Introduction
Changes in the financial performance of an entity from one period to another period depend on a number of factors. These factors are economic (such as fluctuations in the exchange rate, stiff competition and recession), social (such as people’s perception about the product), and climatic factors (adverse weather changes such as drought and constant snow flow) (Vance, 2003). Therefore, an institution should closely monitor the effects of internal and external factors on financial statements (Haber, 2004). Companies are required to publish financial statements for use by various stakeholders. Therefore, it is necessary to analyze the financial performance of a company because it gives stakeholders an understanding of the financial records. Ratio analysis is a vital tool for analyzing the financial performance of a company (Siddiqui, 2005).
Irrational ratios
Profitability, liquidity, leverage, and efficiency ratios are efficient in monitoring the performance of an institution over time. However, these ratios may not provide information on the possibility of manipulation of the financial records. Irrational ratios provide an in-depth insight into the financial performance of a company. They show the possibility of manipulation of financial statements. They also indicate the possibility of fraud. Financial statements such as cash flow statements, statement of financial position, and statement of profit and loss are interrelated. Therefore, it might be impossible to detect any irregularities in the statements using simple ratios (Brigham and Houston, 2009). Irrational ratios reveal any irregularities that exist in the financial statements. Manipulators mean index and non-manipulators index used to carry out hypothesis testing on the ratios computed. The Wilcoxon Rank Sum and Median tests reveal whether there is an existence of fraud in the financial statements. The commonly used irrational ratios are days in sales receivables index, gross margin index, asset quality index, sales growth index, and accruals to total assets (Wells, 2001). This paper attempts to compute irrational ratios for five companies such as HealthSouth, Dell Computers, Overstock.com, Marks and Spencer, and Coca-Cola Company. It further carries out hypothesis tested on the results showing possible existence of fraud in the financial statements of the five companies.
Overview of irrational ratios
Days’ Sales in receivables index
“This ratio measures whether receivables and revenue are in or out of balance in conservative reporting periods” (Wells, 2001). A substantial increase in the value of the index can be an indication that receivables are spurious.
Gross margin index
Gross profit is a reliable indicator of a company’s health. “When an entity’s gross profit margins on sales shrink from one period to the next, the risk is high that management will engage in fraud to create artificial profits or decrease losses” (Wells, 2001). Therefore, a financial analyst should look for significant changes in the gross profit index.
Asset quality index
Asset quality index measures “the proportion of total assets for which future benefits may be less certain” (Wells, 2001). An upward trend in the asset quality index shows a possibility of capitalization of costs in the future.
Sales growth index
The sales growth index helps investigators to know whether growth in sales of a company is justifiable or not. Results of hypothesis testing will enable an investigator to determine whether the growth in sales is genuine.
Total accruals to total assets index
The total accruals to total assets index indicate the possibility of the use of accrual policy to manipulate earnings. “An increase in accruals from one period to the next may indicate that management is attempting to manipulate earnings through its discretionary authority over accrual policy” (Wells, 2001).
HealthSouth Corporation
About the company
HealthSouth, founded in 1984, is a publicly-traded company incorporated in the United States. It offers inpatient rehabilitative services in about 26 centers within America.
Table 1.0 Irrational ratios for Health South Corporation.
Explanation of the results
From the above table, the total accruals to total assets index show that the company manipulated earnings using accrual policy. Also, the gross profit index shows a possibility of manipulation of the gross profit of the company.
Dell Computers
About the company
Dell Computers is a multinational company incorporated in the United States of America. The Company engages in the development, sales and support of computers. Michael Dell founded the company in 1984. The company employs over 100,000 citizens. It has recorded tremendous growth over the years since its formation.
Table 1.1 Irrational ratios for Dell Computers.
Explanation of the results
The table above shows that there was a possibility of manipulation of earnings during the three years. Investigators need to carry out more analysis to verify if there were actual manipulations of earnings.
Overstock.com
About the company
Overstock.com founded in 1997, is an American-based company. The company carries out online trading, auctioning and advertisement among others.
Table 1.2 Irrational ratios for Overstock.com.
Explanation of the results
The table above shows that there was manipulation of earnings in 2004 as indicated by the day’s sales receivable index. Besides, the company also made use of an accrual policy to manipulate earnings during the three years. There was an indication of manipulation of financial reports for the year 2010 because most of the ratios show the possible existence of manipulation.
Marks and Spencer
About the company
Marks and Spencer is an international company having several stores in the United Kingdom. The Company deals with clothing and food products. It is a publicly-traded company. Michael Marks and Thomas Spencer founded the company in 1884.
Table 1.3 Irrational ratios Marks and Spencer.
Explanation of the results
The management of the company manipulated earnings over the three-year period. This is shown by days in the sales receivable index in 2008 and gross margin index in 2009 and a possibility in 2010.
Coca-Cola
About the company
Coca-Cola founded in 1886, deals in soft drinks. It is a multinational company incorporated in the United States of America. The company owns several brand names.
Table 1.4 Irrational ratios for Coca Cola Company.
Explanation of the results
From the table above, the results of hypothesis testing indicate that the company did not manipulate earnings. However, there were possibilities of manipulation especially in 2008 and 2009. Therefore, an investigator needs to carry out more tests to enable him to verify the existence of manipulation of the financial statements.
Conclusion
Irrational ratios were computed for five companies. The results indicate the companies manipulated or showed indications of manipulating earnings within the period of analysis. Manipulation of earnings is a common practice across the globe. Accountants easily manipulate financial records. Fraud is difficult to detect. An investigating body needs to be well informed on matters concerning fraud especially on ways which accountants use to conceal the fraud. An investigator can also use vertical and horizontal analysis to detect fraud. It is necessary to carry out an investigation over the period.
References
Brigham, E., & Houston, F. (2009). Fundamentals of financial management. USA: South-Western Cengage Learning.
Haber, R. (2004). Accounting dimistified. New York: American Management Association.
Siddiqui, A. (2005). Managerial economics and financial analysis, New Delhi: New age international (P) limited.
Vance, D. (2003). Financial analysis and decision making: Tools and techniques to solve. United States: McGraw-Hill Books
Wells, J. (2001). Irrational ratios. Web.