INVESTING: Buffett's letter squeezes firms that 'juice' earnings

April 7, 2008

Berkshire Hathaway Inc. released Warren Buffett's annual letter to shareholders recently. As always, Buffett provided a detailed update of the many businesses and investment positions the company owns. And Buffett added some entertaining commentary on a few topics that are relevant to investors.

Under the heading "Fanciful Figures-How Public Companies Juice Earnings," he comments on two corporate accounting problems: one finally solved, and one that continues to obscure earnings reports.

The first accounting injustice was about to be corrected in 1994, when the Financial Accounting Standards Board was poised to adopt a standard decreeing that stock options be counted as an expense in company income statements.

Buffett noted the board had reached unanimous agreement that the value of options CEOs were awarding themselves should be recorded as an expense. However, under heavy lobbying by corporate executives, the U.S. Senate voted 88-9 to "strong-arm" FASB into watering down its pronouncement.

As Buffett puts it, the board-"now educated on accounting principles by the Senate's 88 closet CPAs"-allowed companies to select between two methods to account for the value of stock options. The preferred method would be to treat options as an expense, but companies could continue to ignore the cost if the options were issued at market value.

As a consequence, only two of America's CEOs chose the "high road" to expense stock options, with the rest ignoring the large cost of stock options, thereby enabling their companies to report higher "earnings."

Worse, Buffett chides, even the "low road wasn't good enough" for some CEOs-who backdated their option grants, falsely reporting that they were issued at market value, instead of at discount prices.

With decades of option accounting nonsense finally rectified-options now must be counted as an expense in company income statements-another accounting issue continues to deceive investors, Buffett wrote.

His beef: the investment-rate return companies assume they will earn on their pension funds, a number used to calculate pension expenses. The higher the rate of return, the lower the pension expense.

The average return assumption on pension plans for companies in the S&P 500 is 8 percent, Buffett said. But the math required for that assumption to be achieved casts doubt on its validity.

Since 28 percent of the funds' holdings are bonds and cash that will not earn more than 5 percent today, the remaining 72 percent of assets-mostly equities-must earn more than 9 percent for a fund to achieve the assumed 8-percent annual return.

Even so, CEOs opt for artificially high assumptions because they result in more rosy earnings reports, Buffett wrote, advising corporate America to ease up:

"Listen to my partner, Charlie [Munger]: 'If you've hit three balls out of bounds to the left, aim a little to the right on the next swing.'"

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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