Warren Buffett: How To Deal With Financial Shenanigans

Johnny HopkinsWarren BuffettLeave a Comment

In the book – Talent, Strategy, Risk: How Investors and Boards Are Redefining TSR, there’s a couple of great quotes by Warren Buffett on how to deal with financial shenanigans. Here’s an excerpt from the book:

Whether people deviate from ethical behavior through bad intention or bad practices, you must put mechanisms in place to control for divergence from policy or good governance. Buffett often serves on audit committees; companies try to steer him away from the compensation committee, knowing he is famously abstemious in directors’ compensation, with Berkshire directors paid an average of $2,700 a year in 2018.

Buffett recalls one company in which Berkshire had a huge investment. He pored over the 10Ks and 10Qs very carefully—a good test of whether someone is a good director—and tried to ask probing questions in meetings. He says, “Finally, after a few years, it was clear to me that the company was just playing games in terms of quarterly numbers. I think they were generally perceived of in the investment community as doing it, but they got cheers for doing it. And I realized that the only way to really get one of the super big-name auditors to behave was to have them more afraid of me than they were afraid of the management.”

From then on, he set out four questions for the auditors to answer each year, and he asked them to do it in writing. This is Buffett’s test:

1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management?

2. If the auditor were an investor, would he have received—in plain English—the information essential to his understanding the company’s financial performance during the reporting period?

3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

4. Is the auditor aware of any actions—either accounting or operational—that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

These questions only even up the playing field. Much of the required financial reporting material either is designed to obfuscate or has the effect of doing so. Buffett says, “The company lawyers tell you to list every possible thing you can dream of in the 10K just as a protection. And one of those things will have a weight of real potential risk. You had to be totally focused on that, and not twenty other risks. They kill you with quantity. The risk committees almost don’t have a chance.”

To protect long-term value, demand that your management gives you the information you need to make sure it behaves ethically.

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