The paper came out a few months ago, but NPR’s recent story reminded me of it. Essentially, a professor and graduate student at Stanford’s Graduate School of Business tried to identify the linguistic signaling used by CEO’s and CFO’s during earnings calls that could be used to reliably predict when their companies were cooking the books (PDF of full report here). Their methodology was to analyze thousands of transcripts from earnings calls and then look for relationships between words and phrases and those companies that later had to restate their earnings.
Here’s a summary of their findings:
Using conservative statistical tests, we nd that the out-of-sample performance of the models that are based on CEO or CFO narratives is signicantly better than random by 4%- 6% (with 50% – 65% accuracy) and provides a signicant improvement to a model based on discretionary accruals and traditional controls. We find that answers of deceptive executives have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholders value and value creation. In addition, deceptive CEOs use signicantly fewer self-references, more third person plural and impersonal pronouns, more extreme positive emotions, fewer extreme negative emotions, and fewer certainty and hesitation words.
CEOs overuse words like “we” and “our team” versus “I”, since lack of “I” indicates that the speaker doesn’t psychologically own their statements or feel “responsible for what [they] are saying”. This implies that investors and officials should regard such skewed ratios as possible indications of fraud.
Additionally, CEO’s overuse of superlatives to describe the current state and future outlook of their companies was also found to be diagnostic (from NPR):
Lying CEOs also tend to use a lot of words that express positive emotion — things are fabulous and fantastic and extraordinary.
Here’s what Enron CEO Kenneth Lay said when he addressed his employees at a time when the company was about to implode: “I think our core businesses are extremely strong. We have a very strong competitive advantage. Of course, we are transferring this very successful business model and approach to a lot of new, very large markets globally.”
Words like that can be a form of overcompensation.
“If all my speech is ‘fantastic,’ ‘superb,’ ‘outstanding,’ ‘excellent’ and all my speech sounds like a big hype — it probably is,” Larcker says.
It is interesting to think about language as a screener and/or signal. One can think of a host of applications outside of earnings calls (politics, criminal justice, job interviews, etc). Essentially, the language used by executives might be taken as a costly signal by investors. Rather than cheap talk, the structure and nature of the words themselves may serve as a credible signal. This makes intuitive sense, since only CEOs that are truthful in their representation of the company are likely able to provide detailed, certain answers that provide the good, bad, and ugly of a company’s performance. However, while this signal may allow honest CEOs to communicate their veracity it will likely lead to a lot of false positives (i.e. suspected fraud), since the type of language cited by the researchers could be deployed for reasons other than fraud.