New accounting rules on how to reflect financial instruments in financial statements are beginning to produce predicted earnings volatility, as recently bemoaned by America’s celebrity investor, Warren Buffett.
In his annual letter to shareholders as chairman at Berkshire Hathaway, Buffett says the new accounting rule will “severely distort” the company’s net income figures, misleading commentators and investors. “For analytical purposes, Berkshire’s ‘bottom line’ will be useless,” he writes. The letter drew heavy attention recently when the board released its first-quarter results showing a $1.1 billion loss.
Buffet never wrote to the Financial Accounting Standards Board, however, to share those kinds of concerns ahead of time as the board sought feedback from stakeholders while it developed the new rule. FASB’s online archive of comment letters shows no letter from Buffett or anyone else at Berkshire Hathaway, and a FASB spokesman says the board has no record of hearing from the company or its chairman as it developed the rule over several years.
The rule drawing Buffett’s ire is Accounting Standards Update No. 2019-01 — Financial Instruments, now codified in the Accounting Standards Codification under Subtopic 825-10. The FASB published the final rule in January 2016 after several years of public deliberations, published exposure drafts, outreach, public re-deliberations based on published comment letters, and then final publication two years before the rule would take effect.
Beginning Jan. 1, 2018, companies are required to reflect the standard’s new methods for how to measure and recognize financial instruments in financial statements. Most significantly, the standard requires companies to report the value of their equity investments at fair value—the price a buyer would pay for the investments if they were sold in an arm’s length transaction—rather than at the price they were purchased. To the extent the value changes from one period to the next, the difference gets recorded in net income.
Accounting rules, ever so gradually, have been shifting over the past few decades toward more reporting at fair value rather than historic cost, largely driven by investor demand for more current, relevant information in financial reports. The CFA Institute has been stumping for more fair value in financial reports for years.
More than a decade ago, the FASB infamously proposed to require all financial instruments, not just equity securities held in a trading portfolio, to be reported at fair value. Not long after, the board’s then chairman, Robert Herz, abruptly left the board. The board reined in its proposal and took an entirely different approach to financial instrument accounting that called for much less use of fair value.
Buffett says the new requirement to report equity securities at fair value will produce “some truly wild and capricious swings” in net income. The company owns $170 billion in marketable securities, and their value can swing by as much as $10 billion within a single reporting period, he says. The company is shifting its earnings announcements to late Friday or early Saturday to give investors and commentators time to digest the full effect of its reporting while markets are closed, he says.