model. However, with categorical outcomes, it has a theoretical maximum value of less than 1, even for a perfect model. The Nagelkerkes 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,

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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 Rsquare statistics indicate that the model is capturing at least 86% of the variance 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 recommended improvements in documented financial policies and procedures do significantly impact the adequacy of internal control over financial management.
5.3 CONTROL EFFECTIVENESS AND FINANCIAL PERFORMANCE

While improvements in policy and procedural guidelines do directly impact the adequacy of internal control design, the control activities in compliance 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 objectives 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 objectives result in control effectiveness, i.e. result in controls operating as intended? 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 these five variables. With the probability of the chi-square statistic (0.000) indicating the model gives a significant improvement over the baseline interceptonly model, we can conclude that auditors evaluation of managements achievement of control objectives and financial performance monitoring practices do significantly impact the Internal Control Effectiveness.

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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 financial policies and the adequacy of financial management controls; and between auditors evaluation of managements achievement of control objectives, financial 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 performance monitoring on Financial Performance. Table 7 shows the financial performance model estimated by ordinal regression. The results in the Table depicts statistically significant positive relationships between Financial Performance and population (p = 0.000); per capita income (p = 0.034); years between audits (p = 0.001); internal control effectiveness (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) indicates the model gives a significant improvement over the baseline interceptonly model, we can conclude that years between audits, evaluation of financial performance monitoring and internal control effectiveness do actually influence Financial Performance in a significant way. Thus, more frequent audits, evaluation of financial performance monitoring and the resulting effective internal controls lead to higher financial performance through higher positive percentage change in net assets. Table 8 contains the frequency distribution showing the percentages of respondents who indicated the yearly intervals of audits performed in each operational 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 consistently 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.

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Table 6. Ordinal Regression Model - Effects of Control Objectives Evaluation (Dependent Variable: Effectiveness of Internal Control) (N = 176)
Coefficient Estimate Threshold Regulatory Compliance Policy Compliance Procedural Compliance Efficiency of Operations Effectiveness of Operations Integrity of Financial Records Safeguard of Assets Financial Performance Monitoring Compliance Monitoring Model Chi-Square Statistics Probability (Chi-Square Statistics) Pseudo R-Square: Cox and Snell 0.876 3.334 3.867 5.137 1.785 2.744 2.283 3.005 2.841 3.820 3.547 185.922 0.000 WaldStatistics 24.380 3.369 3.463 14.125 24.526 2.996 5.295 1.837 3.061 1.681

Standard Error 0.675 0.554 2.760 0.475 0.554 0.319 1.306 2.096 0.184 2.736

P Value* 0.000 0.050 0.063 0.000 0.000 0.083 0.021 0.175 0.040 0.195

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 performed 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 Operations (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 analysis using an independent financial performance indicator calculated from local governments CAFRs does confirm the earlier results regarding the impact of

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internal audit activities on improvements in government financial management.

Table 7. Ordinal Regression Model -Effects of Years Between Audits and Internal Controls (Dependent Variable: Financial Performance [2005-2009] (N = 176)
Coefficient Estimate 4.886 4.156 2.262 -1.960 3.914 1.745 3.538 2.425 WaldStatistics 15.524 13.038 4.489 3.409 11.952 2.725 10.165 5.122

Threshold Population Per Capita Income Unemployment Rate Years Between Audits Internal Control Adequacy Internal Control Effectiveness Financial Performance Monitoring

Standard Error 1.240 1.151 1.068 1.061 1.132 1.057 1.110 1.072

P Value* 0.000 0.000 0.034 0.065 0.001 0.099 0.001 0.024

Model Chi-Square Statistics Probability (Chi-Square Statistics) Pseudo R-Square Cox and Snell Nagelkerke McFadden

479.625 0.000

0.987 1.000 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 receivable (p = 0.038); inventory (p = 0.043); procurement (p = 0.007); expenditures (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 effectiveness are relatively high. Therefore, these results are very consistent with the survey findings.

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Table 8. Frequency Distribution for Responses Regarding Areas Audited
percentages Indicating Yearly Intervals of Audits Performed Governmental Funds Budgeting Cash Management Investments Accounts Receivable Inventory Fixed Assets Procurement Expenditures Accounts Payable Long-Term Debt Public Safety Fire Safety Transportation Public Works Parks and Recreation Health & Human Services Human Resources Payroll Employee Benefits Economic Development Social Services Medicaid IT Operations Revenue Collection E-Government 1 Year 39.3 16.9 43.8 13.5 41.6 36.0 24.7 28.1 43.8 27.0 9.0 11.2 3.4 4.5 9.0 7.9 11.2 7.9 22.5 9.0 5.6 5.6 1.1 19.1 40.8 3.4 2 Years 5.2 1.1 6.6 5.0 5.5 5.5 3.4 13.5 7.7 7.9 2.2 7.9 5.6 7.9 13.5 9.0 5.6 5.6 11.2 6.8 2.2 7.9 2.2 12.4 5.7 4.5 3 Years 6.7 5.6 14.5 9.0 6.7 7.9 15.7 25.8 11.2 13.6 5.6 13.5 9.0 15.7 12.4 18.0 7.9 15.7 12.4 11.2 9.0 7.9 1.1 5.6 14.5 5.6 4 Years 7.9 1.1 9.0 1.0 5.6 11.2 3.4 5.4 5.5 8.7 2.2 9.0 9.0 7.9 7.9 12.4 5.6 13.5 8.7 4.5 4.5 1.1 4.5 6.7 12.0 2.2 5 Years 8.1 4.5 6.3 14.2 13.5 6.3 13.5 7.9 11.9 13.2 5.7 11.2 7.9 9.0 13.5 7.9 6.7 16.9 11.2 15.7 7.9 10.1 2.2 7.9 2.2 5.6 6 Years 17.4 42.3 9.0 20.7 12.0 21.6 14.5 7.6 10.3 16.6 20.6 11.1 14.5 13.4 13.9 11.0 15.6 10.1 13.8 16.9 16.8 15.6 87.8 17.9 13.0 3.4 Not Audited Total 15.4 100 28.5 100 10.8 100 36.6 100 15.1 100 11.5 100 24.8 100 11.7 100 9.6 100 13.0 100 54.7 100 36.1 100 50.7 100 41.7 100 30.0 100 33.8 100 47.3 100 30.3 100 20.2 100 35.9 100 54.0 100 51.8 100 1.1 100 30.4 100 11.8 100 75.3 100

