Berkshire Hathaway 2013 Annual Meeting Audience Question # 62

How Warren and Charlie was able to detect frauds

Warren Buffett:

OK. Station 3.

Audience Member:

Hello. My name is Stuart Kaye and I work in Stamford, Connecticut.

Earlier in the meeting, you said when reading over financial statements, you identified companies you were virtually certain were frauds.

What was it in those financial statements that you saw that made you be so certain they were frauds?

Warren Buffett:

Well, it varies just enormously over the years, but there are… we can’t identify 100 percent of the frauds, or 90 percent, or 80 percent, but there are certain ones that jump out to you, just… people give themselves away a lot, too.

I mean, in poker they talk about tells. And Charlie and I have bought a lot of businesses, and it’s very important when we buy those businesses that we assess the individuals that we’re buying from with some degree of accuracy.

Because, you know, they hand us the stock certificate and we hand them a lot of money, and then we count on them to run the business with as much enthusiasm after they have the money as they did before.

And so we are assessing people. And we don’t think we can assess everyone accurately. We just have to be right about the ones where we make an affirmative decision.

And those decisions have not always been perfect, but they’ve been pretty good. And I would say they’ve probably gotten a little bit better, even, as the years have passed.

Similarly, in looking at financial statements… for example, in the insurance field, we’ve seen some frauds, and they’re… you can see things being done with loss reserves occasionally. We saw it back in… I won’t name any names. Unlike Charlie, I don’t… we’ll call them Company As and Bs instead of naming names.

But you would see companies that, when they were offering stock to the public, you know, the year or two before that, the reserves would be down very suspiciously, and… you know, then… or even when they were selling them to other insurance companies, if they were buying in stock they might be building the reserves.

But there’s a million different ways. And I don’t claim I know all the ways, obviously, but I have seen enough situations over the years, and I’ve seen how promoters act. And you can spot certain people who you know are, one way or another, playing games with the numbers. They give themselves away.

But I can’t give you a checklist of 40 items or something of the sort that you look for in the balance sheet or the income account or the footnotes.

Charlie, can you help?

Charlie Munger:

Sometimes it’s pretty obvious. I once was introduced by Warren, of all people, by accident, to a man who wanted to sell us a fire insurance company. One of the first things he said, with a thick accent, from Eastern Europe, I think…

Warren Buffett:

Don’t name countries.

Charlie Munger:

And I don’t remember the country.

Warren Buffett:

Good.

Charlie Munger:

But what he told me was… he says, “It’s like taking candy from babies,” he said.

“We only write fire insurance on concrete structures that are underwater.” And I figured out instantly that it was probably fraudulent.

Warren Buffett:

The guy’s a crook.

Charlie Munger:

I’m a very acute man.

Warren Buffett:

Yeah, the guy’s a crook.

Well, you actually… you had some experience… you know, he was a lawyer in the movie industry.

Charlie Munger:

Oh, my God.

Warren Buffett:

Yeah. The… when you get into accounting for… well, movies are a good thing, in terms of how fast you write off properties, and anything where you’ve got construction in progress or progress payment-type things… there’s so many ways you can cheat in accounting.

And financial institutions are particularly, probably, prone to it. And there’s been plenty of it in insurance.

Charlie Munger:

A lot of it, they’re not being deliberately fraudulent, because they’re deluded. In other words, they believe what they’re saying.

Warren Buffett:

Yeah. People like to hire them as salesmen.

If you’ve got doubts, forget it. There’s probably some reason you…

It’s interesting. The accounting… they worked harder and harder and harder at coming up with disclosures in accounting. And I’m not sure I find present financial statements more useful or, in some cases, as useful as I found them 30 or 40 years ago.

Charlie?

Charlie Munger:

Well, I think the financial statements of big banks are way harder to understand now than they used to be. They just do so many different things, and they’ve got so many footnotes, and there’s so much gobbledygook, that it doesn’t… they’re not my grandfather’s banks.

Warren Buffett:

Well, we couldn’t understand them when we owned them.

Charlie Munger:

Yeah.

Warren Buffett:

I mean, we bought a company that… Gen Re… where they had 23,000 derivative contracts.

And Charlie and I could’ve spent 24 hours a day, and had the help of 10 or 20 math Ph.Ds. and we still wouldn’t have known what was going on.

It cost us about $400 million to find out, but… and that was in a benign market. But nobody can.

Charlie Munger:

And the accountants had certified the balance sheet.

Warren Buffett:

Sure.

Charlie Munger:

It’s a new kind of asset I invented a name for. I said, “Good until reached for.”

Warren Buffett:

Yeah. Well, and you would… you would actually… the same auditing firm would be auditing two different companies that are on the opposite side of a derivative transaction and attesting to different values to the same contract.

And Charlie found one mistake at Salomon on a derivative contract. What was it, 20 million?

Charlie Munger: No. It was a big contract, and both sides reported a large profit, blessed by their accountants, on the same contract…

Warren Buffett:

Kind of like us and Swiss Re.

Charlie Munger:

… just for breaking it.

Once people get in a competitive frenzy, things just go out of control.

Warren Buffett:

I became the interim chairman of… interim CEO… of Salomon in 1991, and, fortunately, I testified to both the House and Senate committee before I found this out.

And, generally speaking, incidentally, Salomon wanted to have conservative accounting. I think that would be a fair statement. And in many cases did.

But they did come in to me one day and they said, “Warren, you probably should know that we have this item”… and I think it was around 180 million or something like that… with a capital base of 4 billion, maybe… but 180 million.

And they said, this is a plug number, and we’ve been plugging it ever since Phibro merged with Salomon in 19… I guess, ’81.

For ten years, this number moved around every day. And as I remember, Phibro or some… one of them was on a trade date system, and that was on a settlement date system.

And in ten years, with Arthur Andersen as their accountant, paying a lot of money in auditing fees, they just never figured out how the hell to get the thing to balance, so they just stuck a number in every day.

And they literally plugged it for ten years, and I couldn’t figure out how to unplug it myself. I mean, it was… you almost had to start over. Didn’t they do that one time out there?

Charlie Munger:

We did that, Warren.

Warren Buffett:

Right.

Charlie Munger:

We had a discrepancy when we changed accounting systems in our savings and loan, and none of the accountants could fix it. So we just let it run out.

Warren Buffett:

Yeah, we let the account…

Charlie Munger:

We just let the account run out, and then…

Warren Buffett:

Figured we’d start over again.

Charlie Munger:

We started over, right.

Warren Buffett:

Accounting is not quite the science that people might want you to…

Charlie Munger:

In accounting, you can do things like they do in Italy when they have trouble with the mail. You know, it piles up and irritates the postal employees. They just throw away a few carloads… everything flows smoothly thereafter.

Warren Buffett:

You’re naming names again, folks.

That happened in some unnamed international country.

Charlie Munger:

Yeah, Italy.

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