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?

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. 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:
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.
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:
http://www.gsb.stanford.edu/cldr.
Copyright © 2012 by the Board of Trustees of the Leland
Stanford Junior University. All rights reserved.

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. 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. 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.