Why Accounting Changes Can Distort Real Performance And What Investors Should Really Focus On
By Michael Richards, Value Investor and Builder of MyOmaha.ai
Warren Buffett’s 1979 letter to Berkshire Hathaway shareholders is one of his most under-appreciated, yet highly instructive writings. While later letters get more attention, this one quietly lays out a foundational principle of value investing:
Reported numbers can change — but true business performance does not.
Buffett uses Berkshire’s 1979 results, along with a major shift in accounting policy, to teach investors how to separate cosmetic changes from economic reality. In today’s world of fair-value adjustments, earnings “beats,” and volatile mark-to-market swings, his lesson is more relevant than ever.
A New Accounting Rule Suddenly Made Berkshire Look More Valuable
One of the central points Buffett highlights is a change in how insurance companies must value their equity securities.
Before 1979:
- Insurance companies recorded stocks at cost (what they paid for them), even if the securities had gained enormous value.
After the new rule:
- Stocks had to be reported at market value, meaning their current price — not the historical purchase price.
Buffett writes:
“The result of this new policy is to increase substantially both the 1978 and 1979 year-end net worth.”
In other words, Berkshire’s net worth jumped, not because of better business performance, but because accountants changed the rules.
Why This Matters for Investors
This is Buffett’s subtle warning:
Accounting changes can make numbers look better or worse without any real economic change taking place.
It’s a reminder that value investors must always ask:
“What actually happened in the business — not just on the balance sheet?”
Operating Earnings vs. Reported Net Worth: Buffett’s Preferred Performance Metric
Buffett spends much of the letter explaining that even though the new rules make Berkshire’s net worth look larger, the measure he cares about most has not changed:
Operating earnings vs. beginning net worth
This is similar to return on equity (ROE), but using Berkshire’s internally defined framework.
Buffett writes:
“We will continue to report operating performance measured against beginning net worth, with securities valued at cost.”
Beginning Net Worth tells Buffett:
- How efficiently Berkshire used shareholder capital
- How well management deployed resources during the year
- How much value Berkshire created independent of stock market swings
This is why Buffett says:
“Operating earnings for 1979 amounted to 18.6% of beginning net worth.”
And then modestly calls this:
“Reasonably good.”
Which is funny, because most companies would celebrate an 18.6% return on equity like a Super Bowl victory.
But Buffett’s standard was, and remains, exceptionally high.
Example: How Accounting Can Distort Reality
Imagine two investors:
Investor A
- Buys $10,000 worth of Coca-Cola stock
- It rises to $20,000
- Under old accounting rules, their net worth still shows the stock at $10,000
- Under new rules, it now shows $20,000
- No real change happened, just accounting
Investor B
- Buys a business that grows earnings from $1,000 to $1,500
- Earnings grew 50%
- That’s actual performance
Buffett wants investors to focus on Investor B’s improvement, not Investor A’s accounting adjustment.
An Omaha example of Apple’s (AAPL) Operating Earnings vs Capital Gains:
The comparison of Apple’s operating earnings and capital gains shows that both have grown consistently over the past five years, with operating earnings showing a steady increase from $119.4B in 2022 to a projected $143.7B in 2026. Capital gains have also risen, albeit with some volatility, from $99.8B in 2022 to a projected $133.8B in 2026.
For value investors, the key takeaway is that operating earnings are more reliable and sustainable than capital gains, which depend on market sentiment and price fluctuations. Apple’s strong operating earnings indicate a robust business model with consistent profitability, while capital gains reflect investor expectations and market dynamics.
Buffett’s Core Message: Intrinsic Value Comes From Performance, Not Paper Gains
Buffett emphasizes that:
- Market value increases do not equal superior management
- Mark-to-market accounting can inflate net worth during bull markets
- Operating earnings provide a true measure of long-term compounding ability
If a company’s profits compound at high rates, value grows.
If stock prices simply rise, value may appear to grow — but can vanish overnight.
This is why Buffett calls the 18.6% return on beginning equity “reasonably good” because it reflects actual business activity, not mark-to-market windfalls.
Key Lessons for Modern Value Investors
| Buffett Principle | Meaning |
|---|---|
| Ignore one-time accounting changes | Don’t be misled by sudden increases in net worth caused by shifting accounting rules rather than real performance. |
| Focus on return on beginning equity (ROE) | ROE shows how effectively a company uses shareholder capital to generate profit — Buffett’s preferred metric. |
| Separate economic performance from market performance | Rising stock prices ≠ rising business value; only earnings growth and capital efficiency matter. |
| Seek companies with consistent operating earnings growth | Steady growth in operating earnings is the engine of true intrinsic value. |
| Use accounting as a tool, not a truth | Accounting rules shape reports, but they don’t define reality. Investors must look deeper than reported numbers. |
Conclusion: Why Buffett’s 1979 Letter Still Matters
Buffett’s message is simple but powerful:
Real performance creates real value. Accounting changes do not.
As investors, our job is to distinguish between:
- Paper value and intrinsic value
- Market movement and business movement
- Accounting rules and economic reality
Berkshire’s 1979 results didn’t just tell a story about the company.
They taught investors how to think, how to interpret numbers intelligently, and avoid the traps of cosmetic financial reporting.
And that’s why Buffett’s letters remain some of the most important investment education materials ever written.
If you believe investing is about owning great businesses, not chasing hype, then we built something for you.
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