A Quick Lesson in Accounting

Monty Pelerin’s World has posted a clear explanation of the current state of affairs in regard to government finances.

TLDR:  The deficit is much worse than the government is reporting – by about 6 times.

Before your eyes glaze over, please bear with me.  There are two types of accounting practices germane to this discussion:

Cash Accounting:

The cash method is the more commonly used method of accounting in small business. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.  Nolo.com

Accrual Method:

Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don’t have to wait until you see the money, or actually pay money out of your checking account, to record a transaction. Nolo.com

Got that?  OK.  Here is one more tidbit of information which will tie things up in terms of background.

GAAP: Generally Accepted Accounting Principles stipulate that all corporations must use accrual accounting.  Thus GAAP == Accrual Accounting.

From Monty Pelerin’s World:

All major companies use GAAP, Generally Accepted Accounting Principles, to report income. The primary difference between cash basis and GAAP is the use of accruals which are used to match costs with revenues, regardless of whether they occur in the same time period.  To illustrate the difference here is a simple example:

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John Doe builds an airplane which costs $90,000. He sells the plane for $100,000. If the costs are paid and the revenues are received in the same year, John’s income would be $10,000. It would be so regardless of whether GAAP or cash basis accounting were used. But now, suppose John instead collects the revenue from the sale this year but doesn’t pay his suppliers until next year. On a GAAP basis, John would still show a profit of $10,000. On a cash basis, however, John would show a profit of $100,000 this year and a lost of $90,000 next year.

 

Government accounting has the same distortion. That is, revenues are recognized up front while incurred expenses are not. They are back-loaded primarily due to the costs incurred for social security and medicare promises which will not be paid out in cash until future periods. The revenues from these programs are being recognized today while the bulk of the expenses, which will have to be paid down the road, are not.

No big deal you might think. But what is the difference between what the government reports as their loss (deficit) for the year on a cash basis versus a GAAP basis? The government reported a deficit of $1.3 Trillion last year. Using GAAP, their real deficit was almost $6 Trillion. The difference between these numbers equals the amount of debt that Obama added in the last 3.5 years, although has nothing to do with Obama’s addition to the debt. The difference represents additional debt that must be funded down the road. This additional need is not a one-shot or one-year deal. It occurs every year but in increasing amounts. On a present value basis (the future shortfalls in Medicare and Social Security discounted back to the present) represent over $100 Trillion according to the trustees for these funds.

Are we talking semantics or accounting gimmickry here? No, GAAP recognizes costs as they are incurred, not when they are paid. That is proper accounting and produces a much more dismal picture of events than government wants you to know about. The only way that this shortfall is not real is if the promises made under Social Security and Medicare are reneged upon by the federal government.

The bottom line:

Jim Horney, a former Senate budget staff expert now at the liberal Center on Budget and Policy Priorities, says retirement programs should not count as part of the deficit because, unlike a business, Congress can change what it owes by cutting benefits or lifting taxes.

“It’s not easy, but it can be done. Retirement programs are not legal obligations,” he says.

Read the rest at  Monty Pelerin’s World » Measured Properly, Things Are Much Worse Than You Are Being Told.