STANFORD CLOSER LOOK SERIES

Topics, Issues, and Controversies in Corporate Governance and Leadership

Financial Manipulation: Words Dont Lie

By David F. Larcker and Brian Tayan July 23, 2010

Integrity of Financial Statements

Reliable financial reporting is critical to the efficiency of capital markets. When financial statements are prepared according to sound accounting principles, investors are able to make informed investment decisions and either buy or sell assets at prices that are appropriate given their potential risk and return. When financial statements are unreliableeither because of intentional or unintentional misrepresentationinvestment decisions will suffer and asset prices will be inappropriate given their prospects for future return. As a result, accurate and transparent disclosure is essential to a well-functioning capital market. Despite the importance of accurate financial reporting, management may have incentive to misrepresent 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 companys share price and increase the value of their equity holdings. Even in the absence of financial payment, management may gain psychological rewards from inflating corporate returns, in the form of positive press coverage and the admiration 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 fraudulent accounting. These models tend to analyze the

discrepancy between the cash generated by the operating, investment and financial activities of the firm and the earnings reported under accrual accounting. 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 attributes of the companys 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 financial manipulation.3 There is some evidence that quantitative models may be improved through the application of techniques 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 individuals 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 generalities rather than specifics and give responses that are indirect or vague. They may also be marked by caution, nervous behavior, or avoidance of eye contact.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 companys accounting practices, which were first coming under scrutiny. Rather than directly state that the companys methods were appropriate, Kumars responses were evasive: You cant hide [behind] GAAP. GAAP accounting rules are the ones that we all live by and they are very strict.
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Financial Manipulation: Words Dont Lie

He went on to say that the companys explanation of its results was plausible and that there was nothing fundamentally wrong with its activities. The words plausible and fundamentally are unusual qualifiers that raise a red flag about Kumars truthfulness (see Exhibit 1).6 In 2006, Kumar was found guilty of accounting manipulation, securities 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 companys deteriorating financial position. In a conference call just months before Lehmans 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 support her message (see Exhibit 2).7 As another example, executives at Bally Total Fitness were considerably hesitant in answering specific questions about the companys operating 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

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 procedures. 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 occur. According to Glass Lewis, between 200 and 500 publicly traded companies listed in the U.S. restate their earnings each year (approximately 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 detect potential manipulation. 3 For more on this topic, see also: Madhav V. Rajan and Brian Tayan, Financial Restatements: Methods Companies Use to Distort Financial Performance, GSB Case No. A-198, Jun. 10, 2008. Available at: https://gsbapps.stanford.edu/cases/. 4 David F. Larcker and Anastasia Zakolyukina, Detecting Deceptive Discussions in Conference Calls, Jan. 06, 2010. Available at SSRN: http://ssrn.com/abstract=1572705; and Jessen L. Hobson, William J. Mayew, and Mohan Venkatachalam, Analyzing Speech to Detect Financial Misreporting (July 2010). Available at SSRN: http://ssrn.com/abstract=1531871. 5 Aldert Vrij, Detecting Lies and Deceit: Pitfalls and Opportunities, John Wiley &. Sons, 2000. 6 Jonathan R. Laing, Is Your CEO Lying, Barrons, 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.
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Given the difficulty of detecting financial manipulation, it may be time for shareholders and analysts to develop new techniques for identifying deception. Law enforcement agencies and federal investigators rely on linguistic tools and behavioral analysis. Why wouldnt shareholders and analysts use these same techniques to evaluate the truthfulness of management?

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 Stanfords Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate 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 corporate 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 Stanford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

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Financial Manipulation: Words Dont 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 dont want to play tit for tat with the New York Times, because (unintelligible) somebody who buys paper by the barrel, but let me tell you, there is not a single named employee source in there, theres 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 accounting source, and he talks to two customers. [] So Im 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 committed customer contracts, signed, done, signed, sealed and delivered, that doesnt 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: Thats 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 cant 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 dont think theres really any confusion at all with respect to the numbers. And we also, by the way, further details on our call this morning and theres 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 its a perfectly plausible answer. We dont need to have maintenance numbers like anybody else, but we are not doing anything wrong fundamentally in our business. [] Griffeth: Im 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 whats right for the company. Today we want to clarify our business model, defend whats right for the company and defend our shareholders. I am most concerned about shareholder 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.
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Financial Manipulation: Words Dont Lie

Exhibit 2 Erin Callan, CFO of Lehman Brother Selected Comment (March 2008) Erin Callan, CFO: 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 its 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 were 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
Source: Lehman Brothers, Q1 2008 Earnings Conference Call, FD (Fair Disclosure) Wire, Mar. 18, 2008.

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Financial Manipulation: Words Dont Lie

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 wed 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 were looking 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 havent 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. Its hard to give that data, again, until we get the GAAP numbers done. All I can tell you is that were certainly still seeing growth in personal training. But in order to quantify it and give the year-overyear, theres a fair amount of complexity still tied up in the accounting. So thats why we have unfortunately not released that data. But its still growing. Kevin Buckle: Is it meeting your internal budget expectations? Paul Tobak: Hard to say. I guess Id say that said another way, yes. Were not disappointed with where personal training is right now. Its still on a major part of our strategy.
Source: Bally Total Fitness, Investor Call, FD (Fair Disclosure) Wire, Jul. 13, 2005.

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