Warren Buffet invoked the substance-over-form concept to justify accounting for the GEICO and General Foods transactions as dividends distributions rather than sales of stock. Do you agree with Buffet that the substance of each of the proportionate redemptions was a dividend and not a sale of stock?
In deciding how to account for an unusual or unique transaction for financial reporting purposes, should one consider the tax treatment applied to the transaction?
Did Peat Marwick have a right to change its position on the proper accounting treatment for the stock redemptions? What factor or factors may have been responsible for Peat Marwick’s decision to change its position regarding these transactions?
In 1983, GEICO announced plans to purchase several million shares of its outstanding common stock for $60 per share. Among GEICO’s largest stockholders was Berkshire Hathaway, Inc., an investment company. Executives of the two companies decided that Berkshire would tender approximately 350,000 if its GEICO shares in the stock buyback plan, which would allow Berkshire to treat the transaction as a proportionate redemption. In a proportionate redemption, the percentage equity interest of on company in a second company is maintained at the level that existed immediately before the transaction. For federal taxation purposes, the proceeds received by the investor company in a proportionate redemption are taxed as dividends by applying the effective intercorporate dividend tax rate. In 1983, that tax rate was approximately 6.9 percent.
Berkshire also chose to treat the proceeds from the redemption of the GEICO stock as dividend income in its 1983 financial statements. Berkshire’s audit firm, Marwick, Mitchell & Company, approved that accounting treatment. In 1984, another company in which Berkshire had a significant equity interest, General Foods, announced a stock buyback plan. Again, Berkshire structured the sale of stock to General Foods so that the transaction qualified as a proportionate redemption. Berkshire also opted to report the proceeds received from General Foods as dividend income in its 1984 financial statements.
In late 1984, representatives of Peat Marwick told Berkshire executives that the proceeds of the General Foods stock redemption should not be considered dividend income for financial reporting purposes. Instead, Peat Marwick maintained that the transaction should be recorded as a sale of stock with the difference between the selling price and cost reported as a capital gain on Berkshire’s income statement. This treatment of the transaction was less favorable for financial reporting purposes that the option preferred by Berkshire since it did not allow the total proceeds received from General Foods to be reported as revenue. Peat Marwick’s recommendation annoyed Berkshire’s executives. The accounting firm’s next decision irritated those executives even more. Marwick insisted that Berkshire restate its 1983 financial statements to reflect the GECICO stock redemption as a sale of stock rather than as a dividend distribution.
Warren Buffet, Berkshire’s CEO, discussed the GEICO and General Foods stock redemption at length in his company’s 1984 annual report. Buffet disputed Peat Marwick’s contention that the transactions should be treated as sales of stock and not as dividend distributions. He then explained why he eventually agreed to accept the audit firm’s position by saying “…to avoid a qualified auditor’s opinion, we have adopted Peat Marwick’s 1984 view and restated 1983 accordingly.” Buffet as confirmed that Marwick’s decision had no effect on Berkshire’s business with GEICO or General Foods, their cash, taxes, and market value and tax basis of our holdings all remain the same. However, treating the General Foods transaction as a sale of stock reduced Berkshire’s 1984 net income by 8 percent. Applying that accounting treatment to the 1983 GEICO transaction reduced Berkshire’s previously reported net income for 1983 by 1 percent.
The Wall Street Journal reported the disagreement between Berkshire executives and Peat Marwick that evolved from the proportionate redemption transactions. When asked to comment on Buffet’s criticism of Peat Marwick in his company’s 1984 annual report, a Peat Marwick partner simply noted, “It’s the client’s prerogative to disagree. Our report speaks for itself.” Another prerogative of an audit client is to change auditors. In 1985, Berkshire retained Touche Ross & Company to audit its financial statements. As required by the Securities and Exchange Commission, Berkshire filed an 8-K statement with that federal agency to disclose the change in auditors. In that statement, Berkshire reported it was “dissatisfied” with Peat Marwick’s inconsistency regarding the proper accounting treatment for stock redemptions.
The substance over form accounting concept means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity. Preparers of the financial statements should use their judgment when employing the substance over form concept, which helps to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. In some instances the legal aspects of transactions and events may have to be disregarded in order to provide more useful and relevant information to the users of financial statements. The concept of substance over form is imperative to the representation and reliability of information contained in the financial statements.
A proportionate stock redemption is a transaction in which ownership interests are redeemed proportionate to the total shares outstanding. As a result, each shareholder owns the same percentage of the company after the redemption as before. Buffet was justified in recording each of the proportionate redemptions as a dividend and not as a sale of stock, because although GEICO and General Foods repurchased their stocks, Berkshire still maintained the same percentage of equity interest as it did before the transaction. Also, Buffet followed federal taxation purposes, which stated that the proceeds received by the investor company in a proportionate redemption are taxed as dividends; therefore the transaction was recorded as dividends not sale of stock.
