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The Real Scandal
Senator John McCain (R-Arizona), in an editorial entitled “The Free Market Needs New Rules” and published in The New York Times (8 July), wrote that, “in a string of corporate failures and scandals from Enron to WorldCom, we have seen the first principles of free markets – transparency and trust – fall victim to corporate opportunists exploiting a climate of lax regulation. I have long opposed unnecessary regulation of business activity, mindful that the heavy hand of government can discourage innovation. But in the current climate only a restoration of the system of checks and balances that once protected the American investor, and that has seriously deteriorated in the past 10 years, can restore the confidence that makes financial markets work.” Accordingly, “the need for government action and oversight is clear. Corporations [have] fabricated revenues, disguised expenses and established off-balance-sheet partnerships to mask liabilities and inflate profits.” Further, “top executives should be required to certify personally that the company’s public financial reports are accurate and that all information material to the financial health of the company has been disclosed. If their certification is false, they should go to jail.”
Many people in America and elsewhere, it seems, concur with Senator McCain. William Anderson, however, in his article Congress, Accounting and the Free Market, demurs. “Before examining McCain’s proposals, I think it appropriate to ask why a member of Congress, of all people, believes he has the right to demand standards of accountability from anyone, let alone U.S. businesses. For example, he declares that corporations have ‘fabricated revenues, disguised expenses, and establish off-balance-sheet partnerships to mask liabilities and inflate profits.’ This statement is breathtaking, because he is describing current accounting practices of the U.S. government. Remember the nonexistent ‘surpluses’ that seem to have disappeared? It seems that for political purposes, Congress fabricated revenues. Is there a greater scheme of financial fraud than Social Security, a Ponzi construction which, if practiced in the private sector, is a sure ticket to prison? Ever hear of ‘off budget’ agencies like Ginnie Mae, Freddie Mac, and Sallie Mae? These outfits are created precisely to hide the trillions of dollars of financial obligations that ultimately fall upon U.S. taxpayers.”
Anderson concludes: “to put it bluntly, McCain is party to what can be considered the greatest set of financial frauds in world history, something that puts the collapse of Enron and WorldCom in better perspective. It might seem more instructive for the physician to heal himself than for him to try to impose his will upon other parties.”
Thomas Donlan, Barron’s (15 July 2002) agrees. “Federal politicians need a remarkable elasticity of character to complain about phony accounting. The accounting system they devise and work with daily is duplicitous from front to back, designed to inflate revenues, hide expenditures and cover up borrowing. The average businessman really would go to jail if he used federal accounting. Congress this year, for example, has entirely dodged the creation of a budget resolution, so as to avoid putting limits on its spending impulses.”
So too does Bob Officer (The Weekend Australian Financial Review, 6-7 July 2002). “Those who see the problem as an inherent flaw in a capitalist economy with the only solution a return to greater governmental control and even government ownership of private sector assets should be reminded that there have been plenty of examples of misreporting by government trading enterprises. Moreover, public sector accounting systems are typically well behind those of the private sector and the degree of scrutiny is often a good deal less. In short, the problem of reporting and communication between the operators of assets and their owners or stakeholders is inherent in any economic system where there is a separation of ownership and control. Only in the most primitive of economic systems, where stakeholders directly manage their own assets, does this problem disappear.”
There’s – Literally – No Accounting for Government
David Simons, in an article entitled Uncle Sam’s Audit Gap and published in Forbes on 27 June, provides a distressing wealth of detail that corroborates Anderson, Donlan and Officer. Australians should by no stretch of the imagination react smugly to Simons’ grim details. This is because the Report to the Commonwealth Government conducted by the National Commission of Audit (Australian Government Publishing Service, 1996, ISBN: 0644361166), the first presentation of the Commonwealth’s finances on an accruals basis, shows that Canberra’s liabilities ($261.5 billion) and contingent liabilities ($176.8 billion) greatly exceed its assets ($188.1 billion). As was noted at the time, if the Commonwealth were a private sector entity then it would face liquidation and its directors face fines and imprisonment for trading whilst insolvent. But not to fear: as the report candidly observes, “the value shown for net assets is not an indicator of the Commonwealth’s solvency or the sustainability of its financial position. Importantly, it takes no account of the Commonwealth’s ability to raise taxation.” And lo, since the report’s publication the greatest tax rises in Australian history have been enacted.
Indeed, of all Australian jurisdictions, and thanks disproportionately to two ALP Lords Mayor (Jones and Soorley), cautious state cabinets since the 1930s and Sir Johannes Bjelke-Petersen since the 1960s, only the Brisbane City Council and State of Queensland presently have strong balance sheets and S & P credit ratings. It is not just the sunshine and beaches that attract southerners to Queensland. For this reason I propose that our motor car number plates, on which one of two logos (either “Sunshine State” or “Smart State”) are presently inscribed, be amended to read “Solvent State.”
