Keeping The Books


The Senate last spring failed, by a narrow margin, to muster the two-thirds majority needed to pass a constitutional amendment that would have required a balanced federal budget.

Certainly, with the annual federal deficit in the hundreds of billions of dollars, something is needed to bring fiscal discipline to Washington. But would a simple balanced-budget requirement supply it? Curiously—or perhaps not so curiously, as we will see—the political opposition, which ranged right across the spectrum, never mentioned the most important reason it would not: The federal government does not adhere to GAAP—generally accepted accounting principles. Nor does it use independent accountants. In other words, politicians, not accountants, decide how to keep track of the federal government’s financial affairs.

But politicians, like the rest of us, tend to follow the path of least resistance in pursuing their self-interests. It is a lot easier to cook the books a little than it is to make hard political choices on taxes and spending. That’s why a balanced-budget amendment would not reduce the deficit; it would result in a lot of cooked books instead.

Just consider New York State, whose government in more ways than one is the federal government writ small. Like most states, New York has a constitutional requirement that its expense budget be balanced. But in 1992 Albany found itself $200 million short of that mandate. Did the legislature and the governor raise taxes or cut spending? Certainly not. The state of New York simply sold Attica Prison to itself.

I am not making this up. The Urban Development Corporation, a state agency established to help redevelop troubled urban areas, borrowed in the bond market, turned the money over to the state, and took title to the prison. The state, in turn, recorded the $200 million its own agency had borrowed as income, proclaimed the budget balanced, and now rents Attica from the UDC.

Hardly anyone noticed when this governmental fiscal fiddle took place. But what would have happened if a publicly held corporation had tried to pump up its bottom line to the tune of $200 million by having a subsidiary borrow money and use it to buy, say, the corporate headquarters?

The answer, of course, is that no corporation would ever try such a stunt, because its independent accountants would not certify its books if it did. Without independently certified books, the New York Stock Ex- change would suspend its securities from trading and its banks y wouldn’t lend it a dime. Its suppliers would demand cash on delivery. Its customers would put off orders until the dust settled. It would be effectively out of business.

Thus independent accountants, adhering to independent accounting standards, keep corporate books honest. But while accountancy has been around since ancient Mesopotamia, the certified public accountant has been around less than a century. Indeed, the idea is one of the brighter contributions that late-nineteenth-century capitalism gave to the world.

Accounting did not advance much beyond the techniques used by the Mesopotamians until the Italian Renaissance produced double-entry bookkeeping in the fifteenth century. Double entry makes it much easier to detect errors and allows a much more dynamic financial picture of an enterprise to emerge from the raw numbers. Thus the difference between double-entry and single-entry book-keeping as financial tools might be analogous to the difference between an electrocardiogram and a stethoscope as diagnostic ones.

Accountants, armed with L the new methods, came early to the New World, but American enterprises remained very small until well after the Revolution, and their owners did L most of their own bookkeeping. So while professional accountants, working for a variety of clients, existed (Benjamin Franklin used one occasionally to help keep track of his numerous enterprises), they were not common.

Nor were they independent in the sense that they certified books as being correct. They didn’t need to be because American enterprises were nearly always individually owned, so there was no reason for anyone to keep dishonest books.

The Industrial Revolution changed that forever. The railroads were the first industry with capital needs beyond the means of a single person or family. As they became more and more complex, accountants began devising more and more tools to keep track of the money. The great corporate enterprises of the late nineteenth century were possible only because of these new accounting tools. This rapid evolution in accountancy continues unabated today. Just for instance, cash flow is now one of the most important numbers an accountant produces. The very phrase, however, was coined only in 1954.

But as the distance between the owners of the railroad—the stockholders—and the managers who ran it (and kept its books) increased steadily, the interests of the owners and managers with regard to those books diverged as well. The owners wanted timely information that would allow them to evaluate the worth of their holdings and to compare them with other, similar concerns, in order to determine how good a job the managers were doing. The managers, naturally, wanted the freedom to make the books look as good as possible. Not uncommonly the managers parted company with the truth altogether and lurched into fraud.