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 Exchange 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 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.

Many publicly traded companies did not release figures at all, and even when a railroad did issue a report, a contemporary wrote, it was “often a very blind document and the average shareholder … generally gives up before he begins.” The Erie Railroad, for instance, because some of its many bond issues were backed by New York State, was required to file an annual report with Albany. But it could frame that report pretty much as it chose. The managers of the Erie, perhaps the most mismanaged major railroad the world has ever known, had no hesitation in using very creative accounting indeed to hide their own shenanigans.

But The Commercial and Financial Chronicle, the Barron’s of its day, put its finger on the problem and foretold its solution. “The one condition of success in such intrigues,” it noted, “is secrecy. Secure to the public at large the opportunity of knowing all that a director can know of the value and prospects of his own stock, and the occupation of the ‘speculative director’ is gone. … The full balance sheet … showing the sources and amounts of its revenues, the disposition made of every dollar, the earnings of its property, the expenses of working, of supplies, of new construction, and of repairs, the amount and form of its debt, and the disposition made of all its funds, ought to be made up and published every quarter.”

Today quarterly and annual reports are so much a part of the capitalist world that it is hard to imagine that only 125 years ago they were a brandnew idea. But Wall Street immediately realized how important such reports could be in evaluating securities. Henry Clews, a very influential broker in the post-Civil War era, led the push for both regular reports and independent accountants to certify them. The great Wall Street banks that were becoming more and more vital to the new industrial corporations joined him, as did the New York Stock Exchange. The managers did not like the idea, of course, but if they wanted to raise capital or have their securities listed, they had little choice.

In the 1880s, as the American economy industrialized at a furious pace, the number of independent accountants greatly increased. In 1884, there were only 81 accountants listed in the city directories of New York, Chicago, and Philadelphia. Just five years later there were 322. And these accountants were beginning to organize. In 1887, the American Association of Public Accountants came into being, the ancestor of today’s main governing body of the profession.

In 1896, New York State passed legislation establishing the legal basis of the profession and, incidentally, using the phrase Certified Public Accountant for the first time to designate those who met the criteria of the law. The legislation, and the phrase, were quickly copied by the other states.

But government was largely unaffected by the revolution in accountancy that accompanied the Industrial Revolution. The federal government did not even have a formal budget process until 1922. And all federal accounting is still oriented toward preventing fraud and theft, not toward controlling costs. To this day the government makes no attempt even to determine the overhead of any of its vast array of departments, bureaus, and agencies.

And the United States government, the largest fiscal entity on earth, still doesn’t use double-entry bookkeeping. It keeps its books the way you and I keep our checkbooks: single entry and on a cash basis. One of the Western world’s great intellectual achievements—modern accountancy—is virtually unheard of in Washington, D.C., as is the one device—independent certifying accountants—that assures honest books.

Will independent accountants and GAAP come to Washington soon? Well, given human nature, only if the “shareholders” insist that the “managers” give up the power to keep the books as they please.

Again, look at New York State. In 1976, when New York City teetered on the brink of bankruptcy, nearly the first thing the state government did before helping to bail it out was insist that the city adhere to GAAP in its future bookkeeping. But did the state government impose GAAP on itself while it was at it? Of course not. If it had, it couldn’t have sold a prison to itself 15 years later and called it income.