Americans are not so lucky. Simons notes that six years ago the U.S. Congress enacted the most sweeping reform of federal financial management in 40 years. Alas, nothing much has happened. Today, 83% of the federal agencies subject to it do not comply fully with it. Indeed, “the accounting is so bad that no one knows how much it’s costing taxpayers in erroneous payments and inefficiency. Reports from the U.S. General Accounting Office indicate that $100 billion annually wouldn’t be unreasonable. That’s equal to an Enron – or a tax cut – every year.”
Since 1997, the U.S. Treasury has analysed the federal government’s accounts and the General Accounting Office has issued an overall assessment with respect to those accounts. Unfortunately, 2001 was the fifth consecutive year during which the GAO was unable to judge “whether the consolidated statements are fairly stated in conformity with U.S. generally accepted accounting principles.” The GAO says: “the government did not maintain adequate systems or have sufficient, reliable information.” One result is the issue erroneous payments on a massive scale. These occur either as honest mistakes or through fraudulent claims (systems of accounting presently in place are not robust enough to distinguish the one from the other). Estimates of total mistakes with respect to Medicare, food stamps and earned income tax credit refunds alone totaled $21 billion in 2001.
According to Simons, “the fine print of the tidy-looking Financial Report of the United States Government reveals some painfully basic accounting deficiencies. For example, to make the statements balance, there’s a $17.3 billion decrease to net operating cost labeled “unreconciled transactions.” That’s up from $4.8 billion in 2000. According to the GAO, a major reason is failure of agencies to accurately reconcile their records of disbursements to the Treasury’s records of actual payments. That’s as basic as reconciling a checkbook with bank statements.”
“The balance sheet is equally crude. The negative $6.5 trillion total net position isn’t derived via balanced accounting entries. Instead, the $7.4 trillion of liabilities is simply subtracted from $926 billion of assets. And the GAO reported that substantial amounts of government-owned plant, equipment and inventories, on the books at $491 billion, couldn’t be verified to exist or have their value substantiated. Though 16 of the 24 major agencies required to provide audited financials received a ‘clean’ opinion, the GAO found it often was achieved only by ‘extensive ad hoc procedures’ and ‘billions of dollars in adjustments’ – much like a taxpayer organizing a shoebox of financial documents on April 14.”
The auditors of no fewer than 20 of the 24 federal agencies deemed the financial management systems significantly deficient in meeting federal requirements enacted in 1996. The Department of Defense (DoD), whose $764 billion budget for 2001 (including retiree health benefits) is by far the largest of any agency, is the major offender. In the words of Robert Higgs (US National Security: Illusions versus Realities), the illusion is that DoD “has the motivation and the capacity to manage effectively the vast resources placed at its disposal, in a way that enhances the security of the American people in America.” The reality, however, is starkly different: it “is either unable or unwilling to deal seriously with its decades-long engagement in massive waste, fraud, and mismanagement, especially (but not exclusively) in its relations with the big defence contracting companies.”
According to a memorandum by the deputy assistant inspector general for auditing and dated Feb. 15, 2001, “we identified $1.1 trillion in department-level accounting entries to financial data used to prepare DoD component financial statements that were not supported by adequate audit trails or by sufficient evidence to determine their validity. In addition, we also identified $107 billion in department-level accounting entries to financial data used to prepare DoD component financial statements that were improper because the entries were illogical or did not follow accounting principles.” More generally, “DoD did not fully comply with the laws and regulations that had a direct and material effect on its ability to determine financial statement amounts.” The memo concluded: “DoD could not provide sufficient or reliable information for us to evaluate management’s assertions or verify amounts on the FY 2000 DoD Agency-wide Financial Statements.”
According to Higgs, the government’s audit agencies also found the accounts of the individual armed services were in such a mess that those records could not be audited. “The Military Department audit agencies attempted to audit those financial statements and issued disclaimers of opinion.” The DoD’s inspector general reported “the financial data reported on the FY 2000 financial statements for Army, Navy, and Air Force General Funds; the Army, Navy, and Air Force Working Capital Funds; and the U.S. Army Corps of Engineers, Civil Works Program, were unauditable and comprise a significant portion of the financial data reported on the DoD Agency-wide Financial Statements for FY 2000.”
