E Investment Decisions Made On The Basis Of Government’s Income Statement And Balance Sheet

Webster’s dictionary defines allegory as a story in which people, things or happenings have a symbolic or hidden meaning that can be used effectively in teaching or explaining difficult ideas.Accordingly, an allegoric story is used here to explain the important difference between a government income statement and balance sheet, and its application for investment decisions in financial markets.

Simplistically, the government’s income statement records all its activity over a specific period of time during which it brings in revenues, disburses some benefits and pays some expenses. Individual and corporate income taxes provide the lion’s share of those revenues.When the cost of government and its expenditures are deducted from its revenues the balance is either a surplus or savings, or as has been our experience over the last few decades – there is a budget deficit.Such deficits have to be financed, and it results in persistent issue and growth of our national debt.In our allegory, the budget deficits will be represented by a not large hole in the hull of a ship, whereas the governmental debt is represented by the accumulated flow of water in the hull of a ship

The balance sheet of our government shows its assets, which include value for its vast holdings of land, and liabilities which should include our sovereign national debt and all unfunded liabilities.The difference between these two values, in accounting terms, would show the net worth of the nation.A large positive value would imply that the U.S. is a wealthy country, whereas a large negative value would signify that the country cannot honor or fully pay its liabilities and is bankrupt.

Corporations and individuals are presently required to provide accounting of their activities to the government on a quarterly basis in order that it may collect tax revenues on a timely basis.It is noteworthy that there are two acknowledged methods of accounting; on a cash basis, one only records the amounts actually received or expended during the accounting period, whereas on generally accepted accounting principle basis (GAAP) one has to recognize revenues and expenses on an incurred basis.  Under GAAP, the sale of a large project or product which provides a multi-year revenue stream, or the multiyear expenditure of contractual amounts from an agreement would have to be recognized in the year the contract was signed.

It is noteworthy that our government does not conduct its accounting on a GAAP basis -which it demands from all corporations.It may be said, without exaggeration, that if corporations did their accounting on a basis consistent with that of government that the officers of these corporations would be jailed for fraud.It is easy to see why this would be the case by citing one simple example: if corporations only showed the amount they expended for retired employee pensions in the present year rather than the amounts necessary to be set aside to fund future pensions for all employees they would be substantially understating their liabilities thereby fraudulently inflating the company’s net worth.Accordingly, under its cash accounting basis, government accounting records the amounts expended for Social Security, Medicare and other welfare programs for the current year, but neither does it calculate or show the amount of the actual liability nor the amount necessary to be set aside to fully fund those liabilities. A respected professor/economist at the Boston University, Laurence Kotlikoff, has estimated that on a GAAP accounting basis our government has unfunded liabilities of approximately $200 trillion, rendering the nation unable to meet its financial obligations of the future – therefore bankrupt.

For decades our government has used misdirection, now called fake news, which keeps the populace and Congress from focusing on the real problems of governance.  Our media will focus on sex scandals or wars, while our elected officials’ fiscal spending transgressions have accumulated to levels now endangering our financial markets and the solvency of this very nation.For this reason, any means, including the use of allegory, is reasonable to bring attention to and explain in simple terms the plight of our endangered nation, and the faulty illusion of soundness in financial markets.

Investment decisions

Classical investment analysis for equities would require an informed investor to first look at the market’s investment environment as a whole.If that environment is healthy, then there is more opportunity of profitable investment when compared to an economic environment which is weak.One would select an industry which is stable or growing and has a good regulatory record, and then look to analyze individual companies.That company could be small with expectations of rapid revenue and earnings growth, or it could be a relatively large company where the rate of growth is lower but it is balanced by the expectations greater stability of results.In our allegory increased growth will be represented by a ship of state moving at a faster speed.

Equity investors are often less concerned with a company’s balance sheet as opposed to its income statement.Supposedly, growth in revenues and earnings will fix all corporate problems.But this is not always so.A company developing a new product for its market uses up its cash balances in that process.If its cash is spent before the product is available to be sold in the market, and further borrowing is denied by investors, the company is forced to close down – with prior investors losing their money.

Fixed income investors are not so much interested in huge capital gains but rather in the certainty of receiving regular cash disbursements in addition to getting the original loan repaid.This type of investor is much more interested in the soundness of that company’s assets, liabilities and its net worth.This investor focuses on that company’s ability to repay all of its liabilities, and therefore is highly interested in the company’s balance sheet.  It should be obvious that the fixed income investor is more conservative than the equity investor.  In our allegory, a lack of financial soundness is represented by the draft of the ship (the part under water) and the size of the hole in its hull that allows water to flow into the ship’s hull and endanger its eventual sinking – regardless of the speed at which the ship is moving forward.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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