Tuesday, February 16, 2010

The Source of Funny Accounting

The more I hear about the budget problems in Greece, the more it appears that the crux of the problem is accounting. It was convoluted accounting mechanisms that allowed the budgetary imbalances to go undetected for so long, and various forms of funny accounting continue to make it difficult to properly measure the problem. In other words, it’s a little like the mortgage problems in the United States.

When you start to talk about funny accounting, a lot of people jump to the conclusion that the accounting is sloppy, like the corporate accounting of the 1980s, or that someone is cooking the books, calculating ways to rearrange the numbers to make them look better than they are. And no doubt, sometimes these things occur. But there is no particular reason to expect to find any of that in the Greek government budget accounts or in the exchange of mortgage-backed securities in the United States.

Funny accounting can occur by accident, but when companies and governments are managing by the numbers, it is rooted out and corrected only when it makes the numbers look bad. Otherwise, it tends to be tolerated. This is the reason why Wall Street companies didn’t notice the bizarre patterns of derivatives trading that many of their employees were doing to inflate their bonuses. These particular obligations were kept off the books, the result of an accounting rule that no one stopped to question because it wasn’t making the books look bad. By the time the companies got around to checking, more than a few of them had trillions of dollars in off-balance-sheet liabilities. Then, after some slight clarifications of the accounting rules, the volume of dodgy derivatives trades fell by more than three fourths.

In the case of Greece, there really is no crisis. All that is needed is an honest look at the budget accounts, followed by some honest decisions. All this will be easy enough to do now that people have taken a skeptical look at the accounting and have started to see it for what it really is.

Funny accounting happens naturally when institutions are managing by the numbers, and managing by the numbers tends to occur when institutional leaders are overconfident and the institutions they manage are under stress. Does this scenario sound like any multinational corporations or state or federal governments you’re familiar with? The solution, of course, is to root out the funny accounting before it becomes a crisis.

The U.S. federal budget took a step in this direction this year by eliminating the various accounting fictions that had kept foreign military adventures mostly off-budget for the past decade. Let’s hope Congress can chip away at some of the other accounting fictions that are lurking in the budget in time to get some more honest numbers into next year’s budget.