Imagine a company that allows its employees to take nothing in salary this year in exchange for promissory notes to pay them twice as much in 10 years. Although there would be no immediate cash outlay, the company would still be required to accrue expenses reflecting the promises.
That “accrual basis” treatment is important, because without it a company could present a false picture of its finances. If it didn’t have to show the cost of promised future expenditures, the company could present itself as breaking even or making money when neither was the case. Creditors, suppliers, customers and employees dealing with the company would be unaware of the risks they were taking.
Yet this is precisely the accounting sleight of hand that state and local governments are permitted to use with “cash-basis budgeting,” which, according to the State Budget Crisis Task Force, led by Richard Ravitch and Paul Volcker, “recognizes expenditures only when cash is actually disbursed.”
Cash-basis budgeting leads to nonsensical outcomes, such as Gov. Chris Christie’s New Jersey being able to claim a balanced budget simply by pushing a $3 billion payment from one fiscal year into the next, or Gov. Jerry Brown’s California reporting a $2.4 billion surplus even though it incurred an additional $15.8 billion of unfunded retirement promises in the same year.
Because of cash-basis budgeting, expenses will only show up in future budgets when cash is required to meet the promises. And when they do show up, the amount of cash diverted from those budgets will be many times higher than what was promised because of compound interest.
This form of budgeting creates absurdities on the revenue side, too. Under cash-basis budgeting, a state or local government can claim a balanced budget even if 100 percent of its revenue is borrowed because revenue is defined as cash received, regardless of the source.
According to Ravitch and Volcker, “cash-basis budgeting is a major enabler of budget gimmickry.” Worse, a politician who wants to put money away to meet future promises is forced into a dilemma: Do the right thing but show a degraded budget, or ignore the obligation and show healthier books.
Estate and Corporate Income Taxes are changing next year, and business owners and executives should know the details. The PBN Summit on November 6th will provide those details and more - including how much Obamacare's Employer Mandate could cost.
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