Between the (Balance) Sheets: Why Lawyers Need to Get Intimate with Accounting

[ART #1] MMN Image 1_JupiterIllustrated by Minji Reem

When you stop to think about it, it’s obvious that every financial transaction involves at least two parties: for every buyer, there must be a seller; for every borrower, a lender. Taking this insight to its logical conclusion, it becomes clear that finance is, at its heart, a relational system. If everyone recorded every good, service, loan, investment, and transaction and tallied them up, all the numbers would net precisely to zero.

Given how simple this point is, why is it, then, that whenever we discuss the merits of big, bold, public initiatives—like, say, tackling climate change or child poverty—many of us instinctively wince at the price tag? After all, when it comes to domestic spending, the public sector’s deficit is a private sector surplus, to the penny. As we’ve written before, the government doesn’t actually rely on our tax dollars to fund its spending. In other words, the government’s red ink is our black ink. Even law students, trained to think in adversarial terms of who “gives” and who “takes,” tend to evaluate policy proposals by asking “how much does it cost?” rather than “how much does it cost for whom?”

Such myopia is pervasive in discussions about lending as well as spending. For example, politicians on both sides of the aisle frequently express concern about the U.S. selling Treasury debt to China for dollars, yet never stop to consider that Chinese firms only have dollars in the first place because they previously sold goods to American households and firms.

Accounting for Advocates

A major cause of the problem is the widespread misuse of accounting language in public discourse. Accounting, as the name would suggest, is about accountability. Its function is not merely to provide a common vocabulary for tallying our personal assets and debts, but also to record and structure the credit and debt relationships that bind society together. Accounting methods are social technologies, common reference points that adapt and evolve in response to feedback. They are not objective, neutral, or without controversy. Instead, they are wrought via politics, manifested in law, and implemented by fallible institutions and real people with real agendas.

We at MMN-CLS believe that if lawyers are going to play the economy game, it is important for them to know the rules for keeping score. Not only because money itself is a legal construct, but also for our clients’ sake. After all, the importance of accounting issues to the common law has been evident since at least 1938, when Adolf Berle (former Columbia professor, FDR advisor, and corporate law giant) wrote that prevailing accounting rules, though “un-systematized and indefinite,” had effectively become a form of “super-judicial legislation.”

But look, we get it. Accounting isn’t a particularly sexy topic for law students. To paraphrase John Oliver, it combines two things most of us hate: numbers and also math. But day in and day out, lawyers and policymakers are faced with people presenting big, scary figures as though they threaten our very existence. It is vital to understand what these figures really mean, and this means viewing them through the lens of accounting.

Unfortunately, accounting policy debates tend to be dry and technical, and as a result are rarely acknowledged, let alone understood, by those who aren’t specialists. Perhaps even worse, when accounting issues do come under public scrutiny, such as with the debt-ceiling crisis, they tend to be grossly misunderstood by politicians, the media, and the public alike.

Yet, as advocates for economic justice, we cannot afford to concede the terrain.  Although accounting rules do not divide the world as visibly or as harshly as property law, they are, nevertheless, still coercive legal acts of economic distribution. Indeed, in the context of early 21st-century, late-stage financial capitalism, small decisions about accounting methodology can have global ramifications.

bumperIllustrated by Minji Reem

Seeing Double(-Entry)

One of the most common and egregious #AccountingFails in contemporary political discourse is to apply single-entry accounting logic to our modern double-entry accounting-based economy. Many politicians, for example, talk as if we live in an economy where individuals balance their checkbooks against themselves, in isolation. Rather than acknowledging the relational and relative nature of financial wealth, they talk as if money is merely another commodity to be generated, exchanged and accumulated through private exchange. And, like with any commodity, the aim is to get as much as possible. Surpluses are good, deficits are bad.

But the modern financial world is truly built on the “double-entry” bookkeeping method. Double-entry bookkeeping dictates that every transaction has equal and opposite effects. For example, if you sell a contracts hornbook to a 1L for $20, your “Cash” assets go up by $20, but your “Hornbook” assets go down by $20. Your overall equity (net worth) stays the same, because you still have $20 worth of assets—you just traded a book for cash. Simultaneously, the 1L’s “Cash” assets go down by $20, but their “Hornbook” assets go up by $20. The 1L’s equity stays the same, because she traded cash for a book.

transactionIllustrated by Nelson Hua

Beyond record keeping, the double-entry method creates a comprehensive system whereby accounts are debited and credited in order to maintain balance sheets, which are comprised of financial assets (A), liabilities (L), and equity (E). A balance sheet is “balanced,” because its assets always equal its liabilities plus its equity (A = L + E). Assets include all of the items that you own, including cash. Liabilities represent everything you owe to someone else. Equity, also known as net worth, represents the difference. A = L + E. Always. Although the rules of accounting aren’t set in stone, these are the closest analogues that modern finance has to the laws of physics.

