Accounting, Business

Warren Buffett says this accounting change is a “nightmare” - here’s why I disagree

May 06, 2018

Last December, the Financial Accounting Standards Board (FASB) implemented some accounting changes that will affect the earnings report of US companies. There are many changes in the announcement, but probably the most significant one is that businesses are now required to report their equity investments at fair value. Any gains or losses for the period will need to be reported in net income. This is quite similar to the new IFRS 9 standards that will also require businesses to measure equity investments at fair value.

While these changes by the accounting standards boards are seen as a positive step forward for those who advocate greater transparency in accounting numbers, some companies like investment companies are clearly not very supportive. Warren Buffett has called this situation a “nightmare” because it would significantly distort profit. His argument makes sense because Buffett’s strategy at Berkshire Hathaway is to buy and hold stocks for the long term, so why should short-term market fluctuations matter to Berkshire’s bottom line? So, he argues that investors should strip out these unrealized gains or losses on investments, as they are just due to short-term market volatility and therefore meaningless.

There has been good academic research that investors generally prefer certainty, rather than wild fluctuations in companies’ profit and loss figures. And most likely, this accounting change is going to increase volatility in P&L of companies that hold a large proportion of equity investments in their balance sheets. Already last week, we have seen the impact of this change on Buffett’s Berkshire Hathaway. For the first time in 9 years, the company has registered its first loss of $1.14 billion in the first quarter. Even though Berkshire Hathaway is currently in an overall net loss position for the first quarter of 2018, its operating profit has increased 49% to $5.29 billion during the same quarter due to its insurance underwriting business.

Buffett argues that the net loss position “really is not representative of what’s going on in the business at all”, as the volatility will unnecessarily scare or embolden investors. I understand Buffett’s concerns about volatility, but as an investor, I am not sure that I will agree with his view. For me, more information is always better than less, and I believe investors today are sophisticated enough and have the right to know the actual profits or losses of a company’s investments based on the current market situation.

So, sorry Buffett, as an investor and accounting geek, I stand on the side of the regulators this time, and I truly believe that these changes are for the better for investors, markets and the whole financial industry as a whole.

about author

Lee is currently pursuing a Master’s degree in Finance at INSEAD. Prior to his Master’s, he has worked for about five years in the treasury and accounting space. He graduated from SMU with a double degree in Accountancy and Finance, and is also a Chartered Accountant (Singapore). Other than building Excel spreadsheets and poring through annual reports, he spends his time reading and watching sci-fi movies.