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Warren Buffett: Complex Accounting Is a Warning Sign

·3 min read

There are many skills that value investors need to have in order to be successful in their field. Risk management, having a good head for numbers and industry knowledge are all important. So is having a solid base in accountancy. Warren Buffett (Trades, Portfolio) has said that the most important classes to take at business school (not that you need to go to business school to succeed as an investor) are accounting courses because accountancy is the language in which the histories of businesses are written.

To go into investing without at least a basic understanding of accounting would be like setting out to work in France without knowing French. I was recently struck by something that Buffett said at the 1995 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder conference, when he was asked for advice on what to do when faced with a business with complicated accounting.

An insight into the character of management

Of course, if you are not a confident accountant, then filing that seems confusing to you may in fact be straightforward to a professional. But let's assume that you have done your homework and have a good grasp of the subject. Buffett believes that if a company's financial statements are complicated, then that is probably by design. Of course, there are cases when the rules of accounting will necessitate some complexity, but generally speaking, a forthright management team will want to communicate its financials clearly and concisely. So it stands to reason that in instances where this is not the case, management is possibly trying to hide something.

"Accounting can offer you a lot of insight into the character of management...When you don't have a product where revenues and expenses are being matched up on something close to cash in the short term you have the opportunity for people playing games with numbers - and some people have learned to do that very well and they've sometimes created long-lasting stock manipulation or promotion schemes that have enriched the managers at the expense of the public over time. If you ever get suspicious about accounting just go onto the next company."

Buffett's advice is to treat suspicious accounting as a warning sign and to forget about investing in such a business. Berkshire has never had any success investing in businesses where the financials weren't clearly laid out. I think this advice gels quite well with Buffett's insistence that investors seek out easy-to-understand businesses. Any company that is difficult to understand will present a lot more opportunities for unscrupulous managers to mislead investors.

There is a large number of publicly traded companies in the market, and life is far too short to spend figuring out whether a particular microcap stock has intentionally confusing financials, or whether its accountants and auditors simply lacked the wherewithal to simplify the filings. Either way, you would be better served by staying away.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.