Warren Buffett blasted earnings manipulation as 'disgusting' in his annual letter. Here's what he meant, and how GE legend Jack Welch ties into it.

• Warren Buffett blasted earnings manipulation as "disgusting" and "one of the shames of capitalism."
• Bosses have used restructuring charges, asset sales, and revaluations to hit Wall Street's numbers.

Warren Buffett called out executives who manipulate their companies' earnings in his latest shareholder letter. Look no further than Jack Welch, the late CEO of General Electric, for insights into the legal but controversial practice.

Buffett made clear his disdain for so-called creative accounting, branding it "disgusting" and "one of the shames of capitalism" in his yearly missive.

The famed investor and Berkshire Hathaway CEO has previously bemoaned the rise of this type of financial fiddling. He has pinpointed one-off restructuring charges and merger-related adjustments as two common ways to massage figures and mislead investors.

"Clearly the attitude of disrespect that many executives have today for accurate reporting is a business disgrace," he said in his 1998 letter.

A key issue is that many US companies report at least two sets of earnings. One complies with generally accepted accounting principles (GAAP), while others purport to show their underlying performance.

Even Buffett dismisses GAAP earnings as largely meaningless for Berkshire, as they include unrealized gains and losses in the conglomerate's roughly $300 billion stock portfolio, which cause huge swings in headline profits. He directs shareholders to focus on the company's operating earnings instead.

Welch went a step further. He made it his mission to beat Wall Street's forecasts, and deliver slow, steady growth that would secure a higher valuation for GE stock. He oversaw 40 quarters, or 10 years, of uninterrupted earnings growth during the 1980s and early 1990s.

"If he told research analysts GE was going to earn a certain amount of money in a given quarter, come hell or high water GE was going to earn that amount of money," author Bill Cohan writes in "Power Failure: The Rise and Fall of an American Icon."

The ace in Welch's hand was GE Capital. The conglomerate's financing arm owned around $200 billion of assets, ranging from commercial buildings and leased jets to stock warrants, that it could sell at short notice to offset weakness elsewhere in the company.

GE also incurred $4 billion of restructuring charges between 1983 and 1994, Cohan reported. Moreover, it once offset a $1.4 billion gain from selling its aerospace business by incurring a $1 billion charge for the cost of closing its global facilities. The resulting after-tax gain and loss were both $678 million, canceling each other out.

The utilities titan also adjusted the expected rate of return from its pension portfolio, and tweaked the values of assets it acquired. In a similar vein, it once pulled out $2 billion from the reserves of its insurance subsidiary to avoid reporting an earnings decline, Cohan said.

The goal was to smooth GE's earnings by offsetting any big quarterly gains that would be hard to top in the future, and making up for any significant losses by liquidating assets, tweaking valuations, and moving money around.

However, Welch rejected claims that he "managed earnings," framing his accounting tweaks as simply sensible.

"I'm not manipulating earnings," he told Cohan. "You have to be an idiot to miss a Wall Street estimate."

"I had forty businesses," he continued. "If I can't get a penny here or a penny there for a shortfall, then I'm an idiot … Everybody's got a kitty in every level in every company."

"Staying up all night, fooling with the balance sheet. We didn't do that," he added.

Welch's obsession with GE hitting its numbers each quarter spurred him to ruthlessly cut costs and fire workers as needed. His nickname was "Neutron Jack" because, like a neutron bomb, he could empty an entire building of people but leave the structure standing.

Buffett and Welch clearly differed on what constitutes appropriate accounting, with the Berkshire chief — and one-time GE investor — taking a much more conservative view than the former GE boss. Yet Welch's protests suggest he didn't believe he was crossing the line and engaging in "disgusting" or shameful activities.