Berkshire Hathaway 2003 Annual Report Download - page 66

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Critical Accounting Policies (Continued)
In each year, General Re’ s casualty reserve estimates for prior years’ losses have increased. In addition,
the net reserves of BHRG’ s retroactive reinsurance policies have increased each year, primarily as a consequence of
amortization of deferred charges. As shown in the table, a relatively small percentage change in estimates of this
magnitude will result in a material effect on reported earnings. A hypothetical 5% increase in estimated net unpaid
losses at December 31, 2003, would produce a $1.9 billion charge to pre-tax earnings. Future effects from changes
in these estimates will be recorded as a component of losses incurred in the period of the change.
Berkshire records deferred charges as assets on its balance sheet with respect to liabilities assumed under
retroactive reinsurance contracts. At the inception of these contracts the deferred charges represent the difference
between the consideration received and the estimated ultimate liability for unpaid losses. The deferred charges are
amortized as a component of losses incurred using the interest method over an estimate of the ultimate claim
payment period. The deferred charge balance may be adjusted periodically to reflect new projections of the amount
and timing of loss payments. Adjustments to these assumptions are applied retrospectively from the inception of the
contract. Unamortized deferred charges totaled $3.1 billion at December 31, 2003. Significant changes in either the
timing or ultimate amount of loss payments may have a significant effect on unamortized deferred charges and the
amount of periodic amortization.
Berkshire’ s Consolidated Balance Sheet as of December 31, 2003 includes goodwill of acquired businesses
of approximately $22.9 billion. These amounts have been recorded as a result of Berkshire’ s numerous prior
business acquisitions accounted for under the purchase method. Prior to 2002, goodwill from each acquisition was
generally amortized as a charge to earnings over periods not exceeding 40 years. Under SFAS No. 142, which was
adopted by Berkshire as of January 1, 2002, periodic amortization ceased, in favor of an impairment-only
accounting model.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include
periodically determining or reviewing the estimated fair value of Berkshire’ s reporting units. Under SFAS No. 142,
fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods
of estimating reporting unit values, including market quotations, asset and liability fair values and other valuation
techniques, such as discounted cash flows and multiples of earnings or revenues. If the carrying amount of a
reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable
intangible assets and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair
value of the reporting unit over the estimated fair value of net assets would establish the implied value of goodwill.
The excess of the recorded amount of goodwill over the implied value is then charged to earnings as an impairment
loss.
Berkshire’ s consolidated financial position reflects large amounts of invested assets, including assets of its
finance and financial products businesses. A substantial portion of these assets are carried at fair values based upon
current market quotations and, when not available, based upon fair value pricing models. Certain fixed maturity
securities Berkshire owns are not actively traded in the markets. Further, Berkshire’ s finance businesses maintain
significant balances of finance receivables, which are carried at amortized cost. Considerable judgment is required
in determining the assumptions used in certain pricing models, including interest rate, loan prepayment speed, credit
risk and liquidity risk assumptions. Significant changes in these assumptions can have a significant effect on
carrying values.
Market Risk Disclosures
Berkshire’ s Consolidated Balance Sheets include a substantial amount of assets and liabilities whose fair
values are subject to market risks. Berkshire’ s significant market risks are primarily associated with interest rates
and equity prices and to a lesser degree derivatives. The following sections address the significant market risks
associated with Berkshire’ s business activities.
Interest Rate Risk
Berkshire’ s management prefers to invest in equity securities or to acquire entire businesses based upon the
principles discussed in the following section on equity price risk. When unable to do so, management may
alternatively invest in bonds, loans or other interest rate sensitive instruments. Berkshire’ s strategy is to acquire
securities that are attractively priced in relation to the perceived credit risk. Management recognizes and accepts
that losses may occur. Berkshire has historically utilized a modest level of corporate borrowings and debt. Further,
Berkshire strives to maintain the highest credit ratings so that the cost of debt is minimized. Berkshire utilizes
derivative products to manage interest rate risks to a very limited degree.
The fair values of Berkshire’ s fixed maturity investments and notes payable and other borrowings will
fluctuate in response to changes in market interest rates. Increases and decreases in prevailing interest rates
generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of