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The Accounting Fraud That Bankrupts Governments

Monday December 7th, 2015   •   Posted by Craig Eyermann at 5:10am PST   •  

14748481_S How is it that the politicians and bureaucrats who run governments at all levels of society, from cities to counties to states and territories, keep putting the institutions they control into financial jeopardy?

Jeremy Liss of The Atlantic identifies the unique “cash-basis” accounting rules that politicians and bureaucrats apply to themseleves, which allows them to make financial commitments that they will never be able to fulfill.

By using an accounting method known as cash-basis accounting, legislators project future spending without having to consider billions of dollars of long-term financial commitments, leaving many budgets balanced in name only.

It may be easiest to think in terms of personal finance. Imagine you purchase a car for $20,000 in 2015, but under a special promotion no payments are due on your bill until 2018. In what year did you incur the $20,000 bill? Most people would say 2015, the year you acquired the car. That’s the answer mandated under accrual accounting, a method of financial reporting required of all public companies by the Financial Accounting Standards Board. But many state and city legislatures disagree. They operate with the conviction that a bill is not incurred until the money leaves your bank account to pay it. So if you choose not to pay the bill for your car until 2018, for accounting purposes the bill will only appear that year.

Cash-basis accounting is a recipe for fiscal disaster. State and local governments make long-term commitments for programs like employment compensation plans and public works projects. But they write their budgets on a year-to-year basis, as if starting all over again each year with fresh revenue and expenses. They leave out any revenue not received or, more importantly, any expense not incurred that year. The implications of this financial-planning decision can be immense. In 2010, Virginia reported that it had a cash-basis surplus of nearly $50 million in a budget of $34 billion. When converted to accrual accounting, the surplus turned into a $674.3 million deficit.

In the private sector, the use of accrual-basis accounting practices was mandated for large, publicly-traded companies decades ago, specifically to address the situation where these businesses might not be able to meet their financial obligations. Those rules, which require large private sector firms to demonstrate that they are capable of making future payments on things like their employees’ pensions, is one reason why the debt issued by corporations will sometimes cost less to insure against default than debt issued by governments, even though governments can impose higher taxes to increase their revenues at will to cover their “unfunded” bills as they come due.

It’s not a coincidence that the politicians and bureaucrats who are racking up the biggest bills that can never, ever be paid are also the ones who have itchiest trigger fingers when it comes to raising taxes.

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December 2015