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The Accounting Cycle
The Biggest Accounting Fraud: Social Security

January 2005If the President and members of Congress and those responsible for the management of the federal government were CEOs and CFOs and directors of business enterprises, they might be in prison today.

I wince when I hear them discuss budget deficits and budget surpluses and the future of Social Security. Maybe they don't know what they are talking about, which is bad enough given their enormous responsibilities. But then again, maybe they do understand, in which case they are as guilty of accounting fraud as Skilling and Lay.

The president has started a campaign to allow the partial privatization of Social Security. Republicans view this as a way to save Social Security and to allow average persons to earn more than the pathetic return on their Social Security investments. Democrats lately have countered that there is no crisis, citing the Congressional Budget Office's claim that funds will exist until 2052. As is typical, whenever the two parties debate an issue, they are both wrong.

The key to comprehending the subject is to conceptualize Social Security as one of the government's special purpose entities (SPE). Ever since the passage of the unified budget act during the Nixon administration, the government has had the privilege of looting the Social Security funds by transferring the money into the general fund, from which Congress can spend on whatever pork projects they wish. This ingenious way of raising taxes without explicit legislation has allowed the president and the Congress the use of an extra $2 trillion over the years.

Unfortunately, the funds are as depleted as one of Adelphia's SPEs. John Rigas might even have learned his scheme from Washington! Recall one of the tricks employed in the Adelphia scandal. Rigas set up an SPE that borrowed money from outside investors. In turn, the SPE lent money to Adelphia and held receivables from Adelphia. Of course, the corporation did not consolidate the SPE with its operations, so outsiders did not appreciate the existence of the SPE's liabilities. On the other hand, Adelphia did not bother to recognize its debts to the SPE, arguing that they are off-balance sheet items. The scheme came tumbling down when the investors discovered that the SPE was sitting on a lot of worthless receivables.

Under unified budgeting, Social Security works the same way, with American laborers serving as the investors. The workers transfer some funds in the form of Social Security  taxes to the social security fund. The Social Security fund takes this cash and gives it to Congress to disburse as it chooses. And Congress refuses to combine these activities with the general fund, treating it as an off-balance sheet liability. Some day this scheme will come crashing down.

The Congressional Budget Office and Democrats make the mistake of believing that Social Security has $2 trillion of assets without examining and realizing that these assets predominately consist of receivables from the general fund. These receivables aren't collectible unless additional taxes are imposed on the populace. (As an aside, what type of return would an investor enjoy if he or she had to ante up the cost of the investment not once but twice?)

Republicans led by Bush make the mistake that privatization solves the problem. Emphatically, it does not. It will still require about $2 trillion to clean up this accounting scandal whether or not privatization occurs. This amount will continue to climb until Congress repeals the unified budget act. (What is attractive about privatization is that it will force Congress' hand since the cash from Social Security is no longer available for its members to loot. Also a plus is that it will start the evolution from an unsound defined benefit plan to a sound defined contribution plan.)

In short, Congress must repeal the unified budget act to prevent further looting of Social Security and to report budget deficits correctly. The second step is to find a way of fairly generating $2 trillion over the next few years to pay back the American workers. I suggest removing the cap on Social Security taxes so that those earning over $87,500 can chip in and help. I would also define stock options as compensation to make sure those who receive corporate stock options do their share to save Social Security.

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle for

2005 SmartPros Ltd. All Rights Reserved.

Editorial content does not represent the opinions or beliefs of SmartPros Ltd.

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