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THE IMPACT OF WEAK INTERNAL CONTROLS ON FRAUD

Conference Paper · September 2018

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Proceeding of INSIGHT 2018 1st International Conference on Religion, Social Sciences and
Technological Education
25-26 September 2018 – Universiti Sains Islam Malaysia, Nilai, Malaysia.

THE IMPACT OF WEAK INTERNAL CONTROLS ON FRAUD

Ahmad Saiful Azlin Puteh Salin 1*, Khairul Mizan Zakaria2, Anuar Nawawi3
1
Dr., Universiti Teknologi MARA, Perak Branch Tapah Campus, MALAYSIA,
ahmad577@perak.uitm.edu.my
2
Universiti Teknologi MARA, Shah Alam, MALAYSIA,
yahoo@yahoo.com
3
Universiti Teknologi MARA, Shah Alam, MALAYSIA,
anuar2017@salam.uitm.edu.my
*Corresponding author

Abstract
The purpose of this study is to examine types of internal control weaknesses and their impact
on a company, specifically their contribution to fraud activities. One company was selected as
a study case, and a mixed method of data collection and analysis was employed. This study
found that internal control weaknesses can be a major contributing factor for fraud to be
committed. Some examples of weak internal controls discovered in this research include poor
supervision and lack of documentation processes, which ultimately provide opportunities to
fraudsters to misappropriate company assets. This is worse if the fraud was carefully planned
and involved employee cooperation.

Keywords: Internal control, fraud, malpractices, Malaysia, case study

INTRODUCTION
No doubt, internal control is key for survival of a company other than good governace and
business ethical practices. Prior studies show that a poorly governed company, unethical
corporate practices, and lack of corporate social responsibility will lead to weak financial
structure and poor performance (Salin et al., 2017; Nor et al., 2017; Norbit et al., 2017; Husnin
et al., 2016; Asmuni et al., 2015; Hamid et al., 2011) and damaging reputation of a company
(Salin & Ismail, 2015). In contrast, effective corporate governance mechanisms lead to higher
trasparency (Hashim et al., 2014; Jaafar et al., 2014; Salin et al., 2011; Salin & Abidin, 2011;
Salin & Rahman, 2010), pay for performance link among the directors (Ahmad et al., 2016),
better corporate monitoring (Husnin et al., 2013; Salin et al., 2010), easy access by public to
the required information (Salin & Abidin, 2011), preventing noncompliance to rules and
regulations (Salin, 2017; Salin et al., 2012), and sustainable development (Salin & Abidin,
2011).
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Good quality internal controls are able to steer a company to meet its objectives, either
operational, reporting, and/or compliance. As defined by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) (2013), internal control is a process,
affected by an entity’s board of directors, management, and other personnel, designed to
provide reasonable assurance regarding the achievement of objectives relating to operations,
reporting, and compliance.
This is COSO’s Internal Control: Integrated framework consists of five integrated
components, i.e., control environment, risk assessment, control activities, information, and
communication and monitoring activities (COSO, 2013). The control environment is a set of
standards, processes, and structures that provide the basis for carrying out internal control
across an organization. A board of the directors and top management in the company play a
crucial role in setting the tone of internal control compliance, including code of conduct. Their
support also plays an important role in determining the success or failure of a firm’s project
(Suhaimi et al., 2017). Risk assessment, on the other hand, requires a company to have a
dynamic and iterative process for identifying and assessing risks in regard to the achievement
of objectives and prevent its adverse impact on a company (Amirudin et al., 2017). These
include various risk strategies such as risk acceptance, risk transfer, risk sharing, and risk
avoidance. The other components, i.e., control activities, are the actions established through
policies and procedures that help to ensure that management’s directives to mitigate risks to
the achievement of objectives are carried out. Control activities are conducted in all layers of
an organization; if it is not practical, alternative control activities need to be provided. For
example, access cards to certain high sensitive rooms can be used in replacement of human
guards.
Information and communication include the process and means of a company properly
managing its information starting from the point of receiving and generating information up to
communication of that information to the various stakeholders. This component is important
to support the functioning of other components of internal control. For example, clearly written
manuals and guidance are important to ensure that employees understand and, hence,
comply with the internal control requirements.
The last component is monitoring activities. This component involves ongoing
evaluations, separate evaluations, or some combination of the two in order to ascertain
whether each of the five components of internal control are present, effective, and functioning.
An example of monitoring activities is to periodically review the effectiveness and efficiency of
rules and procedures and conduct a stress test in the event a company is involved in a natural
disaster.
Prior study shows many benefits of internal controls such as better accountability in
resource management (Asare, 2009), highly efficient operation (Feng et al., 2015), superior
earnings quality (Brown et al., 2014), lower shock from unexpected events (Hajiha & Bazaz,
2016), and greater compliance with laws, regulations, policies, and procedures and ability to
eliminate fraud and abuse. However, weak internal control can lead to a reduction of a firm’s
market value (Hu et al., 2013), low reporting quality (Ghosh & Lee, 2013), negative market
reactions (Nishizaki et al., 2014), and provide opportunities for fraudulent activities to occur
(Lokanan, 2014).
In this respect, fraud committed due to weak internal control arguably is the most
important and severe repercussion, as it can involve huge sums of money stolen from a
company. Thus, it is noteworthy to examine this phenomenon by attempting to answer the
following research questions:
RQ1: What is the impact of the weak internal controls on fraud in an organization?
Specifically, the purpose of this study is to investigate the weaknessess of internal controls in
a company and scrutinize how weak internal controls can influence fraud comitted by its
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25-26 September 2018 – Universiti Sains Islam Malaysia, Nilai, Malaysia.

