done within the rules of accounting. If you can’t recognize the differences, you shouldn’t be in the equity-picking business." - Warren Buffett
What Are "Look-Through" Earnings?
We attempt to offset the shortcomings of conventional accounting by regularly reporting "look-through" earnings (though, for special and nonrecurring reasons, we occasionally omit them). The look-through numbers include Berkshire's own reported operating earnings, excluding capital gains and purchase-accounting adjustments (an explanation of which occurs later in this message) plus Berkshire's share of the undistributed earnings of our major investees - amounts that are not included in Berkshire's figures under conventional accounting. From these undistributed earnings of our investees we subtract the tax we would have owed had the earnings been paid to us as dividends. We also exclude capital gains, purchase-accounting adjustments and extraordinary charges or credits from the investee numbers.
We have found over time that the undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire as if they had been distributed to us (and therefore had been included in the earnings we officially report). This pleasant result has occurred because most of our investees are engaged in truly outstanding businesses that can often employ incremental capital to great advantage, either by putting it to work in their businesses or by repurchasing their shares. Obviously, every capital decision that our investees have made has not benefitted us as shareholders, but overall we have garnered far more than a dollar of value for each dollar they have retained. We consequently regard look-through earnings as realistically portraying our yearly gain from operations. (Owner’s Manual [CTRL-F] Key Word: Look-through)
When one company owns part of another company, appropriate accounting procedures pertaining to that ownership interest must be selected from one of three major categories. The percentage of voting stock that is owned, in large part, determines which category of accounting principles should be utilized. (1980 Chairman’s Letter [CTRL-F] Key Word: Ownership)
We prefer a concept of “economic” earnings that includes all undistributed earnings, regardless of ownership percentage. (1982 Chairman’s Letter [CTRL-F] Key Word: Prefer)
Berkshire's own reported earnings are misleading in a different, but important, way: We have huge investments in companies ("investees") whose earnings far exceed their dividends and in which we record our share of earnings only to the extent of the dividends we receive. (1990 Chairman’s Letter [CTRL-F] Key Word: Investees)
As we calculate them, look-through earnings consist of: (1) the operating earnings reported in the previous section, plus; (2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us. The "operating earnings" of which we speak here exclude capital gains, special accounting items and major restructuring charges. (1994 Chairman’s Letter [CTRL-F] Key Word: Investees)
Reported earnings are a poor measure of economic progress at Berkshire, in part because the numbers shown in the table presented earlier include only the dividends we receive from investees -- though these dividends typically represent only a small fraction of the earnings attributable to our ownership. (1997 Chairman’s Letter [CTRL-F] Key Word: Look-through)
Earnings “Management”
It was once relatively easy to tell the good guys in accounting from the bad: (1998 Chairman’s Letter [CTRL-F] Key Word: 1960's)
Deferred Taxes
We have made a significant accounting change that was mandated for 1988, and likely will have another to make in 1990. (1988 Chairman’s Letter [CTRL-F] Key Word: 1990)
A new accounting rule is likely to be adopted that will require companies to reserve against all gains at the current tax rate, whatever it may be. (1989 Chairman’s Letter [CTRL-F] Key Word:Adopted)
A new accounting rule having to do with deferred taxes becomes effective in 1993. It undoes a dichotomy in our books that I have described in previous annual reports and that relates to the accrued taxes carried against the unrealized appreciation in our investment portfolio. (1992 Chairman’s Letter [CTRL-F]Key Word: Plea)
The first negative was produced by a change in Generally Accepted Accounting Principles (GAAP) having to do with the taxes we accrue against unrealized appreciation in the securities we carry at market value. (1993 Chairman's Letter [CTRL-F] Key Word: GAAP)
The Benefit Of Delayed Taxes
Because of the way the tax law works, the Rip Van Winkle style of investing that we favor - if successful - has an important mathematical edge over a more frenzied approach. Let's look at an extreme comparison. (1989 Chairman’s Letter [CTRL-F] Key Word: Rip)
Through my favorite comic strip, Li'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. (1993 Chairman’s Letter [CTRL-F] Key Word: Abner)
Stock Options
When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. (1985 Chairman’s Letter [CTRL-F] Key Word: Earn-More)
At Berkshire, however, we use an incentive compensation system that rewards key managers for meeting targets in their own bailiwicks. (1985 Chairman’s Letter [CTRL-F] Key Word: Bailiwicks)
The most egregious case of let's-not-face-up-to-reality behavior by executives and accountants has occurred in the world of stock options. (1992 Chairman’s Letter [CTRL-F] Key Word: Options)
At Berkshire, we try to be as logical about compensation as about capital allocation. (1994 Chairman’s Letter [CTRL-F] Key Word: Capricious)
Our General Re acquisition put a spotlight on an egregious flaw in accounting procedure. Sharp-eyed shareholders reading our proxy statement probably noticed an unusual item on page 60. In the pro-forma statement of income -- which detailed how the combined 1997 earnings of the two entities would have been affected by the merger -- there was an item stating that compensation expense would have been increased by $63 million. (1998 Chairman's Letter [CTRL-F] Key Word: Sharp-eyed)
"If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" (1998 Chairman’s Letter [CTRL-F] Key Word: Three Questions)
Goodwill Amortization
When Berkshire buys a business for a premium over the GAAP net worth of the acquiree - as will usually be the case, since most companies we'd want to buy don't come at a discount - that premium has to be entered on the asset side of our balance sheet. (Owner’s Manual [CTRL-F] Key Word: Acquiree)
In our annual reports, therefore, we will sometimes talk of earnings that we will describe as "before purchase-accounting adjustments." The discussion that follows will tell you why we think earnings of that description have far more economic meaning than the earnings produced by GAAP. (Owner’s Manual [CTRL-F] Key Word: Spinach)
This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. (1983 Chairman’s Letter [CTRL-F] Key Word: Usage)
Additionally, the Scott Fetzer acquisition required other major purchase-price accounting adjustments, as prescribed by generally accepted accounting principles (GAAP). The GAAP figures, of course, are the ones used in our consolidated financial statements. But, in our view, the GAAP figures are not necessarily the most useful ones for investors or managers. (1986 Chairman’s Letter [CTRL-F] Key Word: GAAP)
As you've probably guessed, Companies O and N are the same business - Scott Fetzer. In the "O" (for "old") column we have shown what the company's 1986 GAAP earnings would have been if we had not purchased it; in the "N" (for "new") column we have shown Scott Fetzer's GAAP earnings as actually reported by Berkshire. (1986 Chairman’s Letter [CTRL-F] Key Word: Fallacy)
When a company is acquired, generally accepted accounting principles ("GAAP") currently condone two very different ways of recording the transaction: "purchase" and "pooling." (1999 Chairman’s Letter [CTRL-F] Key Word: Congress)
