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Unformatted text preview: 1 239 5884 e [email protected] Rest of the world t +44 (0)1234 750903 e [email protected] This case has been made available as part of the Stanford GSB free case collection www.thecasecentre.org/stanfordfreecases 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 t...
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