At 28 pages long, America’s most eagerly anticipated annual letter has plenty of meat in it for Berkshire aficionados. Warren Buffett didn’t disappoint: He covered just about everything the Berkshire Hathaway fans could ask for: The stock market. Hedge funds, investment management and “the bet.” Stock repurchases and intrinsic value. Acquisitions and insurance. Immigration (tangentially). America’s past and future. Even a technical correction about the meaning of “forever” as a holding period.
He also talked about accounting.
Let’s explore that. In my view, Buffett is the rare high-level player who recognizes that the way the score is actually kept matters as much as the game. Furthermore, he can articulate it. I suspect most readers will take his remarks as a slap at accounting, but I don’t think so.
Reporting transactions vs. reporting value. Long-timers in Berkshire stock (I and my clients are holders, but we’re relatively recent – the longest-held position is only about 23 years old) recall that Buffett used to call the company’s book value a proxy for the firm’s intrinsic value. That was in the days when the firm was more like a mutual fund, with large securities holdings “marked to market.” That changed:
By the early 1990s, however, our focus was changing to the outright ownership of businesses, a shift that materially diminished the relevance of balance sheet figures. That disconnect occurred because the accounting rules (commonly referred to as “GAAP”) that apply to companies we control differ in important ways from those used to value marketable securities. Specifically, the accounting for businesses we own requires that the carrying value of “losers” be written down when their failures become apparent. “Winners,” conversely, are never revalued upwards.
Absolutely true. Some might view that as a failing of GAAP accounting; Buffett in fact, does not. He merely points out the problem it causes Berkshire:
We have no quarrel with the asymmetrical accounting that applies here. But, over time, it necessarily widens the gap between Berkshire’s intrinsic value and its book value. Today, the large – and growing – unrecorded gains at our winners produce an intrinsic value for Berkshire’s shares that far exceeds their book value.
Berkshire’s not alone in that quandary: all successful operating companies should have this problem, if they’re not mutual funds. Look at it this way: accounting and financial reporting is supposed to capture what happened – transactions that occurred in such a way that they’re comparable from company to company, so that investors can decide whether or not a firm’s managers are creating value. Reporting the value of businesses is something else entirely.
Don’t forget: beauty is in the eye of the beholder. What might appear valuable through one set of lenses might look atrocious through another set. There’s a lot of subjectivity in perceiving “value.”
If firms were to create estimates of fair value for their operating businesses and report them, would anybody believe them? That would be one way to narrow the gap for all between intrinsic and book values.( I don’t recall too much love being lavished on the re-tooling of fair value reporting about ten years ago when Statement No. 157 was issued.) Or, another way: we can have clean, clear reporting of what happened in a firm issued to investors in fair markets. I’ll take the latter.
Time value of money. It doesn’t get accounted for in Berkshire’s insurance liabilities. By now, a holder should understand Buffett’s concept of “float” – money belonging to someone else that Berkshire can use for long periods of time. He makes a succinct description of the accounting valuation problem it presents:
So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as a typical liability is a major mistake. It should instead be viewed as a revolving fund. Daily, we pay old claims and related expenses – a huge $27 billion to more than six million claimants in 2016 – and that reduces float. Just as surely, we each day write new business that will soon generate its own claims, adding to float.
If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities, however, are treated as equals under GAAP.
Again, absolutely true. The problem: how do you reliably discount the accounting liability? When discounting a future amount back to a present value – assuming a justifiable discount rate is in place – it helps if there’s a schedule of payments. While insurance payment outflows may follow a consistent pattern, there’s always the chance that the future isn’t going to be too much like the past. That could make for some drastic revaluations.
The discounting issue doesn’t affect just Berkshire Hathaway or insurance companies. There are plenty of balance sheet items where a future dollar is treated the same way as a dollar today. Some examples: deferred tax assets; deferred tax liabilities; warranty liabilities; and long-term deferred revenue accounts. They’re not discounted and again, a major difficulty is assigning a discounting period to the cash flows involved.
