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Financial Manipulation: Words Don't Lie


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Linguists and psychologists have developed techniques to identify deceptive language and behavior. Why don’t shareholders use these same techniques to evaluate the truthfulness of management and detect financial manipulation?

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Financial Manipulation: Words Don't Lie

  1. 1. Topics, Issues, and Controversies in Corporate Governance and Leadership S T A N F O R D C L O S E R L O O K S E R I E S stanford closer look series 1 Financial Manipulation: Words Don’t Lie Integrity of Financial Statements Reliable financial reporting is critical to the efficien- cy of capital markets. When financial statements are prepared according to sound accounting principles, investors are able to make informed investment de- cisions and either buy or sell assets at prices that are appropriate given their potential risk and return. When financial statements are unreliable—either because of intentional or unintentional misrepre- sentation—investment decisions will suffer and as- set prices will be inappropriate given their prospects for future return. As a result, accurate and trans- parent disclosure is essential to a well-functioning capital market. Despite the importance of accurate financial re- porting, management may have incentive to mis- represent financial results for personal gain. For example, management may be tempted to inflate current period results in order to increase the size of a performance bonus. They may also do so in order to beat Wall Street estimates for quarterly earnings to boost the company’s share price and increase the value of their equity holdings. Even in the absence of financial payment, management may gain psy- chological rewards from inflating corporate returns, in the form of positive press coverage and the ad- miration of peers. While sound governance systems are expected to have controls in place that prevent or detect such maneuvers, they may not always be effective.1 Methods for Detecting Financial Manipulation Many academics and professionals have attempted to develop models that detect aggressive or fraudu- lent accounting. These models tend to analyze the By David F. Larcker and Brian Tayan July 23, 2010 discrepancy between the cash generated by the op- erating, investment and financial activities of the firm and the earnings reported under accrual ac- counting. When reported earnings diverge from the cash generated by the business, it may be indicative of manipulation by management.2 Some models also incorporate information on the structural at- tributes of the company’s governance system. Still, these efforts tend to have limited success. To our knowledge, no one has yet developed a quantitative model that consistently and reliably predicts finan- cial manipulation.3 There is some evidence that quantitative models may be improved through the application of tech- niques developed by linguists and psychologists to identify deceptive language and behavior.4 These methods rely on the analysis of linguistic patterns and nonverbal cues to evaluate whether individu- als are being truthful. Individuals who are trying to deceive others may exhibit distinct styles of speech, including language that disassociates themselves from their subject matter. They may speak in gen- eralities rather than specifics and give responses that are indirect or vague. They may also be marked by caution, nervous behavior, or avoidance of eye con- tact.5 There are several prominent examples of such behavior. Take, for example, Sanjay Kumar, former CEO of Computer Associates. In a 2001 television interview, Kumar was asked a series of questions about the company’s accounting practices, which were first coming under scrutiny. Rather than di- rectly state that the company’s methods were appro- priate, Kumar’s responses were evasive: “You can’t hide [behind] GAAP. GAAP accounting rules are the ones that we all live by and they are very strict.”
  2. 2. stanford closer look series 2 Financial Manipulation: Words Don’t Lie He went on to say that the company’s explanation of its results was “plausible” and that there was nothing “fundamentally” wrong with its activities. The words “plausible” and “fundamentally” are un- usual qualifiers that raise a red flag about Kumar’s truthfulness (see Exhibit 1).6 In 2006, Kumar was found guilty of accounting manipulation, securi- ties fraud, and lying to federal investigators. He was sentenced to 12 years in prison. In a similar vein, Erin Callan, former CFO of Lehman Brothers, used language that was generic and excessively positive to obscure the company’s deteriorating financial position. In a conference call just months before Lehman’s collapse, she used the word “great” 14 times, “strong” 24 times, and “incredibly” eight times. By contrast, she used the word “challenging” six times and “tough” only once. This had the effect of conveying a positive tone without providing specific factual data to sup- port her message (see Exhibit 2).7 As another example, executives at Bally Total Fitness were considerably hesitant in answering specific questions about the company’s operat- ing performance during a 2005 conference call. Responses were vague and indirect. The syntax was complicated and at times quite stilted. Such speech patterns may indicate that an individual is less than forthcoming or that he is having difficulty suppressing information that he does not wish to divulge (see Exhibit 3). Ultimately, the company restated its financial multiple times, the CEO and CFO were both forced to resign, and the company filed for bankruptcy. Why This Matters Given the difficulty of detecting financial manipu- lation, it may be time for shareholders and analysts to develop new techniques for identifying decep- tion. Law enforcement agencies and federal investi- gators rely on linguistic tools and behavioral analy- sis. Why wouldn’t shareholders and analysts use these same techniques to evaluate the truthfulness of management?  