Wednesday, April 27, 2011

The Economic Illusion: Berkshire Shareholder Letter Highlights

"It has been far safer to steal large sums with a pen than small sums with a gun." - Warren Buffett in the 1988 Berkshire Hathaway (BRKashareholder letter

I mentioned in this previous post that the heavy reliance on non-GAAP earnings by some companies are, if not a red flag, often simply a way for management to present an overly optimistic view (and, of course, in some cases total BS).

It's also true that GAAP has severe limitations so you can hardly count on the reported numbers alone to paint a meaningful economic picture. That's part of what makes interpreting, in a meaningful economic sense, what is going on with any company so tricky. In a perfect world, every CEO would make sure owners/creditors understand and are as informed as possible by the financial information provided.

In reality, the accounting culture can be vastly different from one business to the next.

GAAP is not gospel.

Warren Buffett provides some insights into this dilemma in the 1988 Berkshire letter:

"Despite the shortcomings of generally accepted accounting principles (GAAP), I would hate to have the job of devising a better set of rules. The limitations of the existing set, however, need not be inhibiting: CEOs are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors - and indeed they should. After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation’s CEO. Why, then, should the CEO himself withhold information vitally useful to his bosses - the shareholder-owners of the corporation?

What needs to be reported is data - whether GAAP, non-GAAP, or extra-GAAP - that helps financially-literate readers answer three key questions: (1) Approximately how much is this company worth? (2) What is the likelihood that it can meet its future obligations? and (3) How good a job are its managers doing, given the hand they have been dealt?

In most cases, answers to one or more of these questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality for all enterprises, particularly those operating in a wide variety of businesses, such as Berkshire.

Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome. Too often their accountants willingly assist them. (“How much,” says the client, “is two plus two?” Replies the cooperative accountant, “What number did you have in mind?”) Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the "big bath" quarter are "white lie" techniques employed by otherwise upright managements.

Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP results as gospel. So these charlatans interpret the rules "imaginatively" and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world.

As long as investors - including supposedly sophisticated institutions - place fancy valuations on reported "earnings" that march steadily upward, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be. Over the years, Charlie and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with a pen than small sums with a gun."

I try to keep what Buffett says above in mind when pouring through financial statements during reporting season. The bottom line is it's easier to invest in a business knowing the management team reinforces a culture of conservative accounting practices and transparency. Seems like something to take for granted but it is not. If necessary, I'd buy a slightly inferior business knowing that management would generally report conservatively and honestly (of course, I'll take the best of both worlds anyday).

A business with that kind of culture hardly eliminates all risks but at least reduces the probability of unnecessary surprises.

Knowing that the reported financials are likely to do a reasonably good job of reflecting economic reality makes investing, which is already difficult enough, just a little bit easier.


Long BRKb
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