Savvy investors look forward to the last month of winter every year, because it's when Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) CEO Warren Buffett issues his annual letter to Berkshire's shareholders. The missive comes alongside the insurance giant's full-year financial results, and investors inevitably look at how Berkshire has done as a gauge for the health of the overall market.

This year, you'll find plenty of headlines trumpeting the profit that Berkshire made in 2018 and how much smaller it was than in past years. Yet much of that change comes from a single factor, and Buffett himself not only predicted that something like this would occur but also railed against the things that caused it. In the end, a simple accounting change has rendered Berkshire's results almost meaningless, and it's important to look at alternative measures of success to get an accurate picture of how Buffett's company is actually performing.

Warren Buffett, with several people behind him.

Image source: The Motley Fool.

The big change

If you look solely at Berkshire Hathaway's bottom line, it'd seem to explain the consternation among some of those following the company. Berkshire reported net income of $4.02 billion for 2018, and that number was down a whopping 91% from 2017's figure, largely because of massive losses for the fourth quarter.

Yet if you look at the fundamental operating performance of Berkshire's businesses, you'd get a much different picture. Operating earnings came in at $24.78 billion during 2018 -- including a huge 71% increase in the fourth quarter.

Buffett explained the disparity between the two figures. To calculate reported net income, Berkshire had to:

  • Take its $24.78 billion in operating earnings.
  • Reduce it by about $3 billion to reflect goodwill impairments, largely related to Berkshire's stake in Kraft Heinz (NASDAQ:KHC).
  • Add back in $2.8 billion in realized capital gains from the sale of various investment securities.
  • Take out $20.6 billion in losses representing the reduced amount of unrealized capital gains in Berkshire's investment portfolio.

It's that last number that Buffett finds particularly problematic. The Oracle of Omaha called out the new accounting rule that requires Berkshire to mark its investment securities to market each quarter, with market value changes getting reflected in earnings every three months. That takes away the long-term nature of Buffett's investment strategy, forcing Berkshire to include the volatile ups and downs in its investments four times a year -- what the Berkshire CEO termed as "truly wild and capricious swings in our GAAP bottom line."

Buffett was even more outspoken about the accounting change in last year's shareholder letter:

I must first tell you about a new accounting rule ... that in future quarterly and annual reports will severely distort Berkshire's net income figures and very often mislead commentators and investors. ... With the new rule about unrealized gains exacerbating the distortion caused by the existing rules applying to realized gains, we will take pains every quarter to explain the adjustments you need in order to make sense of our numbers. But televised commentary on earnings releases is often instantaneous with their receipt, and newspaper headlines almost always focus on the year-over-year change in GAAP net income. Consequently, media reports sometimes highlight figures that unnecessarily frighten or encourage many readers or viewers.

What investors need to do about the accounting rule

With a year of the rule under Berkshire's belt, Buffett can point to empirical evidence backing his claims. In the first quarter of 2018, Berkshire posted a $1.1 billion GAAP loss in light of the stock market's swoon. The ensuing market bounce helped Berkshire earn profits of $12 billion in the second quarter and $18.5 billion in the third quarter. Then, the crushing blow that stocks took in the fourth quarter led to a $25.4 billion loss.

Buffett sees no end to earnings volatility, but he does have a solution: focus on operating earnings. Those numbers emphasize the strength of the businesses that make up Berkshire Hathaway, and they're less prone to the accounting tricks that are now required in the reported bottom-line numbers. Even though Buffett expects investment activity to have a long-term, meaningful positive impact on Berkshire's overall performance, that'll only show up over periods of many years -- and the quarterly progress of those numbers is meaningless.

For many, headline numbers touting Berkshire's big earnings hit from market movements will be the only takeaways from the insurance giant's report. But by listening to Warren Buffett's warnings about the dubious value of earnings affected by new accounting rules, you'll have a better sense of how Berkshire Hathaway is actually performing.