1 The audit committee oversees the reporting process and monitors the choice of accounting principles. The external auditor reviews management assumptions and tests selected accounts for material misstatements. The internal audit committee implements corporate controls and ensures compliance with financial reporting proce- dures. The Sarbanes Oxley Act of 2002 requires that both the CEO and CFO certify the integrity of financial statements and holds them personally liable for misrepresentation. Still, restatements oc- cur. According to Glass Lewis, between 200 and 500 publicly traded companies listed in the U.S. restate their earnings each year (ap- proximately 5 to 12 percent of the total). Glass Lewis & Co., “Trend Report: Restatements,” Mar. 19, 2009. 2 Accrual accounting is based on the assumption that revenues and expenses can be more accurately measured by applying them to the period in which they are earned rather than the period in which they are realized. Because accrual accounting relies more heavily on managerial assumptions, it is more subject to manipulation. When management manipulates results over time, reported earnings will diverse from cash flows. The difference between accruals and cash flows (known as abnormal accruals) theoretically can be used to de- tect potential manipulation. 3 For more on this topic, see also: Madhav V. Rajan and Brian Tayan, “Financial Restatements: Methods Companies Use to Distort Finan- cial Performance,” GSB Case No. A-198, Jun. 10, 2008. Available at: 4 David F. Larcker and Anastasia Zakolyukina, “Detecting Deceptive Discussions in Conference Calls,” Jan. 06, 2010. Available at SSRN:; and Jessen L. Hobson, William J. Mayew, and Mohan Venkatachalam, Analyzing Speech to Detect Financial Misreporting (July 2010). Available at SSRN: 5 Aldert Vrij, “Detecting Lies and Deceit: Pitfalls and Opportunities,” John Wiley &. Sons, 2000. 6 Jonathan R. Laing, “Is Your CEO Lying,” Barron’s, Jun. 26, 2006. Full transcript available through Lexis Nexis: “Computer Associates: CEO Interview,” CNBC/Dow Jones Business Video, Apr. 30, 2001. 7 Patricia Sellers, “The Fall of a Wall Street Highflier,” Fortune, Mar. 22, 2010. David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanford’s Cen- ter for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Cor- porate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in cor- porate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stan- ford University. For more information, visit: Copyright © 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
  3. 3. stanford closer look series 3 Financial Manipulation: Words Don’t Lie Exhibit 1 — Interview with Sanjay Kumar, CEO of Computer Associates (April 2001) Bill Griffeth (CNBC): […] Before we get to the specific charges, why do you think these employees would say what they did about your accounting practices? Sanjay Kumar: Well, I mean, you know, I don’t want to play tit for tat with the New York Times, because (un- intelligible) somebody who buys paper by the barrel, but let me tell you, there is not a single named employ- ee source in there, there’s not a single Wall Street analyst named in the article. To me that is just incredible that the New York Times, a paper of record, would write a story like this without talking to a single account- ing source, and he talks to two customers. […] So I’m not sure where the factual reporting is for the story. Griffeth: And in the big picture, I mean, the charge that you are trying to mask a decline in sales, I mean, when you are saying that revenues are up, I mean it comes at a time when everybody is, you know, falling on hard times, especially for information technology spending. I mean there is nothing wrong in this climate with having a declining sales rate right now. Kumar: Well, you are right, there is nothing wrong with it, and we, like everybody else, are seeing tough economic times. You can refer to our April 16th press release where we talked about the fourth fiscal quarter. We clearly said economic times are tough, but we are doing better. […] Part of the difference here is our new business model. […] If you look at our press release, in the body of the press release is a very clear sentence that says we also signed $1.3 billion of backlog in the quarter that under the new business model will come into revenue in the future. That is $1.3 billion more than reported revenue that we signed. These are com- mitted customer contracts, signed, done, signed, sealed and delivered, that doesn’t come into the [current] period, and to leave that out, I think, is just unfair. Griffeth: But there is a question posed in the article of how much of what you have booked was maintenance business as opposed to actual new software business. Kumar: That’s right, and we said very clearly today that our maintenance numbers conformed to GAAP accounting, our maintenance numbers conform to accounting statements of position of 972 and 989 of a technical pronouncement... Griffeth: With all due respect, Sanjay, you can hide behind GAAP accounting methods. Is there a possibility that it is easy to perhaps confuse maintenance business from new software contracts? Kumar: No, you can’t hide [behind] GAAP. GAAP accounting rules are the ones that we all live by and they are very strict. We had both KPMG and [Ernst & Young] yesterday restate that they are ok with our numbers. We have taken the unusual step of getting an attestation to our pro forma numbers. I don’t think there’s re- ally any confusion at all with respect to the numbers. And we also, by the way, further details on our call this morning and there’s information on our Web site as to why our maintenance numbers are in the range, but at the low end of the range, of software companies. And it’s a perfectly plausible answer. We don’t need to have maintenance numbers like anybody else, but we are not doing anything wrong fundamentally in our business. […] Griffeth: I’m running out of time, unfortunately, but for the record, have you been contacted by anybody connected at all with the SEC about any possible investigation, whether it has, in fact, begun or whether they are in formal inquires about your accounting practices? Kumar: No, sir. […] I, my general counsel and CFO have no knowledge whatsoever of any SEC investigation. Griffeth: Any thoughts of taking action on this on your part? Kumar: Well, I think we have to do what’s right for the company. Today we want to clarify our business model, defend what’s right for the company and defend our shareholders. I am most concerned about share- holder value and I think ultimately the truth will prevail. […] Griffeth: Mr. Kumar, thank you for taking the time to chat with us. Source: “Computer Associates: CEO Interview,” CNBC/Dow Jones Business Video, Apr. 30, 2001.
