California Bankruptcy: IOUs from the Terminator!

Last week was a mighty depressing one for any American living in one of the seven states that failed to pass an annual budget. Californians, for instance, were treated to the sad spectacle of Governor Arnold Schwarzenegger vowing to issue IOUs instead of cash payments to any one expecting cash payments from the Golden State.

The Governor once rose to fame on the strength of his Terminator character’s famous film vow “I’ll be back.” But in his current role, he is forbidden by law from seeking another term, and his lame duck status has drained him of any real power in state politics.

But what was it about last week that brought so many states to the brink of financial catastrophe? The answer, it seems, can be found in the arcane field of governmental accounting principles.

GASB vs. FASB

There are all sorts of oddities that exist in the realm of governmental accounting practices in the United States. For instance, did you know that the Financial Accounting Standards Board (FASB) does not establish Generally Accepted Accounting Principles (GAAP) for state and local governments?

That’s right; the FASB establishes GAAP for all American entities except state and local governments. A different quasi-regulatory body, one called the Governmental Accounting Standards Board (GASB), establishes GAAP for those entities.

By the way, the GASB offices aren’t located in or near Washington DC, the capitol of our national government. They’re actually located in the same building as the FASB; in fact, the two bodies even share visitor parking spots with each other!

Same parking spots, same office development … heck, even the same mission: establishing GAAP. Then why is the GASB necessary? Why can’t the FASB handle GAAP for state and local governments, as they do for all other sectors of American society?

GASB itself explains that “governments are fundamentally different” than other sectors, and that “the information needs of the users of government financial statements are different” as well. But why is this true? And why did it lead seven states to the brink of fiscal suicide last week?

The Perils of State Budgeting

Before we plunge into the bizarre aspects of state budgeting, let’s remind ourselves of a few universal accounting and legal principles that apply to most other organizations.

To begin with, most organizations are permitted to earn profits. Even “nonprofits” can earn profits, as long as they reinvest their surpluses in the future development of their charitable activities.

And how do most organizations earn funds to pay their obligations? They sell products and services to customers, and they collect payments from them. If demand for their products and services decline, then revenues and cash collections decline as well, and organizations cut back on operations to reduce their expenditures accordingly. The only ways to avoid such cutbacks are to borrow money from banks, to seek new funding from investors or donors, to sell existing assets, and/or to dip into cash stockpiles.

State governments, though, don’t adhere to these universal principles at all. To begin with, states generally don’t earn profits. Although some try to maintain rainy day funds, most state legislators will opt for tax cuts and new spending programs whenever taxation revenues exceed expenditures.

Furthermore, with the exception of a few user fees for services like automobile registrations and state park admission tickets, states generally do not collect revenues for services rendered. Instead, states generally collect most of their revenues from real estate, sales, and income taxes, and then spend these proceeds on public education, transportation, police, fire, sanitation, and other essential services.

So what happens when large numbers of citizens lose their jobs? Well, state revenues tend to decrease, but the demand for state services tend to increase. So cutbacks become extremely difficult because the demand for government services actually soars at the very time when the revenues required to pay for them decline. That’s a sure fire prescription for financial Armageddon!

But Why Last Week?

Those are pretty unusual conditions, aren’t they? In fact, it’s not surprising that state and local governments, as well as the users of their financial statements, feel more comfortable with their own unique Board for establishing GAAP!

There’s still one question, though, that begs for an explanation. Namely, why last week? What was it about the week leading up to Independence Day that caused dramatic budget crises in seven states?

The answer to that question is a simple one. Virtually all states require themselves to balance their budgets every year.

Let’s think about that for a moment. We all know that state governments cannot easily cut services when their revenues decline because the demands of their citizens increase in times of economic recession. And states can’t seek funding from investors or donors, or sell critically needed state assets.

So one would think that the only available alternative to balancing budgets would be to finance deficits by issuing debt in times of recession, and then repaying those long term liabilities in times of prosperity. But by requiring themselves to balance their budgets every year, state legislators make it impossible to run annual deficits.

Thus, in recessionary times, many states hit a proverbial wall at the annual deadline for passing the following year’s budget. And for most states, that deadline is the final day of the current fiscal year, i.e. June 30.