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

Standardized Coefficients Beta .405 .139 -.125 2.797 .692 .531 -.437 .543 .566 -.557 .448 .993 .065 .682 .526 .013 -.014 .372 .018 .501 .055 .101 .015 .316 -.033 .237 .861 .546 -.059

(Constant) Population Per Capita Income Unemployment Rate Governmental Funds Budgeting Cash Management Investments Accounts Receivable Inventory Fixed Assets Procurement Expenditures Accounts Payable Long-Term Debt Public Safety Fire Safety Transportation Public Works Parks and Recreation Health & Human Services Human Resources Payroll Employee Benefits Economic Development Social Services Medicaid IT Operations Revenue Collection E-Government

Unstandardized Coefficients B Std. Error .112 .093 1.000 .282 .272 .261 -.125 .113 .529 .256 .032 .013 .049 .019 -.023 .012 .054 .025 .023 .011 -.053 .029 .047 .016 .043 .016 .006 .021 .036 .015 .027 .015 .002 .020 -.002 .021 .042 .016 .002 .023 .058 .025 .007 .019 .010 .020 .002 .017 .045 .022 -.005 .025 .048 .031 .039 .015 .063 .029 -.009 .022

t 1.198 3.550 1.043 -1.104 2.066 2.400 2.649 -1.890 2.166 2.124 -1.808 2.882 2.698 .298 2.459 1.844 .086 -.092 2.530 .088 2.284 .348 .490 .099 2.108 -.191 1.531 2.524 2.119 -.398

Sig. .240 .001 .305 .279 .048 .023 .013 .069 .038 .043 .081 .007 .012 .768 .020 .076 .932 .927 .017 .930 .030 .731 .628 .922 .050 .850 .137 .018 .047 .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 management and governmental operations. Further analysis performed using independent data from the CAFRs confirms these assessments and also indicate audits in individual areas contribute significantly to government financial performance. 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

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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 effectiveness and hence mitigation of misappropriation risks. In this regard, the findings confirm the argument of Corain et al. (2007) that through risk evaluations, 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 enhancing 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 significant effect on financial performance. In general, more areas with fewer years between audits contribute significantly to local government financial performance. Based on the research findings, one can argue that frequent audits in the financial areas, as reflected in the fewer years between audits, enables auditors to provide feedback that helps public managers enhance operational efficiency 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 financial records. Thus, the research results suggest local government internal audits lead to the identification of potential savings from operational efficiencies and reporting of findings to management to enable them allocate resources 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, applicable 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 positive manner, we can conclude that local government internal auditors independent evaluations result in significant contributions to the financial oversight process. Thus, by providing senior management audit reports on the accuracy and reliability of financial information to enable them rectify control deficiencies, auditors help to make administrators accountable to citizens

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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 improvements in documented financial policies and procedures significantly impact the adequacy of internal controls over financial management. Documented financial 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 ensure 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 performance monitoring activities plays in enhancing the effectiveness of financial management controls and financial performance. The research findings in Tables 6 and 7 reveal that auditors evaluation of financial performance monitoring practices has significant effect on control effectiveness and financial performance respectively. Considering the fact that the results in Table 7 also show a statistically significant positive relationship between control effectiveness and financial performance, we can safely conclude that in addition to directly influencing financial performance, auditors evaluation of managements 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 government financial monitoring system helps to uncover inefficient practices in operation, and to avoid further deterioration in financial condition. Furthermore, they support a key argument of transaction cost economics theory, which suggests that by comparing actual against expected activity performance, a monitoring mechanism facilitates the adaption of internal organization to changing conditions and reduction of cost of activities.

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This research focused on the role of government internal audit in improving 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 respondents profile provided in the methodology section reveals the survey respondents 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 determine 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 assessments, frequent audits lead to improvements in the adequacy and effectiveness of internal controls, thereby contributing toward public accountability. 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 performance by positively impacting the percentage change in net assets. The evidence suggests this is made possible through auditors identification of potential savings from operational efficiencies that enable senior management allocate 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 audits contribution to government financial performance, represents a fundamental shift in focus from prior research on government internal audits. Therefore, 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 value 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

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help make meaningful improvements in financial management. Given the local government financial constraints due to dwindling state aid and periodic economic downturns among others, internal audits should be viewed as partners with the capability to help improve efficiency and effectiveness of operations, 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 governance and performance Improvement. International Journal of Government Financial Management. pp. 12-27. Baltaci, M. & Yilmaz, S. (2006). Keeping an eye on sub national governments: 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 internal 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 (December): 21-26. Carslaw, C., Mason, R. & Mills, J. R. (2007). Audit timeliness of school district audits. Journal of Public Budgeting, Accounting and Financial Management, 19(3): 290-316. Chaney, B., Meade, D. & Shermann, K. (2002). New governmental financial reporting model. Journal of Government Financial Management (Spring): 2531.

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