Monday, April 23, 2018

When a Non-Random Rule & Random Fluctuations "Swamp the Truly Important"

From Warren Buffett's latest Berkshire Hathaway (BRKa) shareholder letter:

"...I would prefer to turn immediately to discussing Berkshire's operations. But...I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire's net income figures and very often mislead commentators and investors.

The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire's 'bottom-line' will be useless.

The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income. In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they – just like our unrealized gains – fluctuate randomly.

That's largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way. As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse)."

Upon reading this it immediately reminded me of something Charlie Munger once said at a Wesco shareholder meeting:

"Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle. And go ahead if you want to. It will be a memorable moment for all of us."

Charlie's been pretty tough on the accounting profession in the past.

Here's a few additional examples.


Long position in BRKb established at much lower than recently prevailing market prices. No position iKHC.
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