In the footnotes of financial reports – for example under ‘earnings management’ – one can find information that relates to billions of Euros

Or is it only a strange quirk if a report shows questionable numbers? This is what the American Professor of Accounting Jim Wahlen, who teaches at Indiana University, tries to explain in his classes.

Although Wahlen thinks it is important not to look for ‘earnings management’ (profit steering), it is addressed in a part of his course that people find ‘surprisingly interesting’. “The first step when looking for profit steering must be to know the fundamentals of accounting and think about them rigorously. Making people aware that even companies that follow the standards can come up with bad financial reports.”

Why Starbucks?

Wahlen mentions Starbucks as an example. A complex case in which he discusses components such as ‘leasehold improvements’, and often sees people’s eyes glaze over. Why Starbucks? “Everyone knows them and it is a simple model to use for illustration. I can walk into a room with 30 people and everyone there will have heard of Starbucks. Most of them would have been there.”

He for example discusses where the lease rights can be found in Starbucks’ financial reporting. Where are they? That’s when you get to the footnotes. “They reveal a lot of information about the leases, about all the stores Starbucks has.” It turns out to concern tens of billions of Euros. In his classes the students will then make their own versions of the reports. “The adjusted financial reports that we compile probably provide much better information about Starbucks’ actual financial position than the balance sheets that the company itself publishes according to the US GAAP American accounting standards.”

Real companies

But there is no question of profit steering here. Starbucks follows the required regulations. “They’re not trying to cook the books.” However, the rules make it difficult for a company like Starbucks – while it’s not even clear if it works to their advantage or disadvantage. “You can explain it both ways.”

‘In my classes, I cover three, four or five case studies, all based on existing companies. Some are cases that are discussed at universities and some I have written myself. We do exercises, analyze strategies, read reports, study industries, and identify which accounting information is of high and which is of low quality. When there is question of low quality, it is important to look at the motives of the management. Are they perhaps trying to misrepresent the company?”

Want to learn more from Professor Jim Wahlen? In May, he will give a five-day training course “Advanced Financial Statement Analysis” at the Amsterdam Institute of Finance.

This article was published in Dutch on CFO.nl on 22 February 2019.

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