Control Using Accounting Ratios Any practices and standards are merely models of the things or ideas that they represent. The accounting world presents unique challenges in finding true value through abstract manipulation of symbols and numbers. This practice is stereotypically boring and trite, but when examining the power of accounting ratios when investigating ideas from a qualitative perspective the importance of these ratios becomes self evident.

The purpose of this essay is to examine the importance of demonstrating control using accounting ratios. This essay will argue that the numerical manipulation of these numbers is mostly a useful practice that can demonstrate the value of good accounting practices. The literature used to support this argument will be used to build a case supporting this reasoning and eventually lead the reader to garner a new appreciation for the accounting ratios and their ability to be tooled to a fine instrument for an organization to use and wield in efforts to gain a competitive advantage in their industry.

Importance

Effective management will find a way to align organizational strategy with the operational execution of their team. The importance of this alignment can only be measured by models that reflect this idea. A useful model will be simple to understand and serve to clear the air instead of mudding the waters. Accounting ratios can serve this purpose, but only when they are understood in the proper context.

Accounting rations are essentially lifeless tools of precision and depth. They can be used for whatever purposes the wielder of the model chooses. In other words, it is essential to understand the importance of accounting when identifying and discussing instances where these tools have been modeled to perform worthwhile and successful tasks as measured by research. Empirical examples can provide the missing link in this puzzle and further demonstrate the relationship between control and accounting ratios.

Literature Review

DeYoung (1997) explored the challenges and initial problems that are often viewed when discussing the modeling potential of accounting ratios. The research article explained how the idea of efficiency is mishandled within the application of accounting ratios. He premised his research on the idea that "Although cost ratios are easy to construct and use, they can be difficult to interpret. Myopic analysis of expenditures can be misleading -- reduced spending on labor, materials, or physical plant is no guarantee that a bank is being run efficiently, and high levels of spending on these items does not necessarily signal inefficiency." This idea supports the notion that ratios are important but can serve to hide rather than illuminate in some instances.

The author suggested that all statistics are invalid unless appropriate attitudes are understood about the inference. Accounting ratios are useful but also very harmful if not placed in the right frame of reference. He concluded "Accounting-based cost ratios are popular tools for analyzing the efficiency of banks because they are simple to construct and easy to use. However, bank efficiency is a complex phenomenon for which simple analysis can yield misleading conclusions. Comparing the cost ratios of two different banks is inappropriate unless both banks are nearly identical in terms of product mix, bank size, market conditions, and other characteristics that can affect the banks' expenses."

Lev & Sunder (1979) portrayed another viewpoint of the control issues with accounting ratios. Their research was based on the methods of the application of the ratio, and not merely the ratios themselves. This idea again supports the idea of the importance of the subjective application of ratios as they are best expressed throughout this model.

The researchers make a very important philosophical argument in their argument that suggests that intuition is necessary in the methodology of creating financial ratios. They explained " A major reason for using financial variable in the form of ratios is to control for the systematic effect of size on the variable under examination. The use of ratios by practitioners and researchers is necessarily based on a hypothesis (either explicitly specified or implicitly assumed) about the relationship between the numerator variable and the denominator size. In this situation, evidence must be gathered by the researcher to determine if the use of the ratio in that context conforms to his a priori expectations, thereby avoiding unwarranted inference from using the ratios." This beforehand knowledge is also modeled as human intuition expressed through subjective demonstrations.

Kemal (2011) provided a very clear and appropriate use of the accounting ratios to highlight how they can be used in a qualitative manner. His research is based on the Royal Bank of Scotland (RBS) and its performance...

The research utilized 20 such ratios to describe the value of the merger in a very unique yet specific manner that serves to clarify rather than obscure. He argued "profitability ratios, liquidity ratios, market value ratios have been considered as the most reliable and efficient ratios to check the profitability of the companies. Financial ratios can be an important tool for business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. Management makes extensive use of these accounting ratios to access the performance of the organization. These accounting ratios also help in making rational decisions and future planning for the betterment of the organization."
Muscettola (2015) demonstrated another use of accounting ratios for control as viewed through the paradigm of predicting bankruptcy. The article was premised on the idea that predicting bankruptcy was an important issue in the financial world and can provide greater insight into the depths of economic development and theory creation. He wrote "In recent decades many techniques occurred and many studies have been addressed by scholars throughout the world to clarify the most diverse aspects on the prediction of firms insolvencies. These models, despite their specificity, have in common the ability to select a subset of indicators that distinguish firms that become insolvent by healthy firms. So, regardless of the different methods used over time, it is possible to summarize this concept: talking about quality of the analytical techniques or functionality of the model means a successfully developed framework capable to predict the highest percentage of default and to commit, therefore, the fewer of forecast errors. In other words, it comes to detect the predictive ability of some indicators taking in a certain account the phenomenon of insolvency."

This research aimed to prove the value of simple accounting ratios by finding links between insolvency cases and trends found in accounting ratios. Here we see the research using the ratios to control his subjective argument and portray the ratios as something to be used and not something simply to attain. The author concluded that "therefore, the research develops a corporate failure prediction models using a parsimonious logit model with 32 financial ratios. The explanatory variables were subsequently used to build an alternative model using the specific averages of each accounting ratio in order to explore the incremental information content of individual ratios in predicting the probability of business failure."

Vladu et al. (2014) introduced a moral element into the use of accounting ratios and suggested that power of accountants is very great and should be tempered with restraint and wisdom. The importance of leadership in guiding the tone and quality of the company becomes obvious and the use of accounting ratios is merely an extension of this intent. They authors wrote "most of the scholars regard earnings management as a logical result of the flexibility of the accounting rules, allowing managers to choose the option that maximize the shareholder value. Good earnings management happens when executives generate stable financial performance by acceptable voluntary business decisions. Bad earnings management practices happen when managers generate artificial accounting entries or extend estimates beyond realistic limits. A defense of creative accounting behavior can be made which rests upon agency and positive accounting theories."

In this case we see how accounting ratios are lifeless and powerless unless a guiding force is moving them in one direction or another. The researchers used the ratios themselves to detect manipulation and thereby creating a useful model. "The study conducted is similar to the study conducted by Beneish (1999), in this respect we used financial data in order to construct the variables that seek to capture the effects of manipulation and predispositions that may prompt companies to engage in earnings management practices. Our study confirms the predictive content of the explanatory variables (e.g. accounting ratios) that take into account the simultaneous bloating in asset accounts."

Summary

The aforementioned research suggests the importance of several key factors in dealing with accounting ratios and how they can control or illuminate certain models of understanding. Financial statistics are tools that can be applied in a number of ways that are only limited by the imagination of the employing force. The power to deceive is also great within the accounting ratios that were discussed in the empirical research on this topic, further demonstrating the neutrality of the ratios themselves.

The issue of control through the use of accounting ratios boils down the issue of control itself. Leadership who…