employees.
This study contributes to the literature in several ways. First, it provides an in-depth
understanding on the impact of weak internal controls against fraud committed in a company.
As this study focuses on one organization that operates in a specialized industry, the
information derived is valuable to be learned by academics and practitioners because it is not
easy to get access on that kind of sensitive information. Second, the findings of this study will
add to the theoretical framework and body of literature on internal controls and fraud, which is
rare in the literature, particularly for a study conducted in a developing country such as
Malaysia. Many prior studies focus on organizations in more developed countries such as in
the US, UK, Europe, Japan, and Australia.
This paper is organized as follows. The next section is a review of the literature,
followed by research methodology. The fourth section presents findings and discussion, while
the fifth section is the conclusion. The last section presents limitations and suggestions for
future research.
LITERATURE REVIEW
Limitations in Internal Controls
Strong and robust internal controls encourage efficiency, compliance with rules, laws,
regulations, policies, and procedures (Rahim et al., 2017). In addition, internal controls are
also able to eliminate fraud and prevent abuse of power. Based on COSO (2013), internal
controls can be generally classified as preventive and detective controls. Preventive controls
are designed to avoid errors or irregularities from even occurring in the first place. For
example, job rotation serves as a shield from employees to abuse their power and position
and cover up its malpractices for many years. On the other hand, detective controls are
designed to identify an error or irregularity after it has occurred. Frequent internal audit and
examination are good examples in which to discover employee errors in the working process
both intentionally or unintentionally.
However, several limitations are inherent in internal control systems, e.g., judgment.
The effectiveness of controls will be limited by decisions made with human judgment under
pressure to conduct business based on the information at hand and resources available. For
example, a small company or organization may be unable to segregate so many positions,
tasks, and responsibilities because of the need to hire more people in every role, meaning
higher cash outflow due to increased perks paid to employees. Thus, a company needs to
judge and balance the requirements to have sufficient internal control within a limited budget.
Second is breakdown. Perfectly well-designed internal controls can break down, as
employees may sometimes misunderstand instructions or simply make mistakes. For
example, forgetting to change computer systems regularly or, worse off, revealing their own
password to someone else. In this context, errors may also result from new technology and
the complexity of computerized information systems. Thus, lack of knowledge, skills, and
competencies in handling and managing new technologies bring tendencies of the current
designed internal control outdated.
Third, management can override internal controls. High-level personnel may be able
to override prescribed policies and procedures for personal gain or advantage due to more
power and authority belonging to them. This poor accountability and immorally behaved
attitude will have a negative impact on the lower level of employees and company as a whole
(Shariman et al., 2018; Manan et al., 2013; Khadijah et al., 2015) such as waste of resources
and misuse of money (Shariman et al., 2017). For example, using company assets such as a
car for a personal vacation. This will deteriorate company’s assets quickly, as more repairs
may be necessary using the company’s money. This should not be confused with
management intervention, which represents management actions to depart from prescribed
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Technological Education
25-26 September 2018 – Universiti Sains Islam Malaysia, Nilai, Malaysia.

policies and procedures for legitimate purposes. For example, a one-off directive from top
management to strengthen current internal controls for a temporary period.
Last is collusion. In certain situations, internal control systems can be circumvented by
employee collusion. Individuals acting collectively can alter financial data or other
management information in a manner that cannot be identified by control systems. For
example, different employees are responsible for making purchases, receiving goods in
inventory, and making payments and collaborating with each other to make fictitious
purchases.

