Berkshire Hathaway 2002 Annual Meeting Audience Question # 41

Why Berkshire’s audit costs are so low

Audience Member:

OK, the third point is… the first of March, the Wall Street Journal analyzed… or compared… the auditing fees by the fees related to audit services and other audit services for the 30 stocks in the Dow Jones Industrial Average.

And there seems to be an inverse relation between the amount of non-audit fees with respect to market capitalization, an inverse correlation with that factor to the five-year compound growth of earnings, or the five-year total return for the companies.

And for the top… for the companies with the lowest ratio of non-audit fees to market capitalization, the increase in earnings was 10 percent annually. The total return was 18 percent annually.

For the other… for the total… it was 5.2 percent return annually on increase in earnings, and 11 percent increase in total return.

Is it because these non-audit fees are non-productive that it has this result? Or is it a chance… just a spurious fluctuation? Or is there something to the relation?

Warren Buffett:

I don’t know the answer to that. And I hadn’t seen what you are referring to. But it doesn’t totally surprise me, because we like places that care about expenses.

And you know, I’ve never… I think Jack Welch had something in his book about no, you know, no company ever getting… going broke from cutting expenses too rapidly.
And when you see managements that are pretty lavish in what they toss around, you know, I think on balance that group doesn’t do as well for shareholders as the other, but I have no statistical way of proving that.

And I don’t know a way that… I don’t know how you would set up a sample that would really be valid in terms of one kind versus the other kind.

But what you say doesn’t shock me. We try to watch all expenses around Berkshire.

And I think that, at our subsidiaries, we… generally speaking… we have managers that are very, very good about that.

And I think that our audit costs, relative to the size of the enterprise and all of that, I think, are fairly low, although they’re not as low as they were a few years back. But it’s something that we care about, I can assure you of that.

I don’t know how to… I wouldn’t want to buy stocks, though, or sell stocks, based on any kind of statistical measure like that, even though that it looks good on what they call a backtest.

Charlie?

Charlie Munger:

Well, one of the reasons our audit costs are so low is we have this passion for keeping everything simple. We don’t want to be difficult to audit. And we prefer activities that are simple.

If you take the See’s Candy company, the whole company goes to cash at the end of December every year, as if it were a farm where the crop came in and was sold in December.

I mean, an idiot could audit the See’s Candy company without getting into trouble.

And there’s a lot in Berkshire that’s like the See’s Candy company. It would be really hard to screw up.

Warren Buffett:

We don’t like complicated accounting. I mean, it… we really do like things that produce cash.

And Enron is a good example. Enron’s grotesque in what happened. But there’s no question in my mind that auditors have been unduly compliant to client wishes over the last few decades, and more so as they went along, even to the point where they started suggesting what I would consider quite dubious accounting to people in mergers and so on, so as to make their figures look better later on. And I’ve seen it firsthand.

So, I just… I think that although the auditors are supposed to work for the shareholders, that they got too much so they were working for management.

But I think that Enron may push them back significantly, even in the other direction. So, I think Enron will have a distinct beneficial effect on auditing, and it was needed.

Charlie Munger:

Well, it’s going to have a distinct beneficial effect on one fewer auditors.

Warren Buffett:

Yeah, although… you know, it’s an interesting question, and Charlie and I may differ on this. I mean… I don’t think that… I don’t know how many people Andersen employed, but it was a huge number.

And I certainly… it’s clear that the weaknesses and culpability at Andersen goes far beyond anything remotely we saw at Salomon.

But it would have been a shame for Salomon, with 8,000 people, to have, actually, the bad acts of one guy, and the lapse in terms of reporting and all of that… which was a big mistake, but by a few other people… cause 8,000 people to get dislocated in their lives and lose their jobs.

I don’t know, how do you feel, Charlie, about, you know, the bottom 40,000 people at Andersen who really didn’t have a damn thing to do with shredding or the Houston office or anything of the sort? I mean, their lives are really getting changed in many cases.

Charlie Munger:

I regard it as very unfair and totally undeserved in all those cases. Yet even so, I think that capitalism without failure, as somebody once said, it’s like religion without sin or…

Warren Buffett:

Religion without hell.

Charlie Munger:

… religion without hell.

I think when it gets this bad, and the lack of adequate control mechanisms throughout the system, I mean, Andersen plainly didn’t have a good total system of control.

And I think that it may be that capitalism should just accept this kind of unfairness in all these individual cases and let the firms go down.

Warren Buffett:

Well, let’s say you and I did something really terrible, Charlie, at Berkshire. How do you feel about the 130,000 people then? I mean, should they…

Charlie Munger:

You’d feel terrible about them, and there’s no question about it.

And… but I’ll tell you something, they wouldn’t go down. The way we’re organized, they wouldn’t go down.

Warren, there’s nothing you can do that is going to destroy the value of the subsidiaries… and the careers within the subsidiaries.

You can blow your own reputation, you can blow the reputation at the holding company level, but you can’t destroy their livelihood.

I… that is a good…

Warren Buffett:

Well, we can mess up…

Charlie Munger:

… way to be organized.

Warren Buffett:

We can mess up their lives though, I mean, if they lost their funding. Or yeah, I mean, I agree with you about their…

Charlie Munger:

Not very much.

Warren Buffett:

… viability, but you know…

Charlie Munger:

Not very… Andersen was particularly vulnerable, being a professional partnership.

But maybe you should be extraordinarily careful if you’re a professional partnership, with what clients you take on and how far you go for them.

The law firms that I admire most have fairly strict cultures of risk control. I think it’s crazy, in the kind of world we inhabit, to operate in any other way.

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