Crisis of confidence- 24th July 2002

Warren Buffet - New York Times

OMAHA - 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. This article first appear in The New York
Times on 24th July 2002.


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