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Creative Accounting and Failed Risk Management

David M. Cannon, Joseph H. Godwin, and Stephen R. Goldberg

BOOKS REVIEWED:
de la Torre, Ignacio, 2008, Creative Accounting Exposed (Houndmills, Basingstoke, Hampshire, UK: Palgrave MacMillan). Hubbard, Douglas W., 2009, The Failure of Risk Management: Why Its Broken and How to Fix It (Hoboken, NJ: Wiley). The books selected for review address deceptive financial reporting practices and improving risk management. In Creative Accounting Exposed, Ignacio de la Torre describes how organizations legally and illegally mislead users of financial statements. In The Failure of Risk Management, Douglas W. Hubbard shows how to identify and fix hidden risk management problems.

CREATIVE ACCOUNTING EXPOSED

Creative Accounting Exposed is a comprehensive compendium of aggressive accounting practices across the
2009 Wiley Periodicals, Inc.

Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20550

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world. Written in a clear, concise, and surprisingly nonjudgmental and factual style, author Ignacio de la Torre details numerous examples of how organizations legally and illegally achieved desired reporting results that were not truly representative of their financial performance or position. For many readers, this book will provide eye-opening insights into the degree and ease with which financial statements can be manipulated. In the books introduction, the author defines creative accounting as the use of subjectivity in the interpretation of accounting rules to the extent that the financial information does not reflect the real situation despite complying with the law. The techniques and examples presented in later chapters suggest he also includes illegal methods in his definition of the term. The schemes and methods presented in the book range from simplistic aggressive revenue recognition techniques to highly sophisticated financial statement manipulations involving both the use of complex derivatives and

the complicity of multiple external entities. As an academic, the author does a great job of explaining the economic effects of a transaction and then shows how a particular scheme operates and results in a desired reporting distortion in the financial statements. This book is organized into eight chapters, the first six of which address different categories of creative accounting schemes and techniques. For example, Chapters 1, 3, and 5 discuss creative accounting in the revenue recognition, offbalance-sheet financing, and recognition of financial items categories, respectively. Chapter 7 covers creative accounting in governmental and privately held entities, while Chapter 8 relates the authors perspective on creative accounting practices in the context of recent history and international accounting, reporting, and regulatory environments. Creative Accounting Exposed is extremely well written, belying the fact that it is a translation of a work written and originally published in Spanish

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in 2006. The text flows seamlessly between descriptions of aggressive accounting techniques, their effects, the motivations of those that use them, the underlying accounting principles and true economic effects of the supporting graphs and tables, and copious real-life examples of the use and effects of aggressive accounting. The seamless quality also applies to how de la Torre is able to effortlessly shift between examples of creative accounting practices under U.S. generally accepted accounting principles (GAAP), countryspecific accounting standards, and International Financial Reporting Standards (IFRSs). In spite of massive changes in the economy since the original 2006 publication of Creative Accounting Exposed, the book remains highly relevant. The author notes that the bursting of the economic bubble in 2007 exposed the billions and billions of dollars that the main Western banks . . . kept out of their balance sheets. Other types of organizations were likewise found to have been using many of the schemes outlined by the author when the schemes or organizations failed in the face of the massive economic events of late 2008 whose reverberations continue to this day. The lone additions to the 2006 Spanish edition, which was updated and published (in English) in 2008, appear to be a brief mention of 2007 economic events in the acknowledgment page in the books front cover, and a two-page epilogue in Chapter 3 that describes the role of creative accounting in the mid-2007 economic crisis. One of the underlying lessons of this book is that the adoption of new accounting standards, and in particular, IFRSs, can expose the prior use
DOI: 10.1002/jcaf

of creative accounting practices. Many of the examples used by de la Torre were illustrated by the differences in reporting between national accounting standards and IFRSs. While all such differences cannot be attributed to creative accounting, there are some that have no other rational explanation. This book is highly recommended for executives, investors, lenders, auditors, forensic accountants, credit analysts, or anyone with an interest in the reliability of financial statements. Most readers, and particularly graduate accounting and business students, should benefit from the insights they can gain into legal and illegal accounting choices and schemes that affect the quality of financial reporting.