Weaknesses in Internal Controls

Weaknesses in internal controls are a major contributing factor to the opportunity to commit
fraud (Nawawi & Salin, 2018; Omar et al., 2017; Zakaria et al., 2016; Suhaimi et al., 2016).
The establishment of a strong internal control environment via clear and well communicated
written policies and procedures that are efficiently and effectively enforced, along with
appropriate implementation of internal control activities and knowledgeable of fraud by the
employees, are among the best deterrents and methods of curtailing fraud. For internal
controls to be effective, they must be constantly reviewed and evaluated for effectiveness and
kept updated as business environment and technological processes are fast changed and
dynamically evolved. Below are examples of common internal control weaknesses
experienced by a company.
 No Segregation of Duties
Generally, no one person should manage more than one type of important business function,
e.g., authorization, record-keeping, and reconciliation. For instance, an employee who
administers petty cash should not have allowed any power for petty cash expenditures related
for approval. Unfortunately, due to limited resources, implementing segregation of duties in an
organization requires a careful study on the benefits–cost analysis. It is unrealistic and
impossible to expect an organization, particularly small and medium enterprises (SMEs), to
have the required number of staff or tools in place to segregate all critical business tasks. Due
to this, many organizations have to compromise with this type of internal control in order to
cap the budgeted salary paid to their employees. Karim et al. (2018) documented that no
segregation of duties and excessive reliance on one person to conduct many tasks will lead
to human error and fraud.
 Nonsystematic Record-Keeping
The ultimate objective of the control in record-keeping is to have a systematic means of easy
and efficient tracking and retrieval of documents and information irrespective of the
transactions. For example, even a small and routine expenditure such as petty cash, which
includes petrol and stamp, must be supported with official bills and receipts.
Egwunyenga (2009) found that problems related to record-keeping are due to negative
attitudes of employees’ poor execution of record management systems, low security of records
and documents, too much dependency on hardcopies and paper, insufficient training for
members of an organization, business operations being conducted using a manual system,
shortage of physical resources such as scarce computer terminals, ineffective retrieving,
retention, and disposition schedule, and unsatisfactory of policy and filing procedure manuals.
All these problems may contribute to deficient record-keeping processes and, hence, lead to
internal control breakdowns.
 Lack of Supervision
The main objective of supervision activities is to ensure that operational activities are properly
conducted in accordance with policies and procedures. Thus, any noncompliance and
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25-26 September 2018 – Universiti Sains Islam Malaysia, Nilai, Malaysia.

