Harvard Case - Potential Volatility Comes to Earnings: A Look at Berkshire Hathaway's Equity Investments
"Potential Volatility Comes to Earnings: A Look at Berkshire Hathaway's Equity Investments" Harvard business case study is written by Luann J. Lynch, Mark E. Haskins. It deals with the challenges in the field of Accounting. The case study is 21 page(s) long and it was first published on : Jun 19, 2019
At Fern Fort University, we recommend that Berkshire Hathaway (BRK) adopt a more transparent and comprehensive approach to reporting its equity investments. This should involve a shift towards more detailed disclosures on the valuation methodologies used, the underlying assumptions driving these valuations, and the potential risks associated with these investments. This enhanced transparency will provide investors with a clearer understanding of the company's financial performance and its exposure to market volatility.
2. Background
Berkshire Hathaway, led by the legendary investor Warren Buffett, is a conglomerate with a vast portfolio of businesses and a significant stake in publicly traded companies. The company's success is largely attributed to its investment strategy, which focuses on long-term value creation through a concentrated portfolio of high-quality businesses. However, the company's accounting practices for its equity investments have come under scrutiny, particularly regarding the potential for volatility in its earnings.
The case study focuses on the challenges faced by Berkshire Hathaway in reporting its equity investments under Generally Accepted Accounting Principles (GAAP). The company's use of the fair value accounting method, which requires marking these investments to market value, has led to significant fluctuations in its earnings, making it difficult for investors to assess the company's underlying performance.
3. Analysis of the Case Study
This case study presents a complex situation where the company's accounting practices for its equity investments are at odds with its long-term investment philosophy. To analyze the situation, we can use a framework that considers both financial performance and corporate governance:
Financial Performance:
- Financial Statement Analysis: The case highlights the impact of fair value accounting on Berkshire Hathaway's income statement and balance sheet. The fluctuations in the value of its equity investments can significantly impact its reported earnings, creating volatility that may not reflect the underlying performance of its businesses.
- Risk Management: The company's exposure to market volatility through its equity investments raises concerns about its risk management practices. While Buffett's investment philosophy emphasizes long-term value creation, the fair value accounting method exposes the company to short-term market fluctuations.
- Profitability: The impact of the fair value accounting method on profitability is a key concern. While the company's overall profitability is strong, the fluctuations in its earnings due to its equity investments can obscure the true picture of its underlying business performance.
Corporate Governance:
- Transparency: The case study highlights the need for greater transparency in the company's reporting of its equity investments. Investors need a clear understanding of the valuation methodologies used, the underlying assumptions driving these valuations, and the potential risks associated with these investments.
- Board Oversight: The role of the board of directors in overseeing the company's investment strategy and accounting practices is crucial. The board should ensure that the company's accounting policies are aligned with its investment philosophy and that investors are provided with adequate information to assess its performance.
- Employee Incentives: The company's compensation structure should align with its long-term investment philosophy. This means that executive compensation should not be tied solely to short-term performance metrics, such as quarterly earnings, which can incentivize short-term trading and create volatility.
4. Recommendations
To address the challenges highlighted in the case study, Berkshire Hathaway should consider the following recommendations:
Enhanced Transparency in Equity Investment Reporting:
- Provide detailed disclosures on the valuation methodologies used to determine the fair value of its equity investments.
- Clearly explain the underlying assumptions driving these valuations, including the expected growth rates, discount rates, and other key factors.
- Disclose the potential risks associated with these investments, including market volatility, regulatory changes, and the performance of the underlying businesses.
- Consider providing supplementary information, such as a breakdown of the performance of its equity investments by sector or industry, to provide investors with a more comprehensive understanding of its investment portfolio.
Adoption of a Hybrid Accounting Approach:
- Explore the possibility of adopting a hybrid accounting approach that combines the fair value accounting method with a more conservative approach, such as the cost method, for certain investments.
- This hybrid approach would provide investors with a more balanced view of the company's financial performance, mitigating the impact of short-term market fluctuations on its reported earnings.
Strengthening Corporate Governance:
- Enhance the board's oversight of the company's investment strategy and accounting practices.
- Appoint independent directors with expertise in investment management and accounting to provide independent oversight of the company's financial reporting.
- Implement a compensation structure that aligns with the company's long-term investment philosophy, reducing the incentives for short-term trading and volatility.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with Berkshire Hathaway's core competency in long-term value investing and its mission to create sustainable shareholder value. Enhanced transparency and a more conservative accounting approach for equity investments will strengthen investor confidence and support the company's long-term goals.
- External Customers and Internal Clients: The recommendations will provide investors with a clearer understanding of the company's financial performance and its exposure to market volatility. This will enhance investor confidence and reduce the risk of short-term fluctuations in the company's stock price.
- Competitors: While Berkshire Hathaway's investment strategy is unique, the recommendations are consistent with best practices in corporate governance and financial reporting. By adopting a more transparent and conservative approach, the company can differentiate itself from competitors and enhance its reputation as a responsible and reliable investment vehicle.
- Attractiveness ' Quantitative Measures: While it is difficult to quantify the impact of these recommendations on Berkshire Hathaway's financial performance, the improved transparency and reduced volatility will likely lead to a more stable and predictable stock price, which is attractive to long-term investors.
6. Conclusion
By adopting a more transparent and comprehensive approach to reporting its equity investments, Berkshire Hathaway can address the concerns raised in the case study and enhance its financial reporting practices. This will provide investors with a clearer understanding of the company's financial performance and its exposure to market volatility, ultimately strengthening investor confidence and supporting the company's long-term growth.
7. Discussion
Other alternatives not selected include:
- Maintaining the status quo: This option would continue the current practice of using fair value accounting for all equity investments. However, this could lead to continued volatility in the company's earnings, potentially alienating investors and impacting the company's long-term growth.
- Adopting the cost method: This option would eliminate the volatility associated with fair value accounting but could result in an underestimation of the company's true financial performance.
The key risks associated with the recommendations include:
- Increased complexity in financial reporting: Providing more detailed disclosures on equity investments could increase the complexity of the company's financial statements.
- Potential for misinterpretation: Investors may misinterpret the company's disclosures, leading to misunderstandings about its financial performance.
8. Next Steps
To implement the recommendations, Berkshire Hathaway should take the following steps:
- Form a task force: Assemble a task force of senior management, board members, and financial experts to develop a plan for implementing the recommendations.
- Conduct a thorough review: Review the company's current accounting policies and procedures for equity investments to identify areas for improvement.
- Develop a communication strategy: Communicate the changes to investors and other stakeholders, providing clear and concise explanations of the rationale for the changes.
- Monitor and evaluate: Monitor the impact of the changes on the company's financial reporting and investor confidence.
By taking these steps, Berkshire Hathaway can address the challenges highlighted in the case study and enhance its financial reporting practices, ultimately strengthening investor confidence and supporting the company's long-term growth.
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Case Description
Based in Omaha, Nebraska, Berkshire Hathaway Inc. is a holding company that invests in many diverse businesses. The most significant of those are property and casualty insurance businesses, although the company owns businesses in the railroad, utilities, energy, and finance industries as well. The case focuses on accounting for investments at Berkshire Hathaway. The company adopted the new US guidance (ASU 2016-01) on accounting for investments in its 2018 10-K, and key excerpts from that report comprise much of the case. Students are asked to review Berkshire Hathaway's financial statements and the footnotes related to its investments, consider the method of accounting for those investments, and decipher their impact on the financial statements.
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