Berkshire Hathaway 2002 Annual Meeting Audience Question # 7

How to detect accounting fraud

Warren Buffett:

Area 7.

Audience Member:

Good morning, Mr. Buffett and Mr. Munger. My name is Andrew Sole, and I’m a shareholder from New York City.
I have two questions. The first one, I’d like to direct to Mr. Munger.

Pertaining to cash flow analysis, given the practices of numerous corporations of deliberately fabricating cash flow numbers, which occurred in some of the telcos, where they characterized like-kind exchanges as product sales.

How do you ferret out this type of fraud? What do you recommend a shareholder, an individual investor, to do, short of obtaining a degree in forensic accounting to uncover this type of fraud?

And the second question is, on a lighter note, what books would either of you gentlemen recommend to shareholders that you read this year that you liked?

Charlie Munger:

Yeah. I think you’re asking for a lot if you want some simple way of not being taken in by the frauds of the world.

If you stop to think about it, enormously talented people deliberately go into fraud, drift gradually into it because the culture carries them there, and the frauds get very sophisticated and they’re very slickly done.

I think it’s part of the business of getting wisdom in life that you avoid getting taken by the frauds.

And so I think you’re asking a very good question, but I don’t think there is any short answer.

I think there are whole fields that you can just quit playing because it looks like there’s too much fraud in it.

And I think we do a lot of that, don’t we, Warren?

Warren Buffett:

Yeah. How many times have we been defrauded in the last 20 years?

Charlie Munger:

Well, damn little that we can… it’s amazing how little.

Warren Buffett:

Yep.

Charlie Munger:

And I’ve always said that the guy who takes us is going to have a modest little office and a modest demeanor and…

Warren Buffett:

He’ll carry around Ben Franklin’s autobiography, I can…

Charlie Munger:

The kind of people who defraud us are not going to be the kind of people who are defrauding everybody else.

Warren Buffett:

Yeah. I mean, it’s a very good question. It’s tough to answer.

But I will tell you that we haven’t, and we won’t get defrauded often. Now, that may mean we pass up a whole lot of other opportunities, too.

But, for example, you raised the question about cash flow. I would say the number of times we’re going to buy into a company, whether it’s through stocks or through the entire company, where people are talking about EBITDA, is going to be about zero.

I mean, we start out with… if somebody’s talking about EBITDA, you know… if we take all the people in the world that talk about EBITDA and all the people in the world who haven’t talked about EBITDA, there are more frauds in the first group, percentage-wise, by a substantial margin. Very substantial. I mean, it is, you know, it’s just a start.

Now, that isn’t… you know, that… it’s very interesting to me. If you look at some enormously successful companies, Walmart, General Electric, Microsoft, I don’t think that term has ever appeared in their annual reports.

I mean, they just… so when people start talking about that sort of thing, either they’re trying to con you in some way, or they’ve conned themselves, to a great degree. I mean…

Charlie Munger:

Or both.

Warren Buffett:

Yeah. Well, that often happens. I mean, if you set out to con somebody, after a while you con yourself, which is why some of the people in the internet stocks, you know, stayed with them.

It’s… if somebody is… if they think you’re focusing on EBITDA, they may arrange things so that that number looks bigger than it really is.

It’s bigger than it really is, anyway. I mean, the implication of that number is it has great meaning.

You take telecoms, they’re spending every dime that comes in, I mean, in many cases.

There isn’t… it isn’t cash flow. I mean, the cash is flowing out. But it… you know, you can look at the statement and there’s billions of dollars, supposedly, in depreciation and so on. But there… you know, interest is an expense.

Actually, taxes are going to be an expense. Anybody that tells us that making a lot of money before taxes, in terms of EBITDA, is meaningful… you know, you get depreciation by laying out money ahead of time. It’s the worst kind of expense.

We look for float, where we get the money and then pay out later on. But depreciation occurs because you buy an asset first and then you get the deduction later on. It’s the worst kind of expense there is.

And you start paying taxes when you actually make money, and when the depreciation runs out at some point.

So these… it just amazes me how widespread the usage of EBITDA has become, and I would say there have been people who have tried to dress up financial statements in a way to appeal to people who are impressed by such a number.

Charlie and I have found, actually, that… at least to us… many of the crooks look like crooks.

Now, we have spotted… we haven’t shorted them… but we have spotted a lot of frauds over the years in public companies. And years before, you know, that the roof fell in.

And they usually are people that tell you things that are too good to be true, for one thing.

I mean, they, you know, they tell you very mediocre businesses are wonderful businesses for one reason or another. Or they… they just have a smell about them, you know, in effect.

Wouldn’t you say that’s true, Charlie?

Charlie Munger:

Well, sometimes it’s amazingly obvious. Maxwell, of England, his nickname was the “bouncing Czech.”

And three weeks before he went under, Salomon…

Warren Buffett:

(This part of the audio is inaudible)

Charlie Munger:

… Salomon was aggressively seeking more business from him, with both Warren and I on the board. It shows how much influence outside directors often have.

Warren Buffett:

Yeah. Wall Street is…

Charlie Munger:

Imagine extending credit to a guy whose nickname is the “bouncing Czech.” You’d think it… if you wrote it as satire, people would say it was too extreme to be funny.

Warren Buffett:

We have read… I mean, Charlie and I have… it’s a hobby keeping track of the Maxwells of the world, and the…

They get… there’s a syndrome. I mean, they give off a lot of the same messages.

I mean, Maxwell was a classic case, but there… time after time… Wall Street has no filter against them. Wall Street loves them, as long as, you know, as long as they’re pushing out securities and the commissions are there.

Charlie and I could not have stopped Salomon from making a deal with Maxwell, you know, right to the last 30 seconds before he sunk, you know, under the ocean.

Charlie Munger:

We didn’t stop First Normandy with Lou Simpson and Warren Buffett and Charlie Munger on the board.

Warren Buffett:

Yeah. First Normandy was a case of some guy that manufactured a record out in California that he claimed was from owning a bunch of securities, including Berkshire Hathaway.

And, he was going to go public and Salomon was courting him. And this… the record was, you know, it was total baloney.

And I think they actually went public for a day or so and then the SEC pulled it back.

Charlie Munger:

Absolutely. They had the offering and then they canceled it before the money changed hands.

But it was a very embarrassing episode. And we remonstrated against this obvious insanity, they told us the underwriting committee had approved it.

Warren Buffett:

I don’t think they changed underwriting committees, either.

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