Berkshire’s Investment Write-Downs: “Gotcha Moment” or Difference of Opinion?

Published on March 29, 2011

It should come as no surprise to careful readers of Berkshire Hathaway’s financial statements that the company recorded an “other-than-temporary impairment loss” of $938 million in the fourth quarter of 2010 related to declines in the market value of certain equity securities.  This information was presented on page 43 of Berkshire Hathaway’s annual report which was released on February 26.  However, we did not know the names of the specific securities that were written down until yesterday when Berkshire released correspondence with the Securities and Exchange Commission identifying the companies in question to be Swiss Re, U.S. Bancorp, and Sanofi-Aventis.

“Gotcha Moment”? or Routine Correspondence?

Having set up systems to keep up to date with SEC filings of this type, we reviewed the disclosures on Monday morning shortly after they were filed and considered the information to be  interesting but not particularly material to Berkshire’s financial results.  It is normal for companies, particularly complicated and high profile organizations, to engage in correspondence with the SEC on various topics related to financial statements.  However, the attractions of writing headlines where one can combine the words “SEC” and “Buffett” appeared to be too tempting for many news organizations to pass up.  This included a ludicrous article in Forbes entitled “Are Stocks Worth Whatever Warren Buffett Says They Are?” and the predictable tweets from various outraged media personalities looking for a “gotcha” moment.

Substance of SEC Complaint

On December 10, 2010, Gus Rodriguez, Accounting Branch Chief of the SEC, wrote a letter (pdf) to Berkshire Hathaway CFO Marc Hamburg asking for further details regarding certain elements of Berkshire Hathaway’s 10-Q for the third quarter of 2010.  Mr. Rodriguez noted that Berkshire’s gross unrealized losses on equity securities increased from $3,047 million at December 31, 2009 to $3,484 million at September 30, 2010 during which time markets had “generally improved”.  Mr. Rodriguez reveals a bias in favor of the efficient market hypothesis in the following statement:

For each individual security, please identify for us the evidence you relied upon to support a realizable value equal to or greater than the carrying value of the investment. In your response, please identify both the positive and negative information you considered that is not already contemplated by and reflected in the quoted market price of the security and the relative significance of this information to the conclusion you reached. For example, your disclosure indicates that you consider “the current and expected long-term business prospects of the issuer,” including that “the future earnings potential and underlying business economics of these companies are favorable.” However, these factors appear to already be contemplated by and reflected in the quoted market price. [emphasis added]

In Mr. Hamburg’s response dated January 11, 2011, he provides details regarding the five securities in question:  Kraft Foods, U.S. Bancorp, Swiss Re, Sanofi-Aventis, and Wells Fargo.  Mr. Hamburg disputes Mr. Rodriguez’s belief that all factors related to the underlying future prospects of each business must be reflected in the quoted market price:

Prior to providing the Commission with additional information regarding the five securities identified in the table above, Berkshire wishes to address the Commission’s inference in its comment letter that at any point in time the quoted market prices reflect future earnings potential and underlying business economics of an issuer of a security. Berkshire management does not believe that the validity of the efficient market hypothesis as suggested by the Commission can either be proven or disproven. [emphasis added]  Information made available by the issuer of a security including current results and expectations regarding the future will likely be interpreted differently by individual investors.

Despite Berkshire’s belief that the investments in Swiss Re, Sanofi Aventis, and U.S. Bancorp are not permanently impaired, in later correspondence, the company agreed to record other-than-temporary impairment charges related to the market value of these investments in Berkshire’s 2010 10-K reporting full year results:

We continue to believe that our ability and current intent to hold these investments for an extended period of time which would be sufficient to allow for an anticipated recovery in market value along with our opinion that the current financial condition and business prospects of each issuer are favorable suggests that it is likely that the market prices of each of these securities will recover to a level equal to or greater than our cost basis in each investment. However, as a result of our discussions, we recognize that the Staff believes that GAAP could be interpreted in such a manner that an OTTI charge should be recorded with respect to each of these investments given the length of time each investment has been impaired, the magnitude of the impairment and the fact that these investments continue to be impaired as of and subsequent to December 31, 2010.

However, Berkshire refused to take impairment charges for Wells Fargo and Kraft Foods although the company will review the issue again prior to reporting results for the first quarter of 2011.

Ultimately, a complete reading of the correspondence clearly indicates that there was a disagreement between the SEC and Berkshire regarding the nature of the unrealized losses in these securities and Berkshire eventually agreed to record impairments despite believing that the intrinsic value of the securities remained above the purchase price.  The SEC’s reliance on the efficient market hypothesis is revealing, although not necessarily surprising.

Accounting Implications of Impairment Charges

There are a few misconceptions regarding the accounting implications of taking other-than-temporary impairment charges that appear to be prevalent in most of the reporting of this situation.  Most of the critical articles seem to either directly state or imply that Berkshire was attempting to hide the market value decline of these securities in reporting financial results to investors.  In reality, unrealized losses on securities are always fully reflected in other comprehensive income and in book value.

When an other-than-temporary impairment charge occurs, the accounting effect is that the loss flows through the income statement for the period in question rather than impacting other comprehensive income.  This means that Berkshire’s reported earnings are impacted but book value is exactly the same regardless of whether the impairment is taken or not.  No one was trying to hide the decline in the market value of these securities, contrary to the Forbes article referenced above that asserted that Berkshire is saying that “stocks are worth whatever Warren Buffett says they are”.

Berkshire has a significant amount of unrealized gains from securities that have been held for many years.  The unrealized gains are fully reflected in book value at the end of each accounting period but do not have an impact on reported earnings.  As Warren Buffett noted in his latest  letter to shareholders, Berkshire could use this reservoir of unrealized gains to manage reported earnings:

If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. Rest assured, though, that Charlie and I have never sold a security because of the effect a sale would have on the net income we were soon to report. We both have a deep disgust for “game playing” with numbers, a practice that was rampant throughout corporate America in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to.

This reveals the absurdity of the claims that Berkshire was attempting to hide anything or to manipulate earnings by not taking an impairment charge on the securities brought up in the SEC inquiry.  If Mr. Buffett wanted to offset the $938 million impairment charge in Q4, he could have easily done so by selling enough securities to generate $938 million in realized gains thereby creating a wash from an accounting perspective.

If the question of taking an impairment charge has no real economic impact, then why would Berkshire object to the SEC request?  Most likely, the objection is due to the fact that taking impairment charges in cases where a security is not really impaired distorts financial statements by requiring a loss to be recorded now when any future recovery in the price of the “impaired” security will never be booked until the security is actually sold.  In other words, if the $938 million impairment taken in Q4 is recovered at some point in 2011, Berkshire will not be permitted to “write up” the investment to market value.

Headline writers may find it irresistible to play up a perceived controversy between Warren Buffett and the SEC but financial journalism is harmed when publishers fail to differentiate between real accounting scandals and routine correspondence that may reflect an honest difference of opinion but fails to have much if any impact on the users of financial statements.

Disclosure:  Long Berkshire Hathaway.

Berkshire’s Investment Write-Downs: “Gotcha Moment” or Difference of Opinion?
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