Manipulation of Accounts through Ratio Analysis

By

ACKNOWLEDGEMENT

I would take this opportunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible

LIST OF ABREVIATIONS and ACRONYMS

D/E Ratio: Debt to Equity Ratio

ROA: Return On Assets

ROE: Return On Equity

P/E : Price Earnings Ratio

EPS: Earning per Share

ACFE: Association of Certified Fraud Examiner.

CFE: Certified Fraud Examiners.

SAS: Statement of Accounting Standard

TABLE OF CONTENTS

ACKNOWLEDGEMENTII

LIST OF ABREVIATIONS AND ACRONYMSIII

CHAPTER 1 - INTRODUCTION1

Background1

Rationale for the study5

Conceptual Framework6

Research Objectives7

Chapter Summary7

CHAPTER 2 - METHODOLOGY10

Introduction10

Objectives10

Methodological Approach10

Research Philosophy12

Chapter Summary13

CHAPTER 3 - LITERATURE REVIEW15

Introduction15

Key Performance Indicators16

Financial Performance17

Ratio Analysis17

Liquidity Ratios17

Current Ratio18

Acid Test Ratio18

Profitability ratios19

Return on Shareholder's Fund (ROSF)19

Return on capital employed (ROCE)19

Operating Profit Ratio20

Gross profit margin20

Efficiency ratios20

Average stock turnover period ratio21

Average settlement period for debtors21

Average settlement period for creditors21

Sales revenue to capital employed22

Gearing ratios22

Investor ratios22

Limitations of Ratio analysis23

Conceptual Framework24

Significant Thinkers25

Trends in this area of Management26

Market Efficiency27

Farfetched Interpretation and Fraud27

Chapter Summary27

CHAPTER 4 - RESULTS33

The Importance of Accounting Information33

Creative Accounting35

Flexibility of Rules37

Appraised Values / Estimates37

False Transactions38

Timing of Transactions38

Main reasons for the use of creative methods40

The role of Accountant and external Auditor in the Creative Accounting41

Changes in the European Union42

Auditor's liability for detection and prevention of the Creative Accounting44

Accounting harmonisation: the struggle against creativity in accounting?47

CHAPTER 5 - ANALYSIS48

Liquidity ratios50

The Efficiency Ratios51

Profitability ratios53

The Leverage Ratios54

Access and calculation of ratios54

Interpretation of your ratios54

Cash ratio (solvency)55

Current ratio55

Quick or Acid Test Ratio55

CHAPTER 6 - CONCLUSION AND RECOMMENDATIONS59

Recommendations62

REFERENCES63

APPENDIX67

CHAPTER 1 - INTRODUCTION

Background

Among the techniques of creative accounting described by Griffiths are those relating to income recognition, cost recognition, the use of pension funds, classification into extraordinary and exceptional items, use of taxation, and foreign currency translation? While some techniques of creative accounting are reasonably transparent, the use of others, such as off-balance-sheet financing, is difficult to detect.

Managers are seen as increasingly being required to tailor company results to meet the demands of the capital markets. Income smoothing techniques are used to produce a steady growth in profits demanded by investors, and earnings are manipulated to meet the expectations of analysts. In takeovers, creative accounting is used by both predator and target companies to flatter their results and financial positions. (Agile 1994 61-81)

Dechow and Skinner (2000) suggests that much of the growth in reported company profits that occurred in the UK during the 1980s resulted from the use of accounting techniques rather than from genuine economic growth. He identifies, and describes, the main techniques that a company may use to flatter its results and financial position, and provides examples of each technique. The book also contains an “accounting health check”, showing for each of over 200 major UK listed companies, whether the company uses one or more of 12 classes of creative accounting technique identified by the author. A company using five or more of these techniques is likely, according to Smith, to have poor relative share price performance. (Agnoli 2000 377-397)

Buckmaster (1992), describe, and attempt to identify the common characteristics of, a number of problems of financial reporting related to the use of creative ...