THE FAILURE OF RISK MANAGEMENT

Natural, financial, and geopolitical disasters at the beginning of the twenty-first century encouraged growth and application of financial and nonfinancial risk management methods. The Failure of Risk Management points out that most risk management methods do not address known sources of errors, and there is a growing realization that systematic errors have undermined the validity of these methods. Also, typical risk management methods have no performance measures to determine their effectiveness. Douglas W. Hubbard shows executives how to measure risk management performance and fix hidden problems. He uses his considerable expertise to illustrate calibrated risk analysis and attendant benefits. He provides checklists and practical examples, which allow managers to hit the ground running. Hubbard

invented Applied Information Economics. He is an expert in measuring intangibles, risks, and value (especially information technology [IT]). His methods have applied to dozens of Fortune 500 IT investments, military logistics, venture capital, aerospace, and environmental issues. He has written and speaks extensively on his areas of expertise. Hubbard questions whether traditional methods work, whether anyone in the organization would know if they did not work, and what would the consequences be if they didnt work. The Failure of Risk Management includes just enough technical information to make the subject accessible to a general management audience. The authors objectives in the book are (1) to reach the widest possible audience among managers and analysts, (2) to give them enough information to quit using ineffective methods, and (3) to get them started on better solutions. Common mode failure arises when a single event causes failures of multiple components in a system. One example is an airplane crash in which a tailmounted engine failed and, with turbine blades flying out of the engine like shrapnel, cut all three redundant hydraulic systems, making the plane uncontrollable. Aviation officials referred to this as a one-in-a-billion failure based on the likelihood of all four events occurring independently. However, the events are not independent. A similar analysis can be made of the current financial crisis. Initial risk assessment must be based on meaningful measures for real risk mitigation. The author applies his technique to examples such as approval and prioritization of investments and
2009 Wiley Periodicals, Inc.

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project portfolios and evaluation of major security threats. Failure of risk management may not be obvious. A single disastrous event does not necessarily constitute a failure of risk management. The author identifies three reasons for failure of risk management. The first reason is a failure to measure the effectiveness of risk management. A second reason for failure is not using methods or research known to work. Examples are (1) failing to use research that shows how humans misperceive and systematically underestimate risks and (2) adding error through arbitrary scales or nave use of historical data. The final reason is not using methods that are proven to work. The book consists of three parts, 12 chapters, and 260 pages, plus a preface, a calibration test,

and an index. Part One: An Introduction to the Crisis consists of three introductory chapters. Hubbard introduces the problem being addressed, outlines the diversity of risk management approaches, and examines how to evaluate risk management methods. The six chapters in Part Two: Why Its Broken introduce four schools of thought to risk management and differences in terminology. Sources of errors in popular methods that have not been addressed are discussed. Fallacies are listed that keep firms from using better methods. The last chapter of this part highlights significant problems with quantitative methods that are used. Part Three: How to Fix It introduces methods that address sources of errors identified in the second part. Basic

concepts behind better methods are discussed. Hubbard suggests how to think about probabilities and how to introduce scientific methods and measurements into risk management. The book concludes by looking at issues involved in creating a culture in organizations that facilitates better risk management. As the author indicates, he attempts to give readers a 10,000-foot view; in addition, he refers readers to his Web site with more hands-on sample spreadsheets to see example calculations. Hubbard makes an interesting contribution to the risk management literature. The Failure of Risk Management is recommended reading for managers at all levels and aspiring executives interested in or involved in risk management, and strategic planning.

David M. Cannon, PhD, CPA, CISA, is an assistant professor at Grand Valley State University. Dr. Cannons teaching interests are in accounting information systems, management information systems, and managerial accounting. His research areas include accounting information systems and methodological issues in accounting research. Joseph H. Godwin, PhD, CPA, and Stephen R. Goldberg, PhD, CPA, are professors of accounting at Grand Valley State University. Their teaching and research interests focus on financial accounting, international accounting, financial derivatives, and economic value added. They have published articles in a number of academic and practitioner-oriented journals.

2009 Wiley Periodicals, Inc.

DOI: 10.1002/jcaf