Friday, October 30, 2009

The Emperor has no Money

Last week three retired CPAs--Bob Lemer, Aubrey Farb, and Tom Roberts--released a report on the city's financial status. (HT: blogHouston) Their conclusion is that the city is essentially bankrupt. While that finding certainly is interesting, another aspect of the report is more so.

According to the report the city uses "modified accrual basis" accounting, which it states is essentially cash basis accounting. I am no accountant, but as a small business owner I know the difference between accrual accounting and cash basis accounting. In accrual accounting income and expenses are recorded when accrued; in cash basis accounting income and expenses are recorded when cash actually changes hands. The primary difference is when income and expenses are recorded. And that can be a pretty significant difference, particularly when significant liabilities are involved.

I will use a simple example to demonstrate the difference between these two methods. Let us say that I start the day with $10,000 in the bank and no debts. My balance sheet will show equity of $10,000 (assets minus liabilities). During the course of the day I take out a loan for $10,000. Under cash accounting, I will now show $20,000 in assets but no liabilities. My balance sheet will show equity of $20,000 even though my financial position has not changed. Under accrual accounting the liability would be recorded when it is incurred. My balance sheet would show equity of $10,000.

From a certain perspective there is a real benefit in using cash accounting--it allows you to mask reality. If your intention is to hide your liabilities, then cash accounting is just what you need. Indeed, the report states that on a cash basis the city had a $19.891 million surplus in fiscal 2008; on an accrual basis the city had a deficit of $281.556 million because of incurred liabilities. Consequently, using cash basis accounting both the mayor and the controller can claim that the city is in good shape financially and present the numbers to "prove" it.

It appears that municipalities are required to use the "modified accrual basis", so at least some responsibility lies outside of city officials. However, the city's Comprehensive Annual Financial Report is prepared on an accrual basis and both the mayor and the controller must sign off on it. Since Mayor White has made a big deal of being a businessman, and Annise Parker has served as controller for 6 years, I would assume that they know how to read financial statements. They have no excuse for hiding the fact that the city is broke--assuming that this is true--from the citizens of Houston.

Like inflation, cash accounting can allow politicians to spend money and shift the true cost to the future. White can claim that the city has a surplus, even though he has committed to spend millions of dollars that future mayors will have to actually include on the budget. The future mayors will take the heat and try to shift the blame to White. And White, if he has his way, will be off in Washington committing an even bigger fraud.

The report states that the problem has not been declining revenues (the report anticipates declining revenues going forward as sales and property taxes decrease), but overspending by the city government. This doesn't come as a huge surprise, given that White has unleashed the pit bulls on virtually every business in the city, from taco trucks to sign companies, from developers to sexually oriented businesses to apartment complexes. He has launched a "green" initiative that includes caulking windows, insulating attics, and sending squiggly light bulbs to Houstonians. He has pushed Houston Hope, which gives taxpayer money to home buyers, and light rail. He has spent and spent and spent.

If you think getting rid of White will solve this problem, think again. The leading mayoral candidates--Parker, Brown, and Locke--intend to follow essentially the same pattern. None has rejected White's premises, and they simply quibble over the details. Eager to secure political support today, they evade the future consequences.

Of course, the fault does not lie entirely with the politicians. They are simply doing as the citizenry requests. The citizens--or at least a noisy portion of them--want to tear down the signs, shutter the strip clubs, and shackle developers. They demand that city officials preserve old buildings, house the needy, and provide mass transit. They are content to spend money that isn't theirs and dictate to their fellow citizens. They believe that their wishes and desires can transform reality, and they want government to fulfill their fantasies.

When the bill comes due--and it will come due--they will no longer be able to evade the fact that the city is bankrupt. It remains to be seen if they will realize that the ideas that have caused this mess are equally bankrupt.

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