By placing the responsibility on the preparers of the financial statements to actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the substance of the situation.
According to the PCAOB’s AU Section 316.66, “…the auditor may become aware of significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual given the auditor’s understanding of the entity and its environment. The auditor should gain an understanding of the business rationale for such transactions and whether that rational (or the lack thereof) suggests that the transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.” (PCAOB, 2002) AU Section 314.21 states that the auditors’ understanding of the entity and its environment consists of an understanding of several aspects, including industry, regulatory, and other external factors (PCAOB, 2002).
Taxation would be an example of the regulatory aspect; therefore, one should consider the tax treatment when deciding how to account for unusual transactions. In the case of Berkshire Hathaway, Inc., since the IRS considers proportionate redemptions to be equivalent to dividend distributions, and the proceeds from the repurchasing of stock are taxed as dividends; to ensure consistency, the transaction should have been recorded as dividends.
The PCAOB states that the auditor should recognize an adjustment to correct a misstatement in previously issued financial statements to ensure the company’s financial statements remain consistent in the auditor’s report, especially if the matter has a material effect on the financial statements (PCAOB, AU 508.16, 2004). Since Peat Marwick was the auditing firm, it had the right to change its position on the proper accounting treatment for the stock redemptions, and since Berkshire wanted to preserve the unqualified opinion, the company complied with the auditors.
In order for Peat Marwick to maintain its reputation as professional auditors and providing quality audits, the firm decided it was in their best interest to record the GEICO and General Foods transactions as sales of stock by Berkshire, rather than as the receipt of dividends. Under this accounting approach, a portion of the cost of the Berkshire’s investment in the stock of each company would be charged against the redemption payment and any gain would be reported as a capital gain, not as dividend income. This is an accounting approach only, having no bearing on taxes; although, Peat Marwick agreed that the transactions were dividends for IRS purposes. Since the change in accounting treatment reduced Berkshire’s net income by 1% and 8% in 1983 and 1984, respectively, Peat Marwick might have deemed this as material and thought it was necessary to correct the way the transactions were recorded.
According to the PCAOB, in evaluating consistency of financial statements, the auditor should evaluate a change in accounting principle to determine whether: the newly adopted accounting principle under GAAP, the method of accounting for the effect of the change is in conformity with GAAP, the disclosures related to the accounting change are adequate, and the company has justified that the alternative accounting principle is preferable (PCAOB, AU 508.17A, 2004). Any of these factors may have been responsible for Peat Marwick’s decision to change its position regarding these transactions.
Although recording the stock redemption as a dividend complied with taxation rules under the IRS, it may not have been in accordance with GAAP. Berkshire may not have justified that recording the stock redemption as a dividend was preferable. Although it was preferable to Berkshire, because total proceeds from General Foods would have been reported as revenue, increasing Berkshire’s net income; it may not have been preferable to all the users of Berkshire’s financial statements, because net income would have been over stated.
Lastly, in Berkshire’s letter to its shareholders, it stated that the GEICO and General Foods transactions were “virtually” identical, except that General Foods repurchased its stock over a period of time in the open market, whereas GEICO had made a “one-shot” tender offer. In the General Foods case we sold to the company, on each day that it repurchased shares, but left Berkshire’s ownership percentage unchanged. Maybe this difference triggered Peat Marwick to look back into the stock redemption, where they found discrepancies with the accounting treatments and recommended that Berkshire make adjustments to report the transactions appropriately.
After Berkshire’s 1984 audit, the company released Peat, Marwick, Mitchell & Company as its auditing firm. Berkshire reported that it was “dissatisfied” with Peat Marwick’s inconsistency regarding the proper accounting treatment for stock redemption. Corporate non-liquidating distributions to shareholders are usually treated as dividends income; however, distributions that qualify as stock redemptions are treated the same as a sale of stock by the investor to the investee. Therefore, capital gain treatment normally results.
Corporate shareholders prefer stock redemptions to be treated as dividend income, because corporate shareholders received the benefits of the dividends, which are deductible and in most cases escape taxation. Qualifying stock redemption results in capital gains that are fully taxable at the corporation’s highest marginal rate. Warren Buffet employed the substance over form concept while accounting for Berkshire’s stock redemption transactions. Since the IRS considers proportionate redemptions to be equivalent to dividend distributions and are taxed accordingly, Buffet justified the accounting treatment used to record these truncations.