Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) have mentioned repeatedly the importance of understanding accounting, the language of business. The two of them have criticized measurements such as EBITDA and some pension adjustments under GAAP rules. During Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)'s 2003 annual meeting, Buffett and Munger provided advice on how to get better at detecting scams or fraudulent accounting.
"Warren Buffett (Trades, Portfolio): I haven't read an accounting book in years. I think I read Finney in college. I'd suggest reading Berkshire reports and things like magazine articles about accounting scandals. You need to know how figures are put together, but also have to bring something else. Read a lot of business articles and annual reports. If I don't understand it, it's probably because the management doesn't want me to understand it. And if that's the case, usually there's something wrong.
Charlie Munger (Trades, Portfolio): "Asking Warren what good books he knows about accounting is like asking him what good books he has on breathing. You start with basic rules of bookkeeping, and then you have to spend a lot of time to really become knowledgeable."
On a separate interview, Munger has said the following:
"…Accounting is 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. And it’s not that hard to understand. 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. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know."
To get better at understanding businesses, we need to get better at accounting, which is the understanding of how numbers are created and why they are the way they are. We can gain a lot of advantages by having curiosity and working through, as Buffett mentions, annual reports, and most importantly, the details of fraud scandals. If we do some forensic analysis in companies such as Enron, we will improve our understanding of how creative a company can get in order to report profits.
Another simple filter is to ask frankly, is this report something very complicated to read? I can compare the simplicity of CostcoÂ (COST, Financial)'s annual report with the complexity of a BPÂ (BP, Financial)'s report. I am not encouraging laziness and recommending reading only simple reports without making an effort to understand others. What I am saying is that if after understanding the basic rules of accounting, if a report is becoming hard to follow, it is likely that is exactly the management's desire.
What do you think?