Wednesday, July 6, 2011

Buffett on Bold & Imaginative Accounting: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1998 Berkshire Hathaway (BRKashareholder letter:

"A distressing number of both CEOs and auditors have in recent years bitterly fought FASB's attempts to replace option fiction with truth and virtually none have spoken out in support of FASB. Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest.

Still, I believe that the behavior of managements has been even worse when it comes to restructurings and merger accounting. Here, many managements purposefully work at manipulating numbers and deceiving investors. And, as Michael Kinsley has said about Washington: 'The scandal isn't in what's done that's illegal but rather in what's legal.'

It was once relatively easy to tell the good guys in accounting from the bad: The late 1960's, for example, brought on an orgy of what one charlatan dubbed 'bold, imaginative accounting' (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception.

In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired 'earnings' or set the stage for them in the future.

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals -- that is, their stock -- is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good."

In a post back in May, I said that the best defense for investors is to buy businesses run by managers with a strong reputation and track record of fostering a conservative accounting culture. This is, unfortunately, not as easy to identify or find as it ought to be.

Buffett on Earnings Precision

"The term 'earnings' has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.

In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them." - Warren Buffett in the 1990 Berkshire Hathaway Shareholder Letter

All things being equal -- and they never are, of course -- I'd buy a slightly inferior business if I thought the management could be trusted to not inflate the score.

Accounting standards provides useful tools. Yet, understanding the inherent limitations of the tools is crucial for investors. The numbers that go into a company's 10-K or 10-Q are not nearly as absolute as we'd all like them to be.

"Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was o­nce the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's o­nly a crude approximation." - Charlie Munger in a talk he gave in 1994 at USC Business School

The problem is that earnings are not particularly precise even when management is doing its best to report the numbers honestly. Yet, when you're confident that the numbers management and the auditor's agree to put up on the scoreboard are a conservative representation of performance, the limitations of accounting should matter a whole lot less.

Conservative scorekeeping makes it easier to be certain you are, in fact, obtaining share ownership with the appropriate margin of safety. You'll be less likely to pay an inflated price resulting from either being misled deliberately by management, or the inherent limits of accounting itself.

So own businesses run by honest and capable management who tend to report the numbers conservatively. This, itself, won't make you rich but it will reduce the probability of waking up some morning only to find out that something you own is actually worth 50 cents on the dollar or worse.

Accounting rules will no doubt change over time but won't end attempts by some to be less than conservative with how the numbers are presented.

Adam

Long position in BRKb

Charlie Munger at USC Business School in 1994

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