In our hypothetical above, for example, you would make entries on your balance sheet to reflect the sale of the book and the receipt of cash. The 1L, in turn, would make entries on her balance sheet to show the purchase of the book and the outflow of cash.

Balance sheets, which track relational effects, make it easier for us to spot errors and assess relative financial positions: One’s financial asset is another’s financial liability. We can even view the entire global financial system as a single network of interlocking balance sheets.

Debts to Society

Double-entry logic thus also helps clarify our thinking at the macro level. For example, many people fear the growing size of the U.S. public debt, but in reality these fears are grossly overblown, as government securities (i.e. public debt) are considered safe, valuable assets by the private sector.

At an even more basic level, the U.S. government is a rich monetary sovereign with its own central bank, and it denominates all of its debts in its own currency. In other words, it can’t “go broke.” It’s common to ask Washington to “balance its checkbook,” but can we really ascribe an accurate dollar value to intangible government assets like the legal power to levy taxes, or to the power to create and regulate the value of money? Although we should always think about the flows between the government and non-government sectors, it’s simply wrong to pretend Uncle Sam’s balance sheet works the same way as yours, Google’s, or even J.P. Morgan’s.

In our current news cycle, you can see clear examples of accounting language abuse in the federal budget debates around “fair value accounting”  and  “dynamic scoring.

Fair value accounting is a methodology included in the Generally Accepted Accounting Principles (GAAP), the accounting standards for non-governmental entities adopted by the SEC.  A “fair value” balance sheet reflects the current market value of an organization’s assets, as opposed to the price originally paid (imagine, for example, a house bought for $40,000 in 1950, that is worth $4 million today). This allows investors to more accurately determine the present value of an organization’s assets, in addition to the historical value.

The Republican-controlled House and Senate both recently passed budget resolutions that apply private-market fair value accounting standards to government credit programs, thereby artificially and inaccurately inflating these programs’ estimated costs. Effectively, these budget resolutions require that the government value the cost of government lending programs in the same way that the programs would be valued by a private-sector company. So, for example, instead of valuing the Stafford Student Loan program at its actual, nominal cost to the government in relation to the Treasury yield rate (the current method), the Congressional Budget Office would be required to factor in the additional costs that hypothetical private banks would have had to pay if they had financed the program instead.

This approach is problematic for a number of reasons, not least of which is that it completely ignores that the federal government’s assets include the powers to tax and create money. On one hand, private banks are constrained in their ability to extend credit on the basis of liquidity, leverage, and capital. Consequently, they are required to deduct the expected risk of loss from a loan program valuation, and charge extra “risk premiums” when lending to other banks, businesses, and consumers. On the other hand, with respect to his balance sheet, Uncle Sam doesn’t really need to worry about the opportunity costs of forgoing profitable ventures, or financial constraints from too many borrowers defaulting, because he doesn’t need to earn a profit in order to survive. No matter how many non-performing loans the government chooses to hold, federal government checks won’t bounce. There will never be a run on the Federal Reserve, nor will the FDIC ever shut it down, because a central bank, unlike a private bank, cannot become insolvent. Thus, it makes no accounting sense to calculate the cost of government lending in the same way as bank lending. Instead, the government should focus on analyzing the distributional effects of channeling investment into particular ventures over others.

This point is well-known by savvy investors, which is why even they don’t value government loans like private loans. It’s also the reason that the Center for American Progress refers to fair value accounting as “added cost accounting.” Yet many Congressional Republicans nevertheless continue to support this accounting gimmick because it bolsters their charges about wasteful government spending, and provides them with cover to cut critical public lending programs for small business owners, college students,  and rural communities.

Another problematic accounting practice touted by the Republican caucus is known as “Dynamic Scoring.” Under this approach, agencies and/or legislators must include in their budgetary estimates for any new program, bill, or regulation not only its book costs, but also any anticipated indirect “macroeconomic” costs, such as those associated with regulatory compliance or environmental preservation. This is a classic example of single-entry thinking. Dynamic Scoring heavily emphasizes the macroeconomic costs of government programs, but ignores the possibility of corresponding macroeconomic benefits, particularly those that defy monetary quantification. This problem also affects the broader regulatory-accounting practice known as cost-benefit analysis (CBA), which requires regulators to compare the estimated costs and benefits of a proposed regulation before enacting the regulation. CBA is often used to stymie government regulations and programs whose positive social impact is large but difficult to measure—such as those instituted in response to the Deepwater Horizon explosion, the global financial crisis, and the recent measles outbreak. Although achieving the capacity to measure macroeconomic effects of a particular government program is a laudable, and even useful, goal, it ultimately depends on who is doing the counting, and even more fundamentally, whether or not the program’s effects are actually quantifiable in the first place.

What Hangs in the Balance

At the end of the day, whether we’re talking about the national debt, the cost of financial regulation, or the default risk of student loans, the rules that govern balance sheets matter enormously. And as all law students know, ignorance of rules can be used against you and those whom you represent. Consequently, when thinking about matters of money and finance, we would all do well to keep in mind the saying: “those who refused to be conned, count!”


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