1995: How should investors approach businesses using convoluted accounting?

AUDIENCE MEMBER: Hi, Gorem Pulich (PH) from New York City.

I have a two-part question, first part very short. I think a lot of people have difficulty valuing businesses because of some convoluted accounting schemes that are out there.

Do you have any suggestions, in terms of books, or something you can read, where you can sort of make sense of some of the accounting stories that are going around?

WARREN BUFFETT: Well, that’s a good question. Abe Briloff used to write for Barron’s quite frequently on various accounting machinations, and Barron’s has continued that somewhat.

But you’re right that there are people out there who will try to paint pictures with accounting that are something far from the economic reality. And sometimes, the rules of accounting themselves lead to that.

I would say that when the accounting confuses you, I would just tend to forget about it as a company. I mean, it’s probably — it may well be intentional, and in any event, you don’t want to go near it.

I — we have never had any great investment results from companies whose accounting we regarded as suspect. I can’t think of a one. Can you, Charlie?

CHARLIE MUNGER: No.

WARREN BUFFETT: It’s a very bad sign.

CHARLIE MUNGER: I made a short sale once that worked out well — (laughter) — in a case like that.

WARREN BUFFETT: It really — accounting can be a — accounting can offer you a lot of insight into the character of management.

And I would say there’s a lot — you know, there’s a — you run into a fair amount of bad accounting. I used to call it creative accounting. And you’d probably run into a lot more, if it was allowed.

But some companies have been able to push their auditors pretty far, and I would be very skeptical of anything that looks suspicious to you.

I think there have been — there’ve been a couple of things written, but I can’t think of where they’ve appeared, where people talk about the questions of, you know, what —

Obviously, if some prepaid expense, deferred asset accounts start building up suspiciously high, and inventories look out of line, you know, with sales and, particularly, the trend of them and all that, you want to look twice at companies like that.

Life insurance, you know, frequently, you know, we see weak accounting in. You can — 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 how to do that very well, and they’ve sometimes created long-lasting stock manipulation or promotion schemes that have enriched themselves, or they’ve enriched the managers or the creators of it, at the expense of the public, over time.

If you ever get suspicious about accounting, just go onto the next company.