GAAP Volatility
The requirement to mark investment portfolios to market each quarter causes wild swings in reported earnings, which Buffett argues distorts true business performance.
GAAP Volatility
GAAP volatility refers to the wild swings in reported earnings caused by mark-to-market accounting rules that require including unrealized investment gains/losses in quarterly earnings. Buffett has repeatedly criticized this rule as producing "wild and capricious swings" that obscure true business performance.
The Problem
New GAAP Rule
In 2016, a new accounting rule required:
- All equity securities must be marked to market each quarter
- Unrealized gains/losses flow directly through the income statement
- This applies to Berkshire's ~$300B equity portfolio
The Distortion
| Quarter | GAAP Earnings Impact |
|---|---|
| Q1 2018 | $1.1B loss |
| Q2 2018 | $12.0B profit |
| Q3 2018 | $18.5B profit |
| Q4 2018 | $25.4B loss |
| Full Year | $4.0B (but operating earnings: $24.8B) |
"Neither Berkshire's Vice Chairman, Charlie Munger, nor I believe that rule to be sensible."
Why Buffett Objects
Focuses on the Wrong Thing
- The quarterly swings are meaningless to long-term value
- They distract from operating business performance
- Market prices are temporary, business value is durable
Timing Mismatch
- Unrealized gains/losses are just paper changes
- Only realized gains/losses represent actual transactions
- Market prices can be wildly wrong in short term
"A new GAAP rule requires us to include that last item in earnings... we both have consistently thought that at Berkshire this mark-to-market change would produce 'wild and capricious swings in our bottom line.'"
The Reality: Operating Earnings
What Actually Matters
| Metric | 2018 Value |
|---|---|
| Operating Earnings | $24.8B |
| Non-cash impairment (Kraft Heinz) | -$3.0B |
| Realized capital gains | +$2.8B |
| Unrealized gains reduction | -$20.6B |
| GAAP Earnings | $4.0B |
Operating earnings grew 41% above the 2016 high — the real story.
Famous Quotes
"This rule produces 'wild and capricious swings in our bottom line.'"
"The GAAP losses of 2018 do not remotely reflect the true earnings of our many businesses."
Related
- intrinsic-value — Why market prices diverge from value
- compounding — Focus on long-term growth
- capital-allocation — How Berkshire deploys capital regardless of mark-to-market