Over the years, there are many accounting improvements to truly reflect the fundamental of operating businesses. However, there have been quite a lot of accounting gimmicks happening along with the improvements of accounting rules improvement. The business economics the same, but the accounting number is different. As Warren Buffett discussed in his letters to shareholders in 1988, CEOs often treat GAAP statements as a beginning rather than an end to their obligations to informs shareholders and creditors. Subsidiaries’ managers have to report the operating information to their parents’ CEOs, not just GAAP barebones, but it’s not the case with CEOs to report to shareholders.
The numbers, which are reported, should be needed by readers to answer three main important questions:
· Intrinsic value of the business
· Whether it can meet its obligations?
· How good is the management?
Buffett said that if just looking at minimum GAAP presentation, it is hard to answer most of the questions in most cases. “The business world is simply too complex for a single set of rules to effectively describe economic reality for all enterprises, particularly those operating in a wide variety of businesses, such as Berkshire.”
Psychologically, managements have the tendency to shoot first then draw the target around the point they just shot to. Nobody likes to underperform, especially the ones with big egos. Even the honest managements with good intentions sometimes stretch GAAP a bit to present figures which are more suitable to present their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed by otherwise upright managements. Then there are managements who use GAAP as a deceptive tool to hide real losses, present fake profits to boost their compensations and share prices. Over the years, Charlie Munger and Warren Buffett have observed many accounting frauds. That is true that it is far safer to steal large sums with a pen than small sums with a gun.
Notably, holding companies or large corporations, which have many business segments, consolidate their financial numbers. The greater the number of economically diverse business operations lumped together, the less useful those presentations are and the less able investors are to answer the above three questions. Buffett confessed that the only reason Berkshire Hathaway prepared consolidated figures was to meet outside requirements. On the other hand, he and Charlie Munger constantly study segment data.
For example, I wrote in value investing contest about a mispriced insurance, Old Republic International (ORI), it is an insurance holding company, consisting of around 27 different subsidiaries in three main segments: the General Insurance, Title Insurance and RFIG (Consumer Credit Indemnity and Mortgage Guaranty, in run-off mode). The run-off segment is mounting up the loss with claims whereas General Insurance and Title Insurance are generating profits. ORI once intended to spin-off its loss making Mortgage Guaranty subsidiaries, but it has been cancelled. When the loss of Mortgage Guaranty is consolidated into the holding’s financial statement, it looks scary. Many investors, who just look at the numbers, might wonder why the loss-making company can keep paying 8% dividend yield. When studying the segment data, investors will realize that as long as the parent doesn’t put any more money behind the run-off segment, there are high probabilities that it will not drain cash from the parent.
Disclosure: Long ORI
About the author:
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla – CFA course in Vietnam Visit Anh Hoang’s Website