  4. 4. stanford closer look series 4 Financial Manipulation: Words Don’t Lie Exhibit 2 — Erin Callan, CFO of Lehman Brother – Selected Comment (March 2008) Erin Callan, CFO: Source: Lehman Brothers, Q1 2008 Earnings Conference Call,” FD (Fair Disclosure) Wire, Mar. 18, 2008. “we did see very strong client flows and a robust trading environment” “our strong core client activity” “our corporate derivative revenues were very strong” “very, very strong high grade underwriting activity” “we continue to have a strong underwriting position with financial institutions” “we had strong client revenues” “incredibly strong client activity” “a very strong performance out of the underlying franchise” “results in fixed income continue to be very strong in Asia” “we expect customer activity to stay strong” “we do have a very strong disciplined program of how we would take assets down on the balance sheet” “incredibly productive group of people for the firm.” “an incredibly good statement about the strength and confidence of our franchise” “an area which we have done incredibly well in and feel well positioned going forward” “it’s just incredibly attractive” “our ability to access that form of financing to do more business with clients is incredibly interesting” “incredibly well received, great participation, great oversubscription” “we continue to do a very, very good job managing the risk on residential mortgages, an area that I think we’re credited with a lot of expertise, a great franchise” “great client franchise performance” “a great amount of transparency on the balance sheet” “just great progress in continuing to move those back at higher prices” “great for our trading businesses” “a great opportunity to do more client business”
  5. 5. stanford closer look series 5 Financial Manipulation: Words Don’t Lie Source: Bally Total Fitness, “Investor Call,” FD (Fair Disclosure) Wire, Jul. 13, 2005. Exhibit 3 — Bally Total Fitness: Earnings Conference Call (July 2005) Excerpted comments from the Q&A Denise Culm, analyst: I have a question regarding cash flow from operations. […] Cash flow from operations for May [is] a couple of million dollars lower than it was versus March and then also versus February. I wonder if there are some items such as higher interest cost or higher legal expenses that we should be aware of when I look at the number? Paul Tobak, CEO: Yes. I think that you, certainly, and I think we talked about this a little bit on the last call. There are higher interest costs this year. I think both the things you said are right. And there are higher amounts, as I said in my opening remarks, of expenses associated with what we’d say are non-operational issues such as restructuring costs and investigation related costs. So both of those things absolutely are affecting it. I think the key thing to be looking at and that we’re look- ing at is that the cash from operations over the five month period is up and the free cash flow is substantially improved over last year. […] Kevin Buckle, analyst: You haven’t given any details at all on the private training area, which is also a specific part of your business as well. Can you give us some sense in the first five months what the trend has been there on a top line year-over-year basis? Paul Tobak: Yes. It’s hard to give that data, again, until we get the GAAP numbers done. All I can tell you is that we’re certainly still seeing growth in personal training. But in order to quantify it and give the year-over- year, there’s a fair amount of complexity still tied up in the accounting. So that’s why we have unfortunately not released that data. But it’s still growing. Kevin Buckle: Is it meeting your internal budget expectations? Paul Tobak: Hard to say. I guess I’d say that said another way, yes. We’re not disappointed with where per- sonal training is right now. It’s still on a major part of our strategy.