Intangibles amortization. This is one place where Buffett openly parts ways with GAAP. His view:
For several years I have told you that the income and expense data shown in this section does not conform to GAAP. I have explained that this divergence occurs primarily because of GAAP-ordered rules regarding purchase-accounting adjustments that require the full amortization of certain intangibles over periods averaging about 19 years. In our opinion, most of those amortization “expenses” are not truly an economic cost.
Our goal in diverging from GAAP in this section is to present the figures to you in a manner reflecting the way in which Charlie and I view and analyze them. On page 54 we itemize $15.4 billion of intangibles that are yet to be amortized by annual charges to earnings. (More intangibles to be amortized will be created as we make new acquisitions.) On that page, we show that the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost.
Eventually amortization charges fully write off the related asset. When that happens – most often at the 15-year mark – the GAAP earnings we report will increase without any true improvement in the underlying economics of Berkshire’s business. (My gift to my successor.)
Because he has so much influence on investment thinking, this practice usually gets interpreted in one of two ways:
- He’s absolutely right: accounting is bunk. Let’s use our own accounting rules!
- It’s hypocritical for him to criticize others for using their own custom accounting rules, then do it himself.
In my view: none of the above. When intangible assets are recorded at acquisition, they’re classified as having an indefinite life and not amortized, or classified as definite-lived and amortized over their expected life. It’s the definite-lived intangibles causing the heartburn here. If either kind of intangible assets arising from an acquisition are viable (that is, not written down as impaired) then they’re doing something to improve the company’s operations. They could be improving revenues or lowering costs – and if they’re definite-lived, there’s an expected limit to how long that benefit is going to last. Where the rub comes in: backing the expiration of those costs from earnings leaves in all the benefits from controlling the intangible asset – without any of the cost of controlling them.
To Buffett’s complaint: the only assets being amortized are the ones with definite lives. Should they be classified as indefinite-lived in the first place? Or if not, are the lives used (15 years) far too short? Or is it “double-counting” to include the amortization because a firm is spending cash to keep those definite-lived intangibles in tip-top shape? That argument is often raised, and the right answer is “show me the money.” There’s no reporting of cash spent to preserve intangibles, and anyone who buys that is doing so based on trust.
The problem is with the accounting, really. Nobody raises issues like these when it comes to depreciation expense (adding it back to earnings) just because a firm does capital spending. It seems accepted that depreciation is accounted for as a cost of production. Maybe depreciation is more accepted because the accounting for the physical investment spending and its expiration is far more visible than it is for intangibles investment spending and its expiration. Hopefully, FASB will be putting intangible asset accounting on their agenda soon.
Speaking of depreciation expense: it’s too low at BNSF. Being such a broad collection of American companies, Berkshire Hathaway is a showcase for some of the problems in accounting that have been around forever - and just won’t go away. Some of those issues relate to the long, long-term nature of the insurance liabilities and the lack of recognizing the time value of money on them. It works in the other direction too - the long, long-term nature of assets leads to disparities in the accounting for depreciation. Read the passage below, and you’ll see what I mean:
Now that I’ve described a GAAP expense that I believe to be overstated, let me move on to a less pleasant distortion produced by accounting rules. The subject this time is GAAP-prescribed depreciation charges, which are necessarily based on historical cost. Yet in certain cases, those charges materially understate true economic costs. Countless words were written about this phenomenon in the 1970s and early 1980s, when inflation was rampant. As inflation subsided – thanks to heroic actions by Paul Volcker – the inadequacy of depreciation charges became less of an issue. But the problem still prevails, big time, in the railroad industry, where current costs for many depreciable items far outstrip historical costs. The inevitable result is that reported earnings throughout the railroad industry are considerably higher than true economic earnings.
A locomotive, the most expensive piece of equipment in a railroad, can realistically last 35 or more years. Even with low inflation, would you seriously expect that a locomotive purchased today is anywhere near the price of the locomotive acquired 35 years ago? Technologically, they’re not even going to be very similar - today’s locomotive would be far more efficient and contain far more embedded software and computer hardware. What’s being reflected in today’s railroad earnings are the expiration of the costs of the old locomotive which won’t come close to expressing the cost of replacing it. Thus, depreciation expense understates the cost of keeping the railroad running.
