1. Economic reality, not accounting

1. Economic reality, not accounting reality. Financial statements prepared by
accountants conformed to rules that might not adequately represent the economic
reality of a business. Buffett wrote:
Because of the limitations of conventional accounting, consolidated reported earnings may re-
veal relatively little about our true economic performance. Charlie [Munger, Bufi'ett‘s
partner] and I, both as owners and managers, virtually ignore such consolidated ntnnbers. . . .
Accounting consequences do not influence our operating or capital-allocation process?
Accounting reality was conservative, backward-looking, and governed by gener-
ally accepted accounting principles (GAAP). Investment decisions, on the other
hand, should be based on the economic reality of a business. in economic reality,
intangible assets such as patents, trademarks, special managerial expertise, and
reputation might be very valuable, yet under GAAP, they would be carried at little
or no value. GAAP measured results in terms of net profit; in economic reality,
the results of a business were its flows ofcash.
A key feature to Buffett’s approach defined economic reality at the level of
the business itself, not the market, the economy, or the security—-he was afundw
mental analyst of the business. His analysis sought to judge the simplicity of the
business, the consistency of its operating history, the attractiveness of its long-
terrn prospects, the quality of management, and the firnfs capacity to create value.