March 1, 2012

Bryan R. Lawrence is founder of Oakcliff Capital, a New York-based investment partnership.

Accounting standards may seem like a sleep-inducing subject to many people. But when retirement promises are improperly accounted for, companies and governments can go bankrupt, and hardworking Americans who have relied on the promises can suffer.

General Motors made its first retirement promises to workers in 1950. Under the accounting rules of the time, GM did not have to recognize the current cost of these future promises, as they were considered immaterial to the company’s operations.

Forty-two years later, Americans’ longer life spans and increasingly expensive health care had dramatically increased the cost. The Financial Accounting Standards Board, a private organization given responsibility by the U.S. government for setting private-sector accounting rules, decided that corporate retirement promises had become material, and it required GM and other companies to begin recognizing their current cost.

The $33 billion charge GM recorded in 1992 was equal to 29 percent of the company’s revenue — well above the 5 percent threshold that accountants commonly use to gauge whether a liability is material. Seventeen years later, these retirement promises were a major factor in GM filing for bankruptcy.

Given this history, consider the Treasury Department’s decision to not accrue for Social Security and Medicare promises. The current cost of these programs is calculated each year by the Government Accountability Office, and described in great detail in appendices. But Treasury’s “Citizen’s Guide” to the GAO financials does not accrue for Social Security or Medicare promises, even though it does accrue for the cost of retirement promises to federal employees and veterans.

This decision is embraced by virtually every one of our elected leaders and accepted by virtually all of our journalists. The $1.3 trillion budget deficit would be $4.2 trillion if the change in the current cost of Social Security and Medicare promises during fiscal 2011 were included. Why is this cost excluded?

It is not because the promises are immaterial. Remember that 5 percent threshold? The current costs of Medicare and Social Security total $33.8 trillion, which is more than 1,400 percent of the federal government’s 2011 revenue.

Instead, the legal reason for this exclusion is that the government follows “obligation-based” accounting standards, which require the recognition of future promises not when they become material but only when they are legally binding.

Since the U.S. government made its first retirement promises in 1935, it has seen the economics of Social Security and Medicare affected by the same demographic and cost trends experienced by the private sector. But because the government can rescind its Social Security and Medicare promises, it does not have to recognize their current costs, even though they are material to its financial condition.

They are also material to the financial expectations of tens of millions of Americans. The typical U.S. household has been promised retirement payments totaling $1.2 million, more than 1,200 percent of its median net worth of $96,000.

Is it acceptable that our leaders are able to promise trillions of dollars to the voters but do not have to recognize the cost because their promises can be rescinded?

If the accounting rules for the private sector changed when corporate retirement promises approached a third of annual revenue, why haven’t those for the government changed when its promises have grown to 14 times its annual revenue?

Americans know something is wrong, and they know hard choices about promises and taxes need to be made. They deserve a clear accounting and an honest discussion of how to fix the system.