Is the Federal Government Violating Sarbanes-Oxley?

By Ehren J. Brav

Are the investors in America's largest company being deceived? Section 303 of the Sarbanes-Oxley Act requires that corporate officers of public companies certify that the financial reports of their companies don't "omit ... a material fact necessary in order to make the statements ... not misleading". The federal government, a public company of sorts with revenues of around $2.4 trillion, might run afoul of this standard, as suggested by a recent New York Times opinion by Steven Rattner.

The problem is that the federal government presents its key financial data in a highly misleading way. By law, any business with revenues greater than $5 million must use accrual accounting. But the government uses cash accounting instead, which measures the amount of cash coming in and going out over a year, without considering promises made during that time to pay money in the future. In contrast, accrual accounting tries to match income and expenditures when the promise is made instead of when cash changes hands. Thus if I make a promise today to pay current employees a retirement benefit 30 years from now, I need to record that promise as a part of this year's budget.

Cash accounting does not meet GAAP principles for two reasons: it fails to recognize revenue when it is realized (rather than collected), and it fails to match current revenues with future expenses (for example, recognizing a $50,000 zero-interest for two years home equity loan today without recognizing the need to start paying it off two years from now).

For a debtor, cash accounting is wonderful since it allows you to disclose the bounty of today without directly acknowledging the bill that comes due in the future. For the federal government, the difference is huge. The federal deficit would be $450 billion - $200 billion larger if accrual accounting was used. But the number cited again and again for the budget deficit is $248 billion. This number ignores a host of all-to-real costs: pensions for government workers, future social security obligations, and future Medicare obligations. An accrual accounting financial statement that discusses these obligations is prepared by the General Accounting Office each year, but does not seem to be available yet for 2006.

When the administration trumps its $248 billion deficit number, it acts like a CEO telling everybody the great results given by cash accounting, but burying the accrual accounting numbers in the financial statements. The five year horizon for balancing the cash accounting budget is by most measures purely aspirational. An accrual accounting projection makes this downright fantasy absent radical changes in spending or the economy.

Mr. Rattner points out that Social Security was properly accounted for until 1968, when President Johnson started treating current receipts from workers as if they were normal tax revenues instead of contributions to a trust fund. In trumping the fiscal soundness of his budget, President Bush neglects to mention the trillions that would need to be set aside today to cover future entitlements.

Sarbanes-Oxley, like a host of other securities law requirements, was passed in the wake of financial catastrophe and sought to restore investor confidence in America's capital markets. In signing the bill, president Bush said "the only fair risks are based on honest information. Tricking an investor into taking a risk is theft by another name." Taxpayers very much are investors in the United States. It is time they were given the honest information.

Posted by Jon Berkon on March 5, 2007 11:50 AM | Permalink