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Warren Buffett: Why It's Important to Pay Attention to a Company's Accounting

Warren Buffett (Trades, Portfolio) is an outspoken critic of corporate accounting practices in the U.S.

The Oracle of Omaha believes that a company's accounting practices reveal a lot about a business and its managers. For example, he has said that corporations issuing a lot of stock options could be trying to manipulate earnings figures.


Buffett on stock options

In May 1999, Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), took part in an exclusive interview session titled "The Buffett and Munger Show." The duo covered multiple topics, including the issuance of stock options to company employees.

The Oracle of Omaha opined that when accounting for stock options, companies should figure out the average issuance per year and calculate how much could have been made if the options had been sold as warrants.

The business should then take this number and show it as a cost of doing business to shareholders. By not doing so, he went on to add, companies are hiding their total compensation expense from shareholders, misleading shareholders.

Buffett and Munger generally like to avoid companies that mislead shareholders in any way. He also spoke about company acquisitions, saying that if he were in control, the cost of economic goodwill would not be amortized over time.

Buffett doubled down on this view in his 2013 annual letter to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) investors:


"If Company A announces that it will issue shares to merge with Company B, the process is customarily described as 'Company A to Acquire Company B,' or 'B Sells to A.' Clearer thinking about the matter would result if a more awkward but more accurate description were used: 'Part of A sold to acquire B,' or 'Owners of B to receive part of A in exchange for their properties.' In a trade, what you are giving is just as important as what you are getting. This remains true even when the final tally on what is being given is delayed. Subsequent sales of common stock or convertible issues, either to complete the financing for a deal or to restore balance sheet strength, must be fully counted in evaluating the fundamental mathematics of the original acquisition. (If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy.) "



Often overlooked

Many investors often overlook the importance of company accounting practices and what they indicate about the business in question.

This is, however, something Buffett has learned to pay close attention to over the years. The guru puts a lot of his trust in managers. Generally speaking, he will only invest in a company if he likes the management team. One of the methods used to identify the quality of management is to evaluate their financial practices.

As investors, it is highly unlikely we will never really know the accurate financial position of the companies we own. We have to rely on what the company reports every quarter. These figures are quite easy to manipulate if you know what you are doing and hide the real numbers.

As a result, there is a considerable degree of trust between investors and managers. The only way we can be sure managers are not misleading shareholders with the numbers is with past actions. If managers have always been open and honest with their shareholders, then, in theory, there is little reason to worry. If it is clear management is trying to mislead shareholders (and it doesn't have to be much), however, then we have to start asking the question, what else are they trying to hide?

That's why Buffett places so much emphasis on analyzing a company's financials. He's not just looking at the figures from a valuation perspective. He wants to understand management better.

Disclosure: The author owns shares of Berkshire Hathaway.

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This article first appeared on GuruFocus.