It’s that time of year when Berkshire Hathaway files its annual Form 10-K (along with many other companies), and the filing of their 10-K means another entertaining annual shareholder’s letter written by their 88-year-old CEO, Warren Buffett. Now don’t get me wrong; Warren Buffett is an incredible business man who is extremely intelligent, and a generous philanthropist as well, but the first section of his annual letter makes him sound like an old, grumpy, disgruntled man who hates everything about U.S. GAAP! If you’d like to read his letter in full, click here, where you will also find references to trees, lollipops, Russian-roulette, and tailwinds.
But back to Warren’s dislike of U.S. GAAP, especially as it relates to ASC 321, Investments in Equity Securities. When talking about ASC 321, he specifically says “neither Charlie Munger (Berkshire’s Vice Chairman) nor I believe that rule to be sensible.” He then goes on to say that in Q1 and Q4 of 2018, Berkshire recognized a loss of $1.1 billion and $24.5 billion, respectively, relating to mark-to-market changes in its equity investments. But in Q2 and Q3 of 2018, Berkshire recognized gains of $12.0 billion and $18.5 billion, respectively, on equity investments. I calculate this to be an overall gain of $4.9 billion on equity investments. Not too bad, right?
But what does this all mean? Let’s back up a bit and refresh the new guidance for equity securities. As you may recall, the issuance of ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, created ASC 321, Investments – Equity Securities. ASC 321 requires equity investments with readily determinable fair values within its scope to be measured at fair value with changes in fair value recognized in net income (not comprehensive income).
According to ASC 321, an equity security has a readily determinable fair value if it meets any of the following conditions:
- The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in an over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations (NASDAQ) systems or by the OTC Markets Group Inc. Restricted stock meets that definition if the restriction terminates within one year.
- The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above.
- The fair value of an equity security that is an investment in a mutual fund or in a structure similar to a mutual fund (that is, a limited partnership or a venture capital entity) is readily determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.
If the investment has a readily determinable fair value, then it must be reported on the balance sheet at fair value with changes in fair value reported in the income statement. See this previous blog post for additional detail and the accounting requirements for equity investments without a readily determinable fair value. Additionally, if you need further information, check out our course on Equity Investments on our online eLearning platform, The Revolution. And finally, here is a fun video that explains the subsequent accounting requirements of equity investments under ASC 321.
The problem for Berkshire Hathaway is that they have a substantial portfolio of equity securities with readily determinable fair values. In addition, 68% of the aggregate fair value is concentrated in five companies (American Express, Apple, Bank of America, Coca-Cola, and Wells Fargo). With a substantial, concentrated portfolio, a decline in the fair value of the stock of just one of these companies can have a tremendous impact. Before ASC 321, Berkshire classified these securities as “available-for-sale” meaning any unrealized gains or losses were recorded in other comprehensive income. Now, under ASC 321, all changes in fair value for equity investments with readily determinable market values are recorded in the income statement. Hence, the disdain by Warren Buffet for ASC 321 and his belief that these mark-to-market swings are not indicative of the business. This may be true, but what if Berkshire had to sell these securities? The company would then have to realize the loss, so many believe the rules of ASC 321 are more reflective of a company’s financial position. Tell us what you think! Do you love or hate the ASC 321 requirements?
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