CLOSER LOOK SERIES: TOPICS, ISSUES, AND CONTROVERSIES IN CORPORATE GOVERNANCE

CGRP-07
DATE: 07/23/10

FINANCIAL MANIPULATION:
WORDS DON’T LIE
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 unreliable—either because of
intentional or unintentional misrepresentation—investment 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 in order 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 psychological rewards from inflating corporate
returns, in the form 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

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 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.
Professor David F. Larcker and Brian Tayan prepared this material as the basis for discussion. Larcker and Tayan
are co-authors of the book Corporate Governance Matters. The Corporate Governance Research Program is a
research center within the Stanford Graduate School of Business. For more information, visit:
http://www.gsb.stanford.edu/cldr/cgrp/.

Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Financial Manipulation: Words Don’t Lie, CGRP-07 p. 2

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 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 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 company’s accounting practices, which were first coming under scrutiny.
Rather than directly state that the company’s methods were appropriate, 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.” 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 unusual qualifiers that raise a red flag about Kumar’s
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.

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,” Barron’s, Jun. 26, 2006. Full transcript available through Lexis Nexis:
“Computer Associates: CEO Interview,” CNBC/Dow Jones Business Video, Apr. 30, 2001.
Financial Manipulation: Words Don’t Lie, CGRP-07 p. 3

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 support 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 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

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 wouldn’t shareholders
and analysts use these same techniques to evaluate the truthfulness of management?

7
Patricia Sellers, “The Fall of a Wall Street Highflier,” Fortune, Mar. 22, 2010.
Financial Manipulation: Words Don’t Lie, CGRP-07 p. 4

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
(unintelligible) somebody who buys paper by the barrel, but let me tell you, there is not a single named employee
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 accounting 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 committed 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 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 really 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?

Financial Manipulation: Words Don’t Lie, CGRP-07 p. 5

Exhibit 1 (continued)
Interview with Sanjay Kumar, CEO of Computer Associates (April 2001)

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 shareholder value and
I think ultimately the truth will prevail. […]

Griffeth: Mr. Kumar, thank you for taking the time to chat with us.

Kumar: Thank you.

Source: “Computer Associates: CEO Interview,” CNBC/Dow Jones Business Video, Apr. 30, 2001.
Financial Manipulation: Words Don’t Lie, CGRP-07 p. 6

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”

“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”

Source: Lehman Brothers, Q1 2008 Earnings Conference Call,” FD (Fair Disclosure) Wire, Mar. 18, 2008.
Financial Manipulation: Words Don’t Lie, CGRP-07 p. 7

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 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 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 personal
training is right now. It’s still on a major part of our strategy.

Source: Bally Total Fitness, “Investor Call,” FD (Fair Disclosure) Wire, Jul. 13, 2005.