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Buffett on How Earnings and Assets Can Be Misstated

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Investor-Update

As I said last year, Warren Buffett’s annual letter to Berkshire Hathaway (BRK.B) shareholders is on my must-read list, and I suggest adding it to yours as well. His letters always provide investing insights written in Buffett’s folksy but outspoken manner. This year’s letter was no different. Though the media focused on the what the “Oracle of Omaha” said about productivity and the U.S. economy, a significant portion of the commentary was devoted to how earnings and assets can be misstated.

This may sound like heady accounting stuff, but it has implications for how you view a company’s earnings and its balance sheet. An understanding of how assets, shareholder equity and earnings can be overstated (or understated) will help to you know when to be skeptical of the metrics a CEO wants you to focus on.

There are two big types of noncash charges you will see. I’ll start with depreciation and then move onto amortization. Depreciation is a charge taken to reflect the decrease in value a physical asset incurs. For example, say a firm buys one of its new employees (Jimmy) a cocobolo desk. Accounting rules require that a certain percentage of that desk’s value be deducted each year. These charges count against earnings, but because checks are not being written to cover the charge, the charges do not count against cash flow. Depending on how gentle or tough Jimmy is on the desk, it may retain or lose more value than the depreciation charges imply. I’ve seen fully depreciated assets that could be still be sold. On the other hand, depreciation can understate the amount a company has to truly spend on equipment and machinery. As Buffett observed: “The depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly.”

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The Week Ahead

Just two members of the S&P 500 are scheduled to report earnings next week: Urban Outfitters (URBN) on Monday and Dollar General (DG) on Thursday.

There isn’t much on the economic calendar. Beyond February import and export prices (which will be released on Friday), the only reports of note will be weekly oil inventories and weekly initial jobless claims. The latter two are released every Wednesday and Thursday, respectively.

Federal Reserve Vice Chair Stanley Fischer will speak on Monday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $20 billion of 10-year notes on Wednesday and $12 billion of 30-year notes on Thursday.

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