Growth Companies

Buffett Rebuffed

The Berkshire chairman decried the FASB mandate on new reporting for unrealized gains and losses. His airline holdings proved him wrong.

Warren Buffett was unequivocal in his criticism of the Financial Accounting Standards Board’s ASU 2016-01 — the new accounting for equity securities passed in 2016 and implemented in 2018. In his 2017 letter to shareholders, Buffet noted:

“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. For analytical purposes, Berkshire’s ‘bottom line’ will be useless.”

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The crux of Buffett’s argument was that his intent is to hold securities forever, and therefore short-term fluctuations were irrelevant because he views them as partnerships and periodic market quotations don’t alter long-term value prospects.

Donald Graham, chairman of Graham Holdings, came to Buffett’s defense in a November 2018 opinion piece in The Wall Street Journal.  He said: “On paper, these [short term] fluctuations in stock value dwarf Berkshire’s actual business profits. In reality, they merely record short-term changes in the prices of stocks that may be held for decades before they are sold.”

For good measure, he added, “Berkshire and all other companies already report gains and losses on stocks at the time of sale. Interim fluctuations shouldn’t be allowed to fuzz up reported earnings.”

In response, I noted at the time:

Warren Buffett

“For equity securities for which there is less than a 20% ownership or no significant influence, this new standard more prominently reflects the value of the securities using the price Berkshire would need to exit these positions (e.g. exit price fair value). Although Mr. Buffett considers these businesses rather than ticker symbols, as noted in his remarks, the accounting for such appreciation in net income better reflects the difference in these positions than those over which Berkshire has greater influence or control and can contribute to the business operations.

“It is more accurate to reflect the change in the value of these investments in net income as it occurs rather than simply when management’s intent changes and the decision to sell is made. Reflecting the realized gains in net income at that time inaccurately portrays such earnings as current period events, when in fact, the gains may have accumulated over many years. Now more than ever, the various methods of accounting for equity securities most accurately depicts Berkshire’s business model.”

That response was and remains correct. Still, it seemed to have had little influence.  Perhaps this was because the whole affair had the feel of a supreme verdict that rested on the parsing of obtuse concepts. True, Buffett stated his intention to hold securities forever, had mostly demonstrated that in practice, and set a precedent offering a tenable defense to his ASU 2016-01 interpretation, while my case was rooted in the irrefutable economics of market pricing.

But there was nothing obtuse in Buffet’s communication at the recent Berkshire annual meeting that he had sold his stakes in the four largest U.S. airlines:  American, Delta, Southwest, and United. By selling the stocks he transformed the unrealized losses in the March 31 income statement to realized losses — which investors will see reflected in Berkshire’s June 30 income statement. In making the sale, Buffet contradicts his and Graham’s earlier statements that the investments are held for the long-term and that the accounting — the bottom line, if you will — is not reflective of the economics.

Further, what he fails to point out is that when it came to his investment in airline stocks he took the securities market price or the ticker price and got out — presumably because he thought the long-term prospects were worse than the current securities price. His only “quote” was the market price of the shares on the exchange.

Ultimately, the wisdom of ASU 2016-01 comes down to this: Management intent does not change the value of an equity security. If this were the case, all those asset managers who bought equities with the intent they would rise in value would be insulated from the hard realities of market pricing. And once Mr. Buffett, the most devout student of long-term investing, is forced to confront how market prices influence the value of a portfolio and net income, shouldn’t all investors have to confront the same reality when they look at an income statement?

Sandra Peters is head of financial reporting policy at CFA Institute, where she leads a global team analyzing and developing policy positions related to significant financial reporting, accounting, and auditing issues worldwide. Prior to this, she was vice president and corporate controller at insurance provider MetLife.

(Photo by Daniel Zuchnik/WireImage)