Buffett: Accounting Rule on Stock Holdings Will Distort Earnings

The Accounting Policy & Practice Report ® provides financial accounting policy makers, advisors, and practitioners with the latest news, expert insights, and guidance on emerging, evolving,...

By Steve Burkholder

Warren Buffett warned Berkshire Hathaway Inc. shareholders in a letter that accounting rules on booking unrealized changes in values of stock holdings will “severely distort” the company’s future reported earnings and could mislead investors.

In the Feb. 24 letter, Berkshire Hathaway’s CEO said a provision in the two-year-old standard on accounting for financial assets and financial liabilities “will produce some truly wild and capricious swings” in the company’s bottom line.

Buffett, his long-time business partner Charlie Munger, and Berkshire Hathaway have been known for focusing on long-term earnings potential of investments, rather than viewing results through a short-term, quarter-to-quarter prism.

The accounting rules at issue, ASU 2016-01, prescribe a change in a long-held generally accepted accounting principle on investments in equity securities. Going forward, “the net change in unrealized gains and losses in stocks we hold must be included in all net income figures we report to you,” Buffett said.

Useless Bottom Line

Buffett registered his a fear that, with use of the accounting rules, “Berkshire’s ‘bottom-line’ will be useless.”

Berkshire owns $170 billion of marketable stocks”—excluding its shares of Kraft Heinz Co.—“and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period,” he wrote.

“Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance,” Buffett wrote.

No FASB Comment

A spokeswoman for the Financial Accounting Standards Board, which issued the accounting rules, said the board declines comment on Buffett’s views.

The Nebraska company disclosed recently that it adopted the 2016 FASB rules on Jan. 1 for the current quarter’s reporting.

As of that date, Berkshire reclassified the accumulated net unrealized appreciation stemming from equity security investments, about $61.5 billion, from a place in the financial statements—“accumulated other comprehensive income”—where it doesn’t affect net income.

It moved the amounts to retained earnings, according to its disclosure about impending use of the FASB rules.

Long-Time ‘Communications Problems’

Berkshire has long had “communications problems” in dealing with realized gains and losses that accounting rules compel Berkshire to include in net income, according to Buffett’s letter.

The language in the new rules pertaining to treatment of equity securities’ values compounds those problems, wrote Buffett.

“In past quarterly and annual press releases, Berkshire regularly “warned you not to pay attention to these realized gains, because they—just like our unrealized gains—fluctuate randomly.”

Buffett said that the 2016 accounting rules exacerbate the “distortion caused by the existing rules applying to our realized gains.”

“We will take pains every quarter to explain the adjustments,” the CEO wrote, to counter that distortion and to head off instantaneous televised commentary and newspaper headlines on earnings releases framed around figures that “unnecessarily frighten or encourage many readers or viewers.”

Ex-FASB Member Disagrees

Thomas Linsmeier, a former FASB member who took part in writing the financial instruments rules criticized by Buffett, told Bloomberg Tax Feb. 26 that he disagrees with the Berkshire chief on whether shareholders are served by reporting unrealized gains and losses on equity securities in the period that they occur.

“Excluding unrealized gains/losses from net income provides an incomplete picture of the financial performance of the investment for the current period,” Linsmeier, a professor of accounting at the University of Wisconsin-Madison, said in an email.

“If equity securities increase in value during the current period, that increases the value of the economic resources of the firm and the shareholders are better off as a result of management’s investment in the securities this period,” Linsmeier said. “If equity securities decrease in value this period, shareholders are worse off.

“Including these amounts in earnings provides an accurate measure of the change in shareholders’ wealth” stemming from management’s investment in those securities in that period, he said.

Linsmeier: Improve Net Income Reporting

Buffett’s concerns would be better addressed by improving the reporting of net income, the former FASB member said.

“That improved reporting would require reporting of two components of net income—separately presenting the operating results of the company from the unrealized gains and losses on equity securities for the period,” Linsmeier argued.

FASB has a new standard-setting project on performance reporting. However, the board is focusing—at least initially—on the comparatively narrow topics of improving reporting on the cost of goods sold, on selling, and on administrative expenses.

To contact the reporter on this story: Steve Burkholder in Norwalk, Conn. at sburkholder@bloombergtax.com

To contact the editor responsible for this story: S. Ali Sartipzadeh at asartipzadeh@bloombergtax.com

Copyright © 2018 Tax Management Inc. All Rights Reserved.

Try Accounting Policy & Practice Report ®