Buffett's 1988 letter on accounting tricks and CEO missteps

If you think accounting tells the whole story of a business, you are in for a surprise. And if you assume senior management is always accountable for their decisions, think again. In his 1988 letter to Berkshire Hathaway shareholders, Warren Buffett peels back the curtain on some uncomfortable truths, the kind that most CEOs would rather keep hidden.

This story, a part of our series on Buffett's letters, lays out his insights on seeing through corporate facades, questioning accepted wisdom, and staying grounded in fundamental business principles. Buffett digs into the limitations of accounting standards, the unspoken immunity of senior executives, and the real cornerstones of a great retail business. He even shares his cautious approach to risk arbitrage — a strategy where most people overestimate their odds of success. Let's delve into his lessons:

Numbers that lie

When it comes to accounting, Buffett's stance is clear: don't take GAAP at face value. Generally Accepted Accounting Principles (GAAP) are supposed to bring clarity, but more often than not, they fall short. The problem is that while GAAP numbers give the appearance of precision, they don't always reflect economic reality. And worse, sometimes, they are deliberately manipulated.

Imagine you are a manager reporting to your boss. Would you just throw some basic numbers at him and hope he gets the picture? Of course not. You would explain the context, nuances, and what the numbers actually mean. Yet many CEOs fail to do this and, instead, hide behind GAAP to avoid giving a fuller picture.

The reality is that not all earnings are created equal. Sometimes, managements even use creative interpretations of GAAP to show a smoother trend than reality warrants. They might take a 'big bath' —a tactic by which poor income is made to look even worse to enhance future performance artificially—in a single quarter to clean up their books or stretch earnings (by possibly recognising revenue prematurely) to meet expectations.

And it gets worse: unscrupulous managers know that investors tend to take reported earnings at face value, so they exploit that gullibility by making numbers dance to their tune. In Buffett's world, accounting is a starting point, not the finish line. It's a rough draft, not a final verdict. Always dig deeper.

What makes a good retail business?

According to Buffett, the secret to a great retail business is surprisingly simple: sell cheap and tell the truth. It's not about hype or cutting corners but about being relentless with basics. Buffett has always admired businesses that get these fundamentals right, and there is no better example than Nebraska Furniture Mart (NFM), run by the legendary Rose Blumkin or "Mrs B" as she's affectionately known.

When Buffett bought NFM, he was not just buying a furniture store. He was investing in Mrs B's uncompromising philosophy of retailing. Mrs B believed in offering the lowest prices and never misleading her customers. Her razor-sharp buying skills, relentless focus on cost efficiency, and dedication to serving customers made NFM an unstoppable force.

Buffett lays out six cornerstones that keep retail businesses thriving, and they all reflect Mrs B's ethos:

• Sell cheap and tell the truth: Mrs B didn't believe in markups just to offer fake discounts. Prices were low from the start and customers knew they were getting a fair deal.
  
• Huge selection in a single store: Customers should feel like they are walking into a treasure trove. NFM's sprawling space and endless variety made it the ultimate destination for bargain hunters.
  
• Daily attention to detail by top management: If the boss doesn't care, why would anyone else? Mrs B was famously hands-on, working on the floor well into her 90s. She knew every inch of her store and every detail of her business.
  
• Rapid turnover: Stale stock is dead stock. Move it fast or lose out. NFM kept moving inventory fast by pricing items with the intention to sell.
  
• Shrewd buying: Mrs B was a master at negotiating deals with suppliers, ensuring she got the best prices and passed the savings on to customers.
  
• Incredibly low expenses: Efficiency was key to keeping prices low. Mrs B's thrift and cost-consciousness meant no unnecessary frills or waste.

Buffett didn't just admire Mrs B's business acumen, he revered it. Her relentless focus on value, honesty, and efficiency made NFM a retail juggernaut and a prime example of how keeping things simple and sticking to core principles can build an enduring retail empire.

Assessing combined ratio the right way

The insurance business is all about the combined ratio—the holy grail of measuring profitability. This ratio compares total insurance costs (claims plus expenses) to premium revenue. A ratio below 100 means underwriting profit, while above 100 means a loss.

But here's the kicker: even a ratio of 107-111 can be acceptable if the insurer earns enough investment income from the premiums it holds (the float) to offset the underwriting loss.

The trick is to find the sweet spot between managing risk and maximising float investment. That's why the combined ratio is just part of the story. Successful insurers, like Buffett's companies, don't just aim for underwriting profit; they know how to put their float to work, earning investment income while keeping claims under control.

When accountability goes missing

In the world of corporate hierarchy, it's easier to fire an underperforming secretary than a clueless CEO. Strange, right? But it's true. CEOs, once settled in their roles, tend to stick around despite mediocrity, partly because no one wants to rock the boat.

If a typist can't hit 80 words per minute, they are out. If a salesperson can't meet targets, they are gone. But CEOs? They shoot the arrow and draw the bullseye around it, declaring victory no matter how badly they miss the mark.

The problem is that Boards of Directors don't hold themselves accountable. The board might hire a poor CEO and stick with them for years simply because it doesn't want to admit making a mistake. And when a company gets acquired, outgoing board members often walk away with cushy benefits.

The lesson? Don't blindly trust that a company's top brass is doing a good job just because they are still in power. Real leadership means being accountable, not just comfortable.

Risk arbitrage: Betting smart on uncertain outcomes

Risk arbitrage sounds fancy, but it's simple: you bet on the success of a corporate event like a merger or buyout. You are not speculating whether a stock will go up or down, you are betting on whether a deal gets done.

Buffett approaches risk arbitrage with caution. He doesn't gamble on rumours or speculative whispers. He waits until an event is formally announced before deciding whether to invest. It's a calculated move, which entails weighing probabilities, evaluating risks, and managing uncertainty.

He asks four key questions before jumping in:

• How likely is it that the promised event will happen?
  
• How long will your money be tied up?
  
• What chance is there of a better offer?
  
• What happens if the event falls apart?

Arbitrage is not for the faint of heart. You are essentially taking a calculated gamble but with Buffett's method, it's more chess than roulette. It's about thinking through every possible scenario and never getting swept up by the hype.

Final thoughts: Common sense over complexity

What stands out in Buffett's 1988 letter is his focus on cutting through the nonsense and sticking to fundamentals. Whether it's accounting trickery, retail basics, insurance metrics, corporate governance, or risk arbitrage, Buffett's advice is timeless: don't complicate things. Instead of chasing trends or falling for slick presentations, he reminds us to look at the hard facts and ask the right questions. In investing, as in life, the simplest explanation is often the best.

Also read: 6 insights from Buffett's 1987 letter you shouldn't miss

This article was originally published on April 02, 2025.