It once was relatively easy to tell the good guys in accounting from the bad. The late 1960s, for example, brought on an orgy of what one charlatan dubbed "bold, imaginative accounting" (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception.
In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it's OK to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only OK, but actually their duty.
These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the hoped-for result, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired "earnings" or set the stage for them in the future.
Rationalizing this behavior, these managers often say their shareholders will be hurt if their currency for doing deals -- that is, their stock -- is not fully priced. They also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.
The distortion du jour is the "restructuring charge," an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. In some cases, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by 5 cents per share.
This dump-everything-into-one-quarter behavior suggests a corresponding "bold, imaginative" approach to golf scores. In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers -- double, triple, quadruple bogeys -- and then turn in a score of, say, 140. Having established this "reserve," he should go to the golf shop and tell his pro he wishes to "restructure" his imperfect swing. Next, as he takes his new swing onto the course, he should count his good holes, but not the bad ones. These remnants from his old swing should be charged instead to the reserve established earlier. At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. On Wall Street, they will ignore the 140 -- which, after all, came from a "discontinued" swing -- and will classify our hero as an 80 shooter (who never disappoints.)
For those who prefer to cheat up front, there would be a variant of this strategy. The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score. After rectifying his earlier scorekeeping sins with this "big bath," he may mumble a few apologies, but will refrain from returning the sums he previously has collected from comparing scorecards in the clubhouse.
Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they're playing -- after all, it's easier to fiddle with the scorecard than to spend hours on the practice tee -- and never muster the will to give them up.
In the acquisition arena, restructuring has been raised to an art form: Managements now frequently use mergers to dishonestly rearrange the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. Indeed, at deal time, major auditing firms sometimes point out the possibilities for a little accounting magic (or for a lot). Getting this push from the pulpit, first-class people frequently will stoop to third-class tactics. CEOs understandably do not find it easy to reject auditor-blessed strategies that lead to increased future "earnings."
An example from the property-casualty insurance industry will illuminate the possibilities. When a property-casualty company is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may merely reflect the previous inadequacy of reserves -- though it is uncanny how often an actuarial "revelation" of this kind coincides with the inking of a deal. In any case, the move sets up the possibility of "earnings" flowing into income at some later date, as reserves are released.
Berkshire has kept entirely clear of these practices: If we are to disappoint you, we would rather it be with our earnings than with our accounting. In all of our acquisitions, we have left the loss reserve figures exactly as we found them. After all, we have consistently joined with insurance managers knowledgeable about their business and honest in their financial reporting. When deals occur in which liabilities are increased immediately and substantially, simple logic says that at least one of those virtues must have been lacking -- or, alternatively, that the acquirer is laying the groundwork for future infusions of "earnings."
Here's a true story that illustrates an all-too-common view in corporate America. The CEOs of two large banks, one of them a man who'd made many acquisitions, were involved not long ago in a friendly merger discussion (which in the end didn't produce a deal). The veteran acquirer was expounding on the merits of the possible combination, only to be interrupted skeptically by the other CEO who asked, "But won't that mean a huge charge, perhaps as much as $1 billion?" The "sophisticate" wasted no words, responding: "We'll make it bigger than that -- that's why we're doing the deal."
A preliminary tally by R.G. Associates of Baltimore of special charges taken or announced during 1998 -- that is, charges for restructuring, in-process R&D, merger-related items and writedowns -- identified no less than 1,369 of these, totaling $72.1 billion. That is a staggering amount as evidenced by this bit of perspective: The 1997 earnings of the 500 companies in Fortune's famous list totaled $324 billion.
Clearly the attitude of disrespect that many executives have today for accurate reporting is a business disgrace. And auditors have done little on the positive side. Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.
A big piece of news is that the SEC, led by Chairman Arthur Levitt, seems determined to get corporate America to clean up its act. In a landmark speech last September, Mr. Levitt called for an end to "earnings mismanagement." He correctly observed, "Too many corporate managers, auditors and analysts are participants in a game of nods and winks." And then he laid on a real indictment: "Managing may be giving way to manipulating; integrity may be losing out to illusion."
Mr. Levitt's job will be Herculean, but it is hard to think of another more important for him to take on.
Warren Buffett is chairman of Berkshire Hathaway Inc., Omaha, Neb. This article is excerpted from his annual letter to shareholders, copyright Berkshire Hathaway Inc., reprinted with permission.