Carney’s trick shouldn’t fool anyone that future will be rosier

Article content

The father of double-entry accounting, Luca Pacioli, was onto something when he contributed his wisdom in the 15th century to create what we now know is a basic accounting equation: assets = liabilities + equity.

Article content

Article content

Assets represent the resources owned by a business, liabilities represent the financial obligations owed to others and equity represents the owner’s or shareholders’ interest in the business, such as the accumulated historical earnings of the business net of owner distributions and amounts received for issuing stock. The equation ensures that every financial transaction maintains balance in an organization’s books.

Article content

For example, if a business acquires an asset, it must be financed by either increasing liabilities (such as taking a loan) or equity (using retained earnings and/or issuing shares). Governments must use other assets — perhaps by selling those assets or converting them to cash — dip into current net revenues or issue debt since there is no such thing as equity in the traditional sense with governments.

Centuries later, generally accepted accounting principles (GAAP) were born. Each country has slightly different principles and reporting requirements that encompass GAAP, but, for the most part, GAAP is GAAP around the world. In other words, accounting principles have not changed much over the centuries since the foundational accounting equation has not changed.

However, accounting principles can be malleable and flexible. One of the most common manipulations is the classification of assets versus expenses.

The general rule of thumb is that if an economic outlay has a lingering benefit — usually longer than one reporting period, which is commonly a year — then such an outlay is likely an asset or capital outlay. Such assets are then usually amortized over their useful life, with the annual amount being expensed in the current year. Some assets, such as land, never depreciate in value and are therefore not amortized.

Article content

Article content

Accordingly, there is often gamesmanship with capital versus expenses since if it is capital, the income statement is not as adversely affected.

Preparing a budget for revenues and expenses is always a good starting point for organizations to gauge their expected performance in future years. If expenses exceed revenues, that is usually not a good thing since, ultimately, the resulting loss or deficit will need to be financed by borrowing or equity. In a government context, it means borrowing.

But what if the budgeted income statement is manipulated to reduce expenses and instead characterizes such outlays as assets? That means the budgeted income statement appears better than it actually is since the expenses are reduced. GAAP provides general guidance on what capital amounts are versus expenditures, but there is a lot of flexibility in such determinations.

Given this background, my ears perked up when Liberal leadership frontrunner Mark Carney announced a proposed new approach to government budgeting.

“A government led by Mark Carney will separate the federal government’s operating and capital budgets, and make major changes to each,” he said on his website. “It will balance the federal operating budget over the next three years, creating room for personal tax cuts so that Canadians can keep more of their hard-earned money.”

Article content

The statement lacks further details, but you can easily see the trick being attempted here. Carney and his cohorts will attempt to classify expense spending (which would increase the government deficit) as capital items so as to remove such spending from the operational deficit calculation.

What counts as capital? Good question. Without details, it’s a blank cheque to reclassify spending — say, public-sector wages, pet projects or green energy subsidies — as assets or investments. The result? A rosy deficit picture that hides borrowing reality.

Alberta’s provincial government attempted this kind of budgeting exercise in 2013 and then-disastrous premier Allison Redford was thoroughly and rightfully roasted for this lame attempt to make the numbers look better.

There are other examples in recent history. Former United Kingdom chancellor (and later prime minister) Gordon Brown deployed this trick with his version of the Golden Rule from 1997 to 2009, hiding massive overspending and debt accumulation by keeping such amounts away from the operational budget. The same occurred in Greece before the 2008 financial crisis.

Article content

History shows that when politicians use this approach, it often leads to debt spiralling out of control.

What about Carney’s claims that such an approach would lead to personal tax cuts? Well, keep dreaming.

Any Canadian who falls for this promise should do themselves a favour and take a basic accounting course. Again, if you move expenditures off the budget into a capital budget, that does not reduce cash outlays. For governments, it means piling up debt.

If the spending gets too out of control (like it has in Canada), it leads to inflation, a stealth tax that slams the poor the hardest. Governments can only pay for spending increases by raising taxes and/or significantly reducing expenditures — operational and capital. Reduced personal taxes? I’ll believe that when Pacioli comes back from the dead and develops a new accounting equation.

Famous U.S. economist William Niskanen in his 1971 book, Bureaucracy and Representative Government, said, “The separation of current and capital budgets permits the executive and legislative branches to present a partial picture of fiscal policy that conceals the aggregate growth of public expenditure.”

Article content

His warning rings truer than ever given Carney’s proposal. By separating budgets, governments aren’t balancing finances; they’re hiding spending in plain sight.

The bastardization of Pacioli’s basic principles is usually ridiculous and debatable. Carney’s proposals are simply nutty and there’s a long history of others trying this trick.

Canadians need to reject this kind of manipulation. It certainly won’t help them pay less tax.

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at kgcm@kimgcmoody.com and his LinkedIn profile is https://www.linkedin.com/in/kimgcmoody. 

_____________________________________________________________

If you like this story, sign up for the FP Investor Newsletter.

_____________________________________________________________

Bookmark our website and support our journalism: Don’t miss the business news you need to know — add financialpost.com to your bookmarks and sign up for our newsletters here.

Article content