weaknesses with internal control rules and procedures can be identified and later be improved.
Lalic et al. (2011), for example, suggests that efficiency of internal controls should be regularly
audited. However, it is not easy to find a competent and suitable supervisor who is capable to
monitor business activities. Minimally, a person must have sufficient qualifications, working
experience, and technical and soft skills. Absence of these skills may lead to internal control
collapse.
 Inappropriate Transaction Authorization
The main objective of this control is to ensure business transactions are authorized by a
person with formal power and authority. This is usually given to a superior or manager at a
higher level. The main task of this person is to ensure that transactions are based on the
company’s policies and procedures. For example, any petty cash expenditure needs to be
approved by the admin manager. The admin manager has the right to disapprove the
expenditure that spends beyond the stipulated limits or is in violation of guidelines. However,
this review process might be ineffective if the admin manager fully relies on the statement
prepared by the petty cash clerk and just acts as a rubber stamp to approve all the transactions
without thoroughly verifying the statement.
 Lack of Physical Access Control
Physical access control is a process to ensure a company’s transactions related to assets are
properly processed and the physical assets are appropriately secured. The main objective of
the control is to secure assets from losses due to theft, damage, underutilized, accidental
destruction, and errors. For example, inventories must be kept in a locked and secure
warehouse with restricted access to only particular employees. In addition, good access
control also requires proper recording processes to track the movement of inventories. The
absence of this control will expose a company’s physical assets to theft not only by the insider
but also the foreign person.
RESEARCH METHODOLOGY
The study employed a mixed method of data collection and analysis, along with face-to-face
interviews and archival analysis. Interviews were conducted with internal audit personals of
the company. Only two internal auditors agreed to be interviewed. The first respondent,
designated as an Internal Auditor 1, is a female senior auditor and is responsible for executing
financial, operational, compliance, IT, joint venture, and contractor audits for Malaysia and
Southeast Asia operations. She has worked as an internal auditor for 10 years. The auditor is
a fellow member of the Association of Chartered Certified Accountant (FCCA) and is a certified
internal auditor (CIA). The second respondent, designated as Internal Auditor 2, is a male
internal auditor who also holds the same responsibility as Internal Auditor 1. He has worked
as an internal auditor for seven years. He is a fellow member of the Malaysian Institute of
Accountants and an associate member of the Institute of Internal Auditors.
The other method of data collection is archival or document analysis. The data were collected
mainly through a review of internal audit reports and audit working papers for audit
engagement relating to the administration department. There are two types of audit reports
that are subjected to this study, namely, normal audit report and special audit report. A normal
audit report is an audit report issued for a routine audit engagement based on risk assessment,
whereas a special audit report is an audit report issued for audit engagement requested by
top management such as an investigation audit.
FINDINGS AND DISCUSSION
Results from the Interviews
 Level of Adequacy and Effectiveness of Internal Control System
Both auditors believe the level of adequacy and effectiveness of an internal control system in
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the administration department is at a satisfactory level. Based on controls testing carried out
during their audits, the internal control system is found to be adequate and functioning
accordingly. There was no significant audit finding that required immediate attention from the
management. However, there were some internal control weaknesses that need to be
improved by the administration department.
 Findings Related to Internal Controls Based on Internal Audit Outcome
There were several findings related to internal control weaknesses that had been highlighted
by both of the auditors during the audits such as improper recording, lack of supervision, and
insufficient guidelines. However, the findings were not classified as significant due to no direct
impact on the company’s operations and thus not requiring immediate attention from the
management.
 Improvement Need for Internal Control
Both internal auditors concurred that the department needs to improve the supervision process
in day-to-day operations because most of the audit findings highlighted poor supervision
processes. The frequent excuses given is that the superior trusted his subordinates to conduct
their duties. This poor practice may give a chance for subordinates to manipulate their works,
such as overtime claims, which, in fact, can be settled during normal working hours. In
addition, the internal auditors also suggest that the record-keeping process needs to be
improved. Several findings highlighted during the audits were due to inferior record-keeping
processes. The most obvious finding is a driver not providing adequate information in a
company’s vehicle log books.
 Fraudulent Activities Contributed from Weak Internal Control
Both internal auditors are in agreement that weak internal controls will create opportunities for
fraudulent activities. An example is the improper record-keeping of vehicle log books as
previously noted. Insufficient control of this activity or transaction may create opportunities for
drivers to misuse a company’s vehicles such as for personal use. The person responsible to
monitor a vehicle’s usage has failed to put the control in place because of no cooperation from
the drivers.
Results from the Archival Analysis
 Lack of Supervision on Personnel Overtime
The study finds that timesheets verified by the senior admin executive have never been
questioned by the superior, i.e., assistant manager and senior manager, during payment
approvals. Both managers argued that they trusted their subordinates to verify the timesheets;
hence, they would just sign the verified invoices. Consequently, this research finds that the
overtime work recorded in the timesheets noninformative and lack of description such as the
nature of work conducted, location and person involved.
The study also found an unusual trend related to drivers who consistently claimed eight hours
of overtime on two Saturdays of every month, stating sending the company’s vehicles to
service centers. However, further investigation revealed no maintenance service recorded on
Saturdays for the car. The car was sent to the service center during office hours on weekdays,
and no maintenance service was conducted in one month. Thus, it was proved that the driver
made a false overtime claim.
 Lack of Monitoring Over Unutilized Purchase Orders Issued To Vendors/Contractors
The study found that the unutilized purchase orders were not reported to the procurement
department for closing. Usually, the purchase orders are not utilized because of cancellation
of services or supplies. If it is not reported for closing, the purchase orders would then still be
considered as active and valid for payable processing. This transaction might expose an
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employee to manipulation such as using purchase orders to procure products and services
not permitted by the procurement department.
 Unsatisfactory Petty Cash Expenditure Guidelines
There was an existing policy on petty cash for the company. However, the study found that no
guidelines on the types of expenses allowable to be paid via petty cash fund and the limits for
each transaction. Ill-defined guidelines in petty cash expenditures might lead to fraudulent
activities such as an employee taking advantage of such spending over limits and making
payments for nonrelated work activities.
CONCLUSION
The purpose of this study is to investigate the weaknessess of internal controls in a company
and how these weaknesses influence employee fraud. This study found that some of the major
internal control weaknessess are poor supervision and lack of documentation process. Due to
these, an employee may easily misappropriate company assets via manipulation of overtime
payment, theft of company product and services, and stealing petty cash. Thus, it is
recommended that a company make efforts to improve its internal controls. For example,
awareness of the importance of internal controls can be improved via employee education.
Prior studies show that continuous education can improve human compliance on rules and
regulations (Hassan et al., 2016; Saibon et al., 2016). In addition, continuous audit on internal
controls need to be implemented, as a good quality audit will not only enhance the reliability
of financial statements but also protect stakeholder interest (Jais et al., 2016).
LIMITATIONS AND SUGGESTIONS FOR FUTURE RESEARCH
This study encountered a number of limitations. The first limitation was that the researcher
could not disclose the company’s name in this research. This was mainly due to the sensitivity
of the research topics that might affect the reputation of the company. It might give a negative
perception on the company’s internal control system, which had allowed fraudulent cases to
occur in the company. Further, all of the audit findings and fraudulent cases were not
publicized by the company. All of the cases were resolved internally without any further
investigation by the enforcer. The company did not make any police reports on the fraudulent
cases. Therefore, the researcher decided not to disclose the company’s name in this research
to avoid future problems.
The second limitation was the company’s insistence in maintaining the confidentiality
of information relating to fraudulent practices in the administration department. Thus, requests
for personal access to review the personal files of the personnel involved in the fraudulent
cases were denied. The files are kept by the human resource department and categorized as
highly confidential documents. Therefore, the study is solely based on internal audit reports
and audit working papers from the internal audit department.
The third limitation is in regard to the scope of the study, which was restricted to
reported fraudulent cases. The study did not analyze any unreported fraudulent cases that
would require the cooperation of the administration department’s personnel to disclose any
unreported fraudulent cases. The information obtained for unreported fraudulent cases might
not be reliable for the research. Therefore, the research is solely based on special audit reports
and audit working papers from the internal audit department.
_________________________________________________________________________