It’s a situation similar to what Buffett said about the intangibles running off after being fully amortized - his gift to his successor. Right now, the GAAP earnings are higher than they would be if they reflected the true cost of being in the railroad business.
What to do? Shortening the lives of the equipment might jack up the expense to reflect more of the current cost - but they’d end sooner too, and Berkshire Hathaway would be in the “runoff without costs” situation that wouldn’t report economic reality either. And a company would not be allowed to revalue the equipment once again and reboot the whole depreciation process - that’s a GAAP non-starter. Curiously, when inflation was assumed to be a bigger threat than nuclear proliferation during the early 1980’s, investors actually had information about asset current costs and revalued depreciation charges. It was provided on a supplemental basis, thanks to Statement No. 33. That five-year experiment saw the sun set in 1985; investors didn’t attach any great importance to the information, companies didn’t want to produce it, and the standard died of natural causes.
How should a Berkshire Hathaway investor think of the BNSF depreciation? One thing to do would be to look at the capital spending compared to the reported depreciation expense, and consider that as a proxy for depreciation expense. While all depreciation is something of a guess, this is even more so: how much of the capital spending is for physical capital replenishment? How much is for growth? What are the expected lives involved in the spending? There are no clues in Berkshire’s annual report (unless they’re in the 2016 version, which I haven’t yet read) - or for that matter, any other company’s annual report. This is not just a Berkshire Hathaway issue or a railroad issue - it’s any firm that has a heavy investment in productive assets with long lives.
Restructuring costs & stock-based compensation. The best has been saved for last. As has been the frequent case, Buffett reserved some barbs for the corporate practice of excluding restructuring charges and stock compensation when presenting artisanal, hand-crafted earnings. Quote:
Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire. That’s because there are always things that need to change in our hundreds of businesses. Last year, as I mentioned earlier, we spent significant sums getting Duracell in shape for the decades ahead.
We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary. Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that for several years the huge one-time costs of rationalizing the combined operations be explained clearly to owners. That’s precisely what the CEO of Kraft Heinz has done, in a manner approved by the company’s directors (who include me). But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.
Three cheers here. While GAAP requires information about the accruals involved in a restructuring or exit plan, there’s no requirement to give them specific geography in the income statement. Isolating them and asking investors for a pass is simply a strange tribal custom in the investment world. Don’t believe companies don’t have to isolate restructuring and exit costs? You could look it up. Here’s an excerpt right out of the Accounting Standards Codification:
Costs associated with an exit or disposal activity that does not involve a discontinued operation shall be included in income from continuing operations before income taxes in the income statement of a business entity and in income from continuing operations in the statement of activities of a not-for-profit entity (NFP). Separate presentation of exit and disposal costs in the income statement is not prohibited. However, because neither an exit activity nor a disposal activity is both unusual and infrequent (see paragraph 225-20-45-16), it is prohibited to present exit and disposal costs in the income statement net of income taxes or in any manner that implies they are similar to an extraordinary item, as defined in paragraphs 225-20-45-1 through 45-8. If a subtotal such as income from operations is presented, it shall include the amounts of those costs.
Because a presentation is not prohibited, it becomes optional. And the costs of renewal and/or the mopping up of previous capital mis-allocations do not have to be separately presented. Yet companies insist on such presentations, as if once they’re cleaned up, they won’t happen again. Buffett should be emulated for presenting things this way and addressing them in his letter. Don’t hold your breath waiting for companies to follow suit - it’s been done this way for fifty years and it hasn’t really caught on yet.
As for stock compensation, Buffett had this to say:
Back to reality: If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.
To which I would only add: are you really saying that these employees were willing to work for nothing? Their presence matters and whatever they contributed to the bottom line shows up in earnings. Yet, there’s no cost attached to their services.
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All told, interesting stuff out of Omaha, and probably far less-noticed than Buffett’s other remarks. Yet there’s some valuable food for thought in there - for those who take the time to think about how the score is kept in the game.