Who Really Cooks the Books?
Tne New York Times
July 24, 2002
By WARREN E. BUFFETT
MAHA - There is a crisis of confidence today about corporate earnings reports and the credibility of chief executives. And
it's justified.
For many years, I've had little confidence in the earnings numbers reported by most corporations. I'm not talking about Enron
and WorldCom - examples of outright crookedness. Rather, I am referring to the legal, but improper, accounting methods
used by chief executives to inflate reported earnings.
The most flagrant deceptions have occurred in stock-option accounting and in assumptions about pension-fund returns. The
aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom.
In calculating the pension costs that directly affect their earnings, companies in the Standard & Poor's index of 500 stocks are
today using assumptions about investment return rates that go as high as 11 percent. The rate chosen is important: in many
cases, an upward change of a single percentage point will increase the annual earnings a company reports by more than $100
million. It's no surprise, therefore, that many chief executives opt for assumptions that are wildly optimistic, even as their
pension assets perform miserably. These C.E.O.'s simply ignore this unpleasant reality and their obliging actuaries and
auditors bless whatever rate the company selects. How convenient: Client A, using a 6.5 percent rate, receives a clean audit
opinion - and so does client B, which opts for an 11 percent rate.
All that is bad, but the far greater sin has been option accounting. Options are a huge cost for many corporations and a huge
benefit to executives. No wonder, then, that they have fought ferociously to avoid making a charge against their earnings.
Without blushing, almost all C.E.O.'s have told their shareholders that options are cost-free.
For these C.E.O.'s I have a proposition: Berkshire Hathaway will sell you insurance, carpeting or any of our other products in
exchange for options identical to those you grant yourselves. It'll all be cash-free. But do you really think your corporation will
not have incurred a cost when you hand over the options in exchange for the carpeting? Or do you really think that placing a
value on the option is just too difficult to do, one of your other excuses for not expensing them? If these are the opinions you
honestly hold, call me collect. We can do business.
Chief executives frequently claim that options have no cost because their issuance is cashless. But when they do so, they
ignore the fact that many C.E.O.'s regularly include pension income in their earnings, though this item doesn't deliver a dime
to their companies. They also ignore another reality: When corporations grant restricted stock to their executives these grants
are routinely, and properly, expensed, even though no cash changes hands.
When a company gives something of value to its employees in return for their services, it is clearly a compensation expense.
And if expenses don't belong in the earnings statement, where in the world do they belong?
To clean up their act on these fronts, C.E.O.'s don't need "independent" directors, oversight committees or auditors absolutely
free of conflicts of interest. They simply need to do what's right. As Alan Greenspan forcefully declared last week, the attitudes
and actions of C.E.O.'s are what determine corporate conduct.
Indeed, actions by Congress and the Securities and Exchange Commission have the potential of creating a smoke screen that
will prevent real accounting reform. The Senate itself is the major reason corporations have been able to duck option
expensing. On May 3, 1994, the Senate, led by Senator Joseph Lieberman, pushed the Financial Accounting Standards Board
and Arthur Levitt, then chairman of the S.E.C., into backing down from mandating that options be expensed. Mr. Levitt has
said that he regrets this retreat more than any other move he made during his tenure as chairman. Unfortunately, current
S.E.C. leadership seems uninterested in correcting this matter.
I don't believe in Congress setting accounting rules. But the Senate opened the floodgates in 1994 to an anything-goes
reporting system, and it should close them now. Rather than holding hearings and fulminating, why doesn't the Senate just
free the standards board by rescinding its 1994 action?
C.E.O.'s want to be respected and believed. They will be - and should be - only when they deserve to be. They should quit
talking about some bad apples and reflect instead on their own behavior.
Recently, a few C.E.O.'s have stepped forward to adopt honest accounting. But most continue to spend their shareholders'
money, directly or through trade associations, to lobby against real reform. They talk principle, but, for most, their motive is
pocketbook.
For their shareholders' interest, and for the country's, C.E.O.'s should tell their accounting departments today to quit
recording illusory pension-fund income and start recording all compensation costs. They don't need studies or new rules to do
that. They just need to act.
Warren E. Buffett is the chief executive officer of Berkshire Hathaway Inc., a diversified holding company.
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