Can you tell when a CEO is lying? According to David Larcker and Anastasia Zakolyukina, two researchers at the Stanford Graduate School of Business, some key words and attitudes from corporate leaders can provide valuable signals when it comes to detecting dishonesty. Also, while financial figures do not lie (most of the time), those numbers are prepared and reported by people, and the quality of financial reports can say a lot about the level of transparency from management.
More than words
According a 2010 research paper entitled "Detecting Deceptive Discussions in Conference Calls, the two academics believe you can identify lying CEOs by paying attention to their words and attitudes. Based on an analysis of almost 30,000 earnings transcripts from 2003 to 2007, the CEOs who later had to revise their books displayed some consistent signs and clues.
Many corporate CEOs can be criticized for being too egocentric and self-centered, typically willing to take more than their fair share of the credit when the business is firing on all cylinders. On the other hand, the research paper claims that lying CEOs are more inclined to share the responsibility when the company's performance is disappointing. For example, they use terms such as "we," "the team," and "the company" as opposed to talking in first person, or using "I."
Deceptive CEOs can also be more prone to using general knowledge as a justification for their point of views instead of relying on their own knowledge of and experience with the business, according to the study. They tend to use phrases such as "you know" and "everyone agrees." These kinds of statements can sound authoritative, and they reduce the CEO's personal responsibility.
Also, when a CEO answers questions about an important and complicated matter with a short response and without any sign of hesitation, this can signal the answer has been scripted in advance. There is nothing wrong with being prepared for important questions, but such answers can show the CEO does not feel sufficiently confident to spend much time discussing a hot topic.
In addition, honest CEOs tend to use clear and measured terms such as "good" or "impressive," while lying ones are more inclined toward hyperbolic adjectives with a more uncertain meaning, like "unassailable" and "phenomenal," the study found. This could be because exaggerated words can sound more intense, so they are the weapon of choice for CEOs trying to hide the dirt under the carpet.
On the quality of earnings
These models are only approximations, and individual executives have their own style speaking, so we need to be careful when making generalizations. According to the researchers, the model can make accurate predictions between 50% and 65% of the time, so the method is far from flawless.
Another interesting way of looking at the issue of managerial honesty is by analyzing the quality of earnings, meaning the level of transparency and disclosure the company incorporates into its financial reports.
Apple (NASDAQ:AAPL) can be clear example of a company providing exceptional earnings quality. Most global tech companies are being hurt by an appreciating U.S. dollar lately, so in earnings reports they typically heavily emphasize currency-adjusted figures, which are broadly stronger than figures in U.S. dollars. However, Apple does not go down that road, and the first time management mentioned currency impact during the company's latest conference call was in response to an analyst question.
Also, Apple reports earnings on a generally accepted accounting principles basis, meaning earnings figures account for variables such as expenses related to issuing stock to employees, which many other industry players typically exclude from their adjusted earnings figures.
Amazon.com (NASDAQ:AMZN), on the other hand, gives more attention to non-GAAP figures such as segment operating income, which excludes stock-based compensation expenses. Similarly, Netflix (NASDAQ:NFLX) uses contribution margin as a measure of profitability, and this only includes sales less cost of revenue and marketing expenses, excluding multiple other cost items.
Just to be absolutely clear: Both Amazon and Netflix are operating in accordance to the rules, and they also report GAAP numbers. As you can read in the disclosure below, I own shares of Apple, Amazon, and Netflix, so I don´t believe they are trying to cook the numbers or anything like that.
However, when I look at the numbers from Apple, I feel more confident than when analyzing data from Amazon or Netflix. If the management team is focusing on specific financial measures, there is always a possibility that it could have an incentive to choose those metrics that provide a rosier picture of the business.