Changes in GAAP accounting rules and Investment Trusts

[Cornytiv34]

I am no accountant but wonder whether we should be worried by the simple comments in Warren Buffett’s 2017 letter to stockholders in Berkshire Hathaway. He does tell things as they are!

http://www.berkshirehathaway.com/letters/2017ltr.pdf

“… a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire’s net income figures and very often mislead commentators and investors”.

“… the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line”. (My emphasis)

Referring to some very large holdings they have in other companies he continues

“Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance.”

I am looking at adding some Investment Trusts and started thinking of those in the UK who have holdings in lots of other companies. If their unrealised capital gains are to be included as “net income, and these can vary dramatically in line with market movement, this could cause chaos with large swings in apparent income which might be reversed next year.

Must we expect substantial yearly variation? Will there be any value in comparisons looking at years either side of the change? Where does that leave performance fees?

I did a search to see if the USA rules apply to companies in the UK and found this

http://www.scott-moncrieff.com/assets/publications/Key_differences_between_UK_GAAP_FRS_102.pdf

Detailed under “Listed Investments’ there is this (apparently in force since 2015)

“Under current UK GAAP, investments held in listed shares may be measured at cost or fair value. FRS 102 requires the use of fair value for investments in shares which are publicly traded or where the fair value can be measured reliably. Movements in fair value are recognised in the income statement.” (My emphasis).

I feel I am getting out of my depth a bit here.

Has anyone researched this or got a lifebelt?
TIA

Mike

[forrado]

I feel I am getting out of my depth a bit here.

I think you are. I prefer to adopt a wait and see approach.

[Alaric]

I think you are. I prefer to adopt a wait and see approach.

GAAP stands for "Generally Accepted Accounting Principles". They aren't necessarily the same in the UK and US.

[forrado]

GAAP stands for "Generally Accepted Accounting Principles". They aren't necessarily the same in the UK and US.

Exactly, so what's the point you're trying to make other than the differences between the US and UK, which should be obvious given the wording of the OP. My suggestion given the circumstances is to do nothing other than sit and wait to see what happens.

[Alaric]

Exactly, so what's the point you're trying to make other than the differences between the US and UK

That no notice is taken of Warren Buffett.

[Cornytiv34]

I said I was no accountant but the links I detailed seem to me to indicate that these rules &/or UK versions are already in force in both countries and will affect the next annual accounts published by companies.

This would indicate that the income figures will be more highly variable year to year depending on the state of the stock markets and might make comparisons more complex.

Investment Trusts would seem to be particularly exposed and a rise in income and profit one year might be reversed should stockmarkets decline. The swing will be greater. So a performance fee that had been paid might have actually been unjustified as it was not "real" profit. Similarly a true profit (on the old basis) might result in a reduced profit on the new one so no performance fee actually earned. I have noticed a number of ITs that have dropped performance fees, maybe this is the reason. Maybe performance fees should be over a nuimber of years not one.

Turning now to ordinary companies think about those performance bonuses to executives!

When booming markets fall, say 2008/9 there will be huge consequent reductions in profit.

Still trying to understand.

Mike

[Alaric]

Investment Trusts would seem to be particularly exposed and a rise in income and profit one year might be reversed should stockmarkets decline.

UK Investment Trusts are obliged by the laws regarding their taxation to draw up a set of accounts where they separate their income gains from their capital gains. That's because they are required to distribute at least 85% of their income. By the nature of their structure, income in an investment trust arises from the dividends they receive from the Companies in which they invest. I don't believe those rules have changed. For that matter I would have expected that their accounts already mark to market the value of their holdings. They wouldn't be able to publish regular net asset values otherwise.

[Dod101]

Emerging from self proclaimed purdah for a minute, take a look at any IT's accounts. They already show changes in the value of investments, (realised and otherwise) in their income statement which usually has two columns, Revenue and Capital, and these are totalled in the Consolidated Statement of Comprehensive Income and together give the total income for the period. This of course varies as capital values vary up and down. Since they are now allowed to distribute realised capital gains if they want, I do not think it is very significant and nor do I think the changes that WB writes of should affect us. I do not know the situation in the US.

Back to sleep now. I can recommend taking a very detached view of TLF.

Dod

[SalvorHardin]

Investment Trusts would seem to be particularly exposed and a rise in income and profit one year might be reversed should stockmarkets decline. The swing will be greater. So a performance fee that had been paid might have actually been unjustified as it was not "real" profit. Similarly a true profit (on the old basis) might result in a reduced profit on the new one so no performance fee actually earned. I have noticed a number of ITs that have dropped performance fees, maybe this is the reason. Maybe performance fees should be over a nuimber of years not one.

I don't consider this to be an issue. Fees and performance fees for investment trusts are generally based on net asset value, not income. Investors focus upon NAV and dividends when it comes to investment trusts, not profits as measured in the accounts. The only investment trustn I hold where it's worth paying attention to the profit & loss account is Law Debenture because of its wholly owned fiduciary services business.

The issue with Berkshire Hathaway is that Americans are not used to seeing gains and losses in investments being put through the profit and loss account. In Berkshire's case the media is generally clueless (loads of people think that it is a mutual fund) and cannot distinguish between operating profits and investment profits. As Buffett has said, Berkshire can manipulate its reported earnings to an extraordinary degree by selling investments to realise capital gains.

We see something similar with UK property companies. Changes in estimated NAV are reported in the profit & loss account. When a company's properties are substantially revalued upwards this produces a large earnings per share, hence a low P/E ratio and we get clueless articles which focus on the P/E and ignore that this is not an operating profit but more like a one-off gain.

[Dod101]

In the case of UK companies blame it on IFRS accounting not GAAP.

Dod

[Cornytiv34]

Taking Dod's advice I have been looking at a number of IT accounts, some with year ends in 2017 and some in 2018. I see what he means. Thank you Dod.

There seem to be a variety of ways that the detail is disclosed, some just show it as "gains" but the account notes detail that it is net, while others show it all up front separately.

There seem to be a lot of accounting changes still in the pipeline, who would want to be an accountant? Twenty or thirty years ago I could fully understand our insurance syndicate accounts but having recently delved into sets of current syndicate accounts I find myself thinking "Does all this additional information make me any wiser as to the risks" I doubt it does!

I will now follow all of your advice and see what happens. I will however still listen to WB for he has been ahead of others for donkey's years. At least he made me think.

Mike