Buffett Challenges New GAAP Rule in Annual Berkshire Letter

Warren Buffett (Trades, Portfolio)’s annual letter to Berkshire Hathaway BRK.ABRK.B shareholders was published Saturday, and, as usual, the Oracle of Omaha had a lot to say.

While he covered many of the common themes and topics surrounding business operations, the economy and politics, Buffett gave an unusual amount of attention to new accounting rules, and what they may mean for Berkshire Hathaway going forward.

A gripe with GAAP

According to a new change to generally accepted accounting practices (GAAP), companies must record profits and losses from unrealized capital gains in their investment holdings. This proved to be a big problem for Berkshire In 2018, thanks largely to a big writedown by the Kraft Heinz Co. KHC. The writedown translated to a big negative impact to Berkshire’s bottom line.

In all, Berkshire recorded a $20.6 billion loss thanks to the changes. Buffett took time to highlight the impact of the new GAAP rule and why he and his long-time partner, Charlie Munger (Trades, Portfolio), oppose it:

“As I emphasized in the 2017 annual report, neither Berkshire’s Vice Chairman, Charlie Munger (Trades, Portfolio), nor I believe that rule to be sensible. Rather, both of us have consistently thought that at Berkshire this mark-to-market change would produce what I described as ‘wild and capricious swings in our bottom line.’

“The accuracy of that prediction can be suggested by our quarterly results during 2018. In the first and fourth quarters, we reported GAAP losses of $1.1 billion and $25.4 billion respectively. In the second and third quarters, we reported profits of $12 billion and $18.5 billion. In complete contrast to these gyrations, the many businesses that Berkshire owns delivered consistent and satisfactory operating earnings in all quarters. For the year, those earnings exceeded their 2016 high of $17.6 billion by 41%.”

Those are seriously wild swings. It is unsurprising that Buffett would be so opposed to the new principle, since it clearly does have a meaningful impact on Berkshire’s reported earnings -- and may compromise investors’ ability to accurately value the company on the basis of standardized financial reporting.

Expect more problems ahead

The Kraft Heinz writedown was particularly massive, and thus is unlikely to be repeated elsewhere in Berkshire’s portfolio anytime soon -- if ever. But that will not immunize Berkshire to future volatility in its earnings, as Buffett points out:

“Wide swings in our quarterly GAAP earnings will inevitably continue. That’s because our huge equity portfolio – valued at nearly $173 billion at the end of 2018 – will often experience one-day price fluctuations of $2 billion or more, all of which the new rule says must be dropped immediately to our bottom line. Indeed, in the fourth quarter, a period of high volatility in stock prices, we experienced several days with a ‘profit’ or ‘loss’ of more than $4 billion.”

Given Berkshire’s huge exposure to stocks, it will be particularly susceptible to swings in the value of its massive equity portfolio. That may make the massive conglomerate a far more volatile earner. That could mean a big change for the company, which has been one of the sturdiest and most stable firms out there. With that in mind, Buffett has some advice for Berkshire’s shareholders:

“Our advice? Focus on operating earnings, paying little attention to gains or losses of any variety. My saying that in no way diminishes the importance of our investments to Berkshire. Over time, Charlie and I expect them to deliver substantial gains, albeit with highly irregular timing.”

In the case of Berkshire, that might not be bad advice. But we are more dubious about the wider application of Buffett's criticisms.

Verdict

Operating earnings may be the best way of understanding the Berkshire business day to day, as Buffett suggests. But the sheer size of its equity portfolio cannot be ignored. Yes, the Kraft Heinz writedown probably resulted in an overblown impact to Berkshire’s bottom line, but there is value in recording those losses in a timely fashion.

We empathize with Buffett’s gripe with the new GAAP rule. In practice, it appears to be failing to achieve exactly what was intended. But mark-to-market valuations of equity holdings should not be discarded out of hand, even if they happen to impact a company like Berkshire disproportionately.

Disclosure: No positions.