Higgs concludes: “and to think: Congress is wasting time holding hearings on the accounting shortcomings of Arthur Andersen and Enron, and the President is threatening to sic the Department of Justice on accounting malefactors such as WorldCom and Xerox – all of which are veritable paragons of accounting probity by comparison with the Pentagon.” In another recent analysis Higgs concluded: “last year, defense secretary Donald Rumsfeld told Congress, ‘We have an obligation to taxpayers to spend their money wisely. Today, we’re not doing that.’ Talk about an understatement. Not only is the Department of Defense wasting money by the shipload, but it hasn’t the foggiest idea of how many trillions of dollars it has squandered, and how it has done so, over the past decade. Yet department officials also have testified that no compliance with the law is in sight. The Pentagon lawbreakers simply expect to go on breaking the law, and to get away with it, as they have been getting away with it for years. When Enron or WorldCom can’t present a proper audit statement, they are ruined. When the Department of Defense cannot put its financial records in shape even to be audited, the department is rewarded with the biggest increase in its budget since Ronald Reagan’s first term as president.”
Ominously, Simons observes “a priority of President Bush’s management agenda is more aggressive implementation of federal financial management laws enacted between 1990 and 1996. But the goal of having the government operate as if it’s Uncle Sam Inc. is up against the politics of spending money, not saving it, and the ability to literally paper over the consequences of sloppy accounting.” For this reason, “it’s much easier to raise the debt limit, dip into the Social Security trust fund and otherwise jigger appropriations. In fact, apart from the critical aspects of disclosure and nefarious intent, the techniques of politicos have much in common with the public-company accounting shenanigans they now seek to end.”
Who Audits the Watchdog?
Finally, Simons notes something that is little known and very awkward: the chief arbiter of auditing and financial watchdog of American private sector corporations, the Securities and Exchange Commission, is not subject to audit. “Action last week by the U.S. Senate and the Securities and Exchange Commission seems certain to bring federal oversight of the accounting profession with the assistance of the SEC. Yet the SEC, which administers securities-related fees that last year totaled $2 billion, doesn’t produce audited financial statements of its own operations … The SEC and 25 other independent agencies aren’t subject to federal law requiring audited financials similar to those of public companies.”
“The SEC also is the only agency that doesn’t have a top-level management position equivalent to chief financial officer. As required of all agencies, it has an inspector general who can conduct audits. But responsibility for financial management and accounting is with the office of comptroller, which lies at the bottom of the SEC organization chart. The SEC blames lack of budget authorization for its audit absence. Of course, keeping public company accounting in line should be the priority. But it’s just plain embarrassing that the SEC doesn’t practice what it regulates.”
In Whom Can We Trust?
Senator McCain, in his New York Times editorial, concluded “what is at risk is the trust that investors, employees and all Americans have in markets and, by extension, in the country’s future. To love the free market is to loathe the scandalous behavior of those who have betrayed the values of openness that lie at the heart of a healthy and prosperous capitalist system.” Many others share this view. Perhaps most notably, President Bush said in his weekly radio address on 13 July “perhaps the greatest need for our economy at this moment is restoring confidence in the integrity of the American business leaders.”
William Anderson draws a diametrically different conclusion: “if McCain wishes to hold Congress and the U.S. government to the same standards that they wish to impose upon private enterprise, perhaps his rhetoric should be aimed at Alan Greenspan, or even himself and the politicians and staff members that populate Capitol Hill. McCain’s statement [that ‘top executives should be required to certify personally that the company’s public financial reports are accurate and that all information material to the financial health of the company has been disclosed. If their certification is false, they should go to jail’] is stunning – one that deserves thorough debunking – not to mention being one that is a sign of depraved hypocrisy.” “It is easy for people like McCain … to demand accountability standards that he himself would refuse to meet. Unlike Congress, businesses cannot take in revenues upon coercion. If I refuse to shop at Wal-Mart, for example, that is my right; but if I refuse to give Congress the financial support it demands, then I go to jail. If McCain really wants to impose these standards upon U.S. businesses, perhaps he first should begin with his own legislative house. After all, [by declaring] ‘government’s demands for corporate accountability are only credible if government executives are held accountable as well,’ does that mean U.S. senators? Should McCain be held criminally liable for campaign promises that he fails to honour? Should he be held criminally liable when he fails to keep his oath to ‘protect and defend’ the U.S. Constitution?”
“These are questions I doubt the good senator would want to answer. Instead, we see the moral grandstanding that seems to be an occupational disease in Washington, D.C. One could only hope that real justice would prevail, and that the John McCains of this world would have to be subject to the same sets of laws and penalties they impose upon everyone else … Senator, we do not need to be protected from ‘predatory capitalism.’ The real predators are in Washington, and they are you and your political allies.”
…continued in Part III
 
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