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Salin, A. S. A. P., & Abidin, Z. Z. (2011). Information and Communication Technologies (ICTs)
and a Smart City in Malaysia. In 2010 International Conference on Business and
Economies Research, Kuala Lumpur, Malaysia.
Salin, A. S. A. P., and Abidin, Z. Z. (2011). Information and communication technologies and
local governance trend–A case study of a smart city in Malaysia. In International
Conference on Business and Economics Research, Kuala Lumpur, Malaysia.
Salin, A. S. A. P., & Ismail, Z. (2015). Ethics practices of Malaysian public listed companies -
Empirical evidence. Paper presented at the 10th Annual London Business Research
Conference, 10 - 11 August 2015, Imperial College, London
Salin, A.S.A.P., Kamaluddin, N., and Manan, S.K.A. (2011). Unstoppable fraud, scandals and
manipulation - An urgent call for an Islamic-based code of ethics. In 2011 International
Conference on Sociality and Economics Development. Singapore.
Salin, A.S.A.P., Kamaludin, N., Ab Manan, S.K., and Ghafar, M.S.A. (2012). Directors’ Islamic
code of ethics. World Academy of Science, Engineering and Technology, International
Journal of Social, Behavioral, Educational, Economic, Business and Industrial
Engineering, 6(4), 560-562.
Salin, A. S. A. P., Manan, S. K. A., Kamaluddin, N., & Nawawi, A. (2017). The role of Islamic
ethics to prevent corporate fraud. International Journal of Business and Society, 18(S1),
113-128.
Salin, A. S. A. P. and Rahman, R. A. (2010). Disclosure of board committees by Malaysian
public listed companies. Paper presented at International Conference on Economics,
Business and Management.
Salin, A. S. A. P., Rahman, R. A., Omar, N., Hui, W. S., & Ismail, A. H. (2010). Disclosure on
annual general meetings by Malaysian public listed companies. Proceeding of 2010
International Conference on Business and Economics Research. Kuala Lumpur: IACSIT
Press.
Shariman, J., Nawawi, A. and Salin, A. S. A. P (2017). Public sector accountability – Evidence
from the auditor general’s reports. Management & Accounting Review, 16(2), 231-257.
Shariman, J., Nawawi, A., & Salin, A. S. A. P. (2018). Issues and concerns on statutory bodies
and federal government–evidence from Malaysian Auditor General's
report. International Journal of Public Sector Performance Management, 4(2), 251-265.
Suhaimi, N. S. A., Nawawi, A., & Salin, A. S. A. P. (2016). Impact of enterprise resource
planning on management control system and accountants’ role. International Journal of
Economics and Management, 10(1), 93-108.
Suhaimi, N. S. A., Nawawi, A., & Salin, A. S. A. P. (2017). Determinants and problems of
successful ERP implementations – Malaysian experience. International Journal of
Advanced Operations Management, 9(3), 207-223.
Zakaria, K. M., Nawawi, A., & Salin, A. S. A. P (2016). Internal controls and fraud – empirical
evidence from oil and gas company. Journal of Financial Crime, 23(4), 1154-1168.

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