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...
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