In his 2017 Berkshire Hathaway Annual Letter, Warren Buffett discusses a new accounting rule that will distort net income figures. This rule requires including unrealized stock gains/losses, leading to large swings that don’t reflect actual business performance.
He argues that these fluctuations will mislead investors and render net income useless for analysis. This adds to existing issues with reported realized gains, which can be misleading due to opportunistic selling, not reflecting overall portfolio performance.
Here’s an excerpt from the letter:
After stating those fiscal facts, I would prefer to turn immediately to discussing Berkshire’s operations. But, in still another interruption, I must first tell you about a new accounting rule — a generally accepted accounting principle (GAAP) — that in future quarterly and annual reports will severely distort Berkshire’s net income figures and very often mislead commentators and investors.
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. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period.
Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.
The new rule compounds the communication problems we have long had in dealing with the realized gains (or losses) that accounting rules compel us to include in our net income.
In past quarterly and annual press releases, we have regularly warned you not to pay attention to these realized gains, because they — just like our unrealized gains — fluctuate randomly.
That’s largely because we sell securities when that seems the intelligent thing to do, not because we are trying to influence earnings in any way.
As a result, we sometimes have reported substantial realized gains for a period when our portfolio, overall, performed poorly (or the converse).
You can read the entire letter here:
Berkshire Hathaway 2017 Annual Letter
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