Buffett blames GAAP rule for $25B loss

Investment firm Berkshire Hathaway posted a $25 billion loss in the fourth quarter, mainly due to a writedown from its stake in Kraft Heinz, and chairman Warren Buffett cited a change in accounting standards for the dramatic loss.

Last week, Kraft Heinz disclosed a $15.4 billion impairment charge related to a writedown on the value of trademarks on popular brands such as Kraft Macaroni & Cheese, Oscar Mayer frankfurters and Heinz ketchup. At the same time, the company revealed a subpoena from the Securities and Exchange Commission investigating its accounting for its procurement policies and procedures (see Kraft Heinz slumps on SEC subpoena over accounting, $15.4B in writedowns). Buffett’s firm helped arrange a 2015 merger between Kraft Foods and H.J. Heinz Co., owning 325 million shares in a massive bet on the continued appeal of the two food giants’ brands, but changing consumer tastes have led to a decline in their business. Buffett discussed the loss in his annual letter to shareholders Saturday, noting that the firm earned $4 billion in 2018 under U.S. GAAP.

“The components of that figure are $24.8 billion in operating earnings, a $3.0 billion non-cash loss from an impairment of intangible assets (arising almost entirely from our equity interest in Kraft Heinz), $2.8 billion in realized capital gains from the sale of investment securities and a $20.6 billion loss from a reduction in the amount of unrealized capital gains that existed in our investment holdings,” Buffett wrote. “A new GAAP rule requires us to include that last item in earnings. As I emphasized in the 2017 annual report, neither Berkshire’s vice chairman, Charlie Munger, nor I believe that rule to be sensible. Rather, both of us have consistently thought that at Berkshire this mark-to-market change would produce what I described as ‘wild and capricious swings in our bottom line.’ The accuracy of that prediction can be suggested by our quarterly results during 2018. In the first and fourth quarters, we reported GAAP losses of $1.1 billion and $25.4 billion respectively. In the second and third quarters, we reported profits of $12 billion and $18.5 billion. In complete contrast to these gyrations, the many businesses that Berkshire owns delivered consistent and satisfactory operating earnings in all quarters. For the year, those earnings exceeded their 2016 high of $17.6 billion by 41%.”

The Oracle of Omaha predicted the earnings volatility would keep happening in the future, thanks to mark-to-market accounting. “Wide swings in our quarterly GAAP earnings will inevitably continue,” he wrote. “That’s because our huge equity portfolio — valued at nearly $173 billion at the end of 2018 — will often experience one-day price fluctuations of $2 billion or more, all of which the new rule says must be dropped immediately to our bottom line. Indeed, in the fourth quarter, a period of high volatility in stock prices, we experienced several days with a ‘profit’ or ‘loss’ of more than $4 billion. Our advice? Focus on operating earnings, paying little attention to gains or losses of any variety. My saying that in no way diminishes the importance of our investments to Berkshire. Over time, Charlie and I expect them to deliver substantial gains, albeit with highly irregular timing.”

Christopher Goodney/Photographer: Christopher Goodne

In his letter last year to shareholders, Buffett explained in greater detail what he foresaw from the change in accounting standards. “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,” he wrote. “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).”

Buffett warned Berkshire Hathaway shareholders last year about the temporary effects and against putting too much stock in instant analysis. “With the new rule about unrealized gains exacerbating the distortion caused by the existing rules applying to realized gains, we will take pains every quarter to explain the adjustments you need in order to make sense of our numbers,” he wrote. “But televised commentary on earnings releases is often instantaneous with their receipt, and newspaper headlines almost always focus on the year-over-year change in GAAP net income. Consequently, media reports sometimes highlight figures that unnecessarily frighten or encourage many readers or viewers. We will attempt to alleviate this problem by continuing our practice of publishing financial reports late on Friday, well after the markets close, or early on Saturday morning. That will allow you maximum time for analysis and give investment professionals the opportunity to deliver informed commentary before markets open on Monday. Nevertheless, I expect considerable confusion among shareholders for whom accounting is a foreign language.”