“If the federal government were a private corporation and the same report came out this morning, our stock would be dropping and there would be talk about whether the company’s management and directors needed a major shake-up.” That was David M. Walker, comptroller general of the United States and head of the U.S. Government Accountability Office (GAO), speaking last December about the 2007 Financial Report of the United States Government.

At 182 pages, the government’s annual report for fiscal 2007 (which ended September 30) isn’t exactly a quick read. Yet, it does tell a disturbing story about the nation’s financial condition — replete with rivers of red ink, accounting black holes, and entitlement bogeymen.

Deficits and debt and unfunded obligations abound. Some liabilities would terrify the most hardened CFO. (Try $45 trillion!) There are signs of short-term hope, but also warnings of long-term fiscal disaster.

In short, there is much in the government’s consolidated financial statements to cause readers to tremble. And frightening numbers become even more so when viewed in the lurid light of the current economy.

Deficit Attention

Let’s start with the red ink. For the seventh year in a row, the government ran a budget deficit in FY 2007 — $163 billion (see “A Study in Scarlet” at the end of this article). On the other hand, for the third year in a row, the deficit shrank. At 1.2 percent of gross domestic product (GDP), the deficit was half the 40-year average of 2.4 percent of GDP, according to the Treasury Department. The government attributes the salutary trend to a stronger economy and greater tax receipts from business.

There’s the rub. With economic indicators pointing to a slowdown or recession, tax revenues are likely to stall. In January, the Congressional Budget Office (CBO) projected that the budget deficit would increase this year to $219 billion, or 1.5 percent of GDP, assuming that current laws and policies remain the same.

In two respects, the current budget deficit is worse than it seems. One, as it has been for many years, the deficit was offset by the surplus from Social Security. Subtract the surplus and the deficit more than doubles, to $344 million, according to the CBO. Two, the budget is calculated on a cash basis. If the cost of the government’s operations is calculated on an accrual basis, as it is in the report, then costs exceeded revenues in FY 2007 by $275.5 billion, thanks mostly to postemployment benefit payments.

Here’s another scary number: $5.1 trillion. That’s the amount of federal debt held by the public. About half of that was held by foreign investors (principally China, Japan, and the United Kingdom, according to the CBO). Still, as a percentage of GDP (36.9 percent), public debt could be worse. Starting in the late 1970s, growing budget deficits led to increased government borrowing, with the result that debt held by the public doubled as a percentage of GDP over 15 years. Cresting near 50 percent of GDP in the mid-1990s, public debt has receded to under 40 percent in this decade.

Black Holes

Now for the black holes. For the 11th year in a row — that is, for each year the federal government has prepared consolidated financial statements and submitted them for an audit — the GAO could not express an opinion on the government’s books, primarily because of material weaknesses in financial reporting.

Of the 24 federal agencies that fall under the aegis of the CFO Act of 1994, 19 did produce a clean set of books (that number has been as high as 21). A 20th CFO Act agency, the Department of Agriculture, earned a qualified opinion from the GAO. But the remaining four — Defense, Homeland Security, NASA, and State — received audit disclaimers, thanks to accounting and control deficiencies. These four plus Agriculture represent 25 percent ($740 billion) of the government’s net cost for 2007 and 57 percent ($895 billion) of the government’s total assets.

The worst offender by far is the Department of Defense. The GAO said the agency could not accurately account for its property, plant, and equipment, which make up 69 percent of the government’s total. Nor could the Pentagon “support significant portions of [its] total net cost of operations.” So large is the agency’s budget — 4 percent of GDP in fiscal 2007 — and so serious are its accounting problems that the government’s books will never be clean as long as the DoD’s are dirty.

“It helps to think of the government as an insurance company with an army,” a White House staffer once quipped. When it comes to financial management, the army is basically AWOL.

The $45 Trillion Threat

The insurance company, on the other hand, is present and accounted for — scarily so. For the second year, the annual report contains a mandatory Statement of Social Insurance (SOSI), which consists of long-range actuarial projections of the costs of Social Security and Medicare, plus a couple of other programs. For the first time, the GAO gave that statement an unqualified opinion.

Among other things, the SOSI estimates the present value of expected outlays by federal insurance programs over the next 75 years, in excess of expected future revenues for those programs. For current participants age 15 and above, that combined value — the long-term fiscal gap — is a staggering $45 trillion.

“It seems clear that our nation is on an imprudent and unsustainable long-term fiscal path that is getting worse with the passage of time,” writes Walker in the GAO’s auditor’s report. Treasury Secretary Henry M. Paulson Jr., in his introduction to the Financial Report, calls for “fundamental reform to ensure the sustainability of” Social Security and Medicare.

Some experts, however, say it is misleading to conflate Social Security and Medicare into a single $45 trillion bogeyman, because Medicare poses a far greater fiscal challenge. The CBO projects Social Security spending to grow from its current 4.3 percent of GDP to 6.4 percent in 25 years and then level off — unlike health-care costs, which are expected to continue to soar. Observes the CBO: “The rate at which health-care costs grow relative to national income — rather than the aging of the population — will be the most important determinant of future federal spending.”

Social Security’s shortfall is $6.7 trillion in present-value terms, according to the SOSI, or 1.8 percent as a percentage of taxable payroll, according to the CBO. (Social Security is funded by a 12.4 percent payroll tax, divided between employees and employers.) Instead of fundamental reform, perhaps Social Security could be fixed through, say, another tax hike and a raising of the taxable-wage cap.

Meanwhile, Medicare’s $34 trillion shortfall over 75 years is predicated chiefly on rising medical costs, not demographics. Unchecked, those costs will eventually derail the economy, whether paid through Medicare or out of private pocketbooks. The solution may be not to reform Medicare, but rather to overhaul the nation’s health-care system.

What the Financial Report of the United States Government makes crystal clear is that the growth of federal mandatory spending — now more than 62 percent of the total budget — is unsustainable in the long run. The same clarity about the government’s discretionary spending, however, won’t emerge until the Pentagon drains its financial-management swamp. Who knows what horrors lurk therein?

Edward Teach is articles editor of CFO.