Recently the federal government announced that the budget deficit for the fiscal year ending September 2012 is going to be $1.1 trillion. This is very misleading, as using correct accounting methods shows the actual deficit is much larger.
People are not fully grasping the extent of government financial problems both in the United States and abroad because of a lack of appreciation for the accounting systems typically used by governments.
Most national governments use cash-based accounting, while it is commonly accepted that accrual accounting, required of most businesses, more accurately reflects their financial situations.
Cash accounting consists of recognizing expenditures when they are paid and revenues when they are received. It is very much like your checking account, and for most of us individually it works out fine.
Accrual accounting, on the other hand, recognizes revenues when they are earned and expenses when they are incurred. It is particularly important when actions now cause actual payments or receipts later.
Consider a life insurance company issuing a life insurance policy based on one payment now. Under cash accounting, this year it is very profitable because it has a payment and it is unlikely that you have died. However, at a later date it will have a substantial loss, as it has to make a payment without any corresponding revenue. Under accrual accounting, the company would have to set aside funds today that could be invested prudently to make that future payment. The profit is much lower now, but in the year of the payment, those invested funds should be available, minimizing the impact of the payment.
Cash accounting presented a fairly accurate picture of most national government operations up until about 100 years ago. They paid salaries to soldiers and teachers and built roads and bridges.
But then they got into the insurance business as they started to offer old-age pensions and health care insurance. While taking in Social Security contributions, they were also incurring future obligations that they were not formally recognizing.
Take, for example, fiscal 2010.
The reported federal deficit was $1.3 trillion. However, if you add back in the present value of government pension obligations and the liabilities of government sponsored enterprises, the net operating cost of the federal government increased to $2.1 trillion. This is the first step toward recognizing the actual deficit for the year.
While Social Security and Medicare on a cash basis was showing a small surplus, the trustees acknowledged that both had a future unfunded liability of $43 trillion.
In other words, it expected to be obligated to pay out in future much more than it expected to bring in. Those unfunded future obligations are going to have to be adjusted or paid by someone.
So now let’s look abroad. Greece and other European countries have been operating in a similar fashion. They have not been recognizing their future obligations.
While the current recession has added to their budgetary problems, their obligations to seniors that were not recognized in the past but are due now make their solvency problems almost impossible. They are not going to be able to pay what they owe.
While the European Central bank can solve a liquidity problem when solvent institutions need to convert illiquid long-term assets into liquid assets such as cash, it can do nothing for insolvent institutions – and regrettably Greece is in that position.
Hopefully, we in the United States will learn a lesson and attempt to get these future obligations under control. It is unlikely that the federal government deficit will be dramatically reduced even with a recovery because of those past obligations becoming due.
In conclusion, using poor accounting methods eventually can come back to hurt you. I hope that a lesson has been learned.