Non-Controlled Ownership Earnings
When one company owns part of another company, appropriate
accounting procedures pertaining to that ownership interest must
be selected from one of three major categories. The percentage
of voting stock that is owned, in large part, determines which
category of accounting principles should be utilized.
Generally accepted accounting principles require (subject to
exceptions, naturally, as with our former bank subsidiary) full
consolidation of sales, expenses, taxes, and earnings of business
holdings more than 50% owned. Blue Chip Stamps, 60% owned by
Berkshire Hathaway Inc., falls into this category. Therefore,
all Blue Chip income and expense items are included in full in
Berkshire’s Consolidated Statement of Earnings, with the 40%
ownership interest of others in Blue Chip’s net earnings
reflected in the Statement as a deduction for “minority
interest”.
Full inclusion of underlying earnings from another class of
holdings, companies owned 20% to 50% (usually called
“investees”), also normally occurs. Earnings from such companies
- for example, Wesco Financial, controlled by Berkshire but only
48% owned - are included via a one-line entry in the owner’s
Statement of Earnings. Unlike the over-50% category, all items
of revenue and expense are omitted; just the proportional share
of net income is included. Thus, if Corporation A owns one-third
of Corporation B, one-third of B’s earnings, whether or not
distributed by B, will end up in A’s earnings. There are some
modifications, both in this and the over-50% category, for
intercorporate taxes and purchase price adjustments, the
explanation of which we will save for a later day. (We know you
can hardly wait.)
Finally come holdings representing less than 20% ownership
of another corporation’s voting securities. In these cases,
accounting rules dictate that the owning companies include in
their earnings only dividends received from such holdings.
Undistributed earnings are ignored. Thus, should we own 10% of
Corporation X with earnings of $10 million in 1980, we would
report in our earnings (ignoring relatively minor taxes on
intercorporate dividends) either (a) $1 million if X declared the
full $10 million in dividends; (b) $500,000 if X paid out 50%, or
$5 million, in dividends; or (c) zero if X reinvested all
earnings.
We impose this short - and over-simplified - course in
accounting upon you because Berkshire’s concentration of
resources in the insurance field produces a corresponding
concentration of its assets in companies in that third (less than
20% owned) category. Many of these companies pay out relatively
small proportions of their earnings in dividends. This means
that only a small proportion of their current earning power is
recorded in our own current operating earnings. But, while our
reported operating earnings reflect only the dividends received
from such companies, our economic well-being is determined by
their earnings, not their dividends.
Our holdings in this third category of companies have
increased dramatically in recent years as our insurance business
has prospered and as securities markets have presented
particularly attractive opportunities in the common stock area.
The large increase in such holdings, plus the growth of earnings
experienced by those partially-owned companies, has produced an
unusual result; the part of “our” earnings that these companies
retained last year (the part not paid to us in dividends)
exceeded the total reported annual operating earnings of
Berkshire Hathaway. Thus, conventional accounting only allows
less than half of our earnings “iceberg” to appear above the
surface, in plain view. Within the corporate world such a result
is quite rare; in our case it is likely to be recurring.
Our own analysis of earnings reality differs somewhat from
generally accepted accounting principles, particularly when those
principles must be applied in a world of high and uncertain rates
of inflation. (But it’s much easier to criticize than to improve
such accounting rules. The inherent problems are monumental.) We
have owned 100% of businesses whose reported earnings were not
worth close to 100 cents on the dollar to us even though, in an
accounting sense, we totally controlled their disposition. (The
“control” was theoretical. Unless we reinvested all earnings,
massive deterioration in the value of assets already in place
would occur. But those reinvested earnings had no prospect of
earning anything close to a market return on capital.) We have
also owned small fractions of businesses with extraordinary
reinvestment possibilities whose retained earnings had an
economic value to us far in excess of 100 cents on the dollar.
The value to Berkshire Hathaway of retained earnings is not
determined by whether we own 100%, 50%, 20% or 1% of the
businesses in which they reside. Rather, the value of those
retained earnings is determined by the use to which they are put
and the subsequent level of earnings produced by that usage.
This is true whether we determine the usage, or whether managers
we did not hire - but did elect to join - determine that usage.
(It’s the act that counts, not the actors.) And the value is in
no way affected by the inclusion or non-inclusion of those
retained earnings in our own reported operating earnings. If a
tree grows in a forest partially owned by us, but we don’t record
the growth in our financial statements, we still own part of the
tree.
Our view, we warn you, is non-conventional. But we would
rather have earnings for which we did not get accounting credit
put to good use in a 10%-owned company by a management we did not
personally hire, than have earnings for which we did get credit
put into projects of more dubious potential by another management
- even if we are that management.
(We can’t resist pausing here for a short commercial. One
usage of retained earnings we often greet with special enthusiasm
when practiced by companies in which we have an investment
interest is repurchase of their own shares. The reasoning is
simple: if a fine business is selling in the market place for far
less than intrinsic value, what more certain or more profitable
utilization of capital can there be than significant enlargement
of the interests of all owners at that bargain price? The
competitive nature of corporate acquisition activity almost
guarantees the payment of a full - frequently more than full
price when a company buys the entire ownership of another
enterprise. But the auction nature of security markets often
allows finely-run companies the opportunity to purchase portions
of their own businesses at a price under 50% of that needed to
acquire the same earning power through the negotiated acquisition
Warren E. Buffett
February 27, 1981 Chairman of the Board
of another enterprise.)
