What's the real federal deficit? The federal government keeps two sets of books. The set the government promotes to the public has a healthier bottom line: a $318 billion deficit in 2005. The set the government doesn't talk about is the audited financial statement produced by the government's accountants following standard accounting rules. It reports a more ominous financial picture: a $760 billion deficit for 2005. If Social Security and Medicare were included — as the board that sets accounting rules is considering — the federal deficit would have been $3.5 trillion. Congress has written its own accounting rules — which would be illegal for a corporation to use because they ignore important costs such as the growing expense of retirement benefits for civil servants and military personnel. Last year, the audited statement produced by the accountants said the government ran a deficit equal to $6,700 for every American household. The number given to the public put the deficit at $2,800 per household. A growing number of Congress members and accounting experts say it's time for Congress to start using the audited financial statement when it makes budget decisions. They say accurate accounting would force Congress to show more restraint before approving popular measures to boost spending or cut taxes. "We're a bottom-line culture, and we've been hiding the bottom line from the American people," says Rep. Jim Cooper, D-Tenn., a former investment banker. "It's not fair to them, and it's delusional on our part." The House of Representatives supported Cooper's proposal this year to ask the president to include the audited numbers in his budgets, but the Senate did not consider the measure. Good accounting is crucial at a time when the government faces long-term challenges in paying benefits to tens of millions of Americans for Medicare, Social Security and government pensions, say advocates of stricter accounting rules in federal budgeting. "Accounting matters," says Harvard University law professor Howell Jackson, who specializes in business law. "The deficit number affects how politicians act. We need a good number so politicians can have a target worth looking at." The audited financial statement — prepared by the Treasury Department — reveals a federal government in far worse financial shape than official budget reports indicate, a USA TODAY analysis found. The government has run a deficit of $2.9 trillion since 1997, according to the audited number. The official deficit since then is just $729 billion. The difference is equal to an entire year's worth of federal spending. Surplus or deficit? Congress and the president are able to report a lower deficit mostly because they don't count the growing burden of future pensions and medical care for federal retirees and military personnel. These obligations are so large and are growing so fast that budget surpluses of the late 1990s actually were deficits when the costs are included. The Clinton administration reported a surplus of $559 billion in its final four budget years. The audited numbers showed a deficit of $484 billion. In addition, neither of these figures counts the financial deterioration in Social Security or Medicare. Including these retirement programs in the bottom line, as proposed by a board that oversees accounting methods used by the federal government, would show the government running annual deficits of trillions of dollars. The Bush administration opposes including Social Security and Medicare in the audited deficit. Its reason: Congress can cancel or cut the retirement programs at any time, so they should not be considered a government liability for accounting purposes. Policing the numbers The government's record-keeping was in such disarray 15 years ago that both parties agreed drastic steps were needed. Congress and two presidents took a series of actions from 1990 to 1996 that: • Created the Federal Accounting Standards Advisory Board to establish accounting rules, a role similar to what the powerful Financial Accounting Standards Board does for corporations. • Added chief financial officers to all major government departments and agencies. • Required annual audited financial reports of those departments and agencies. • Ordered the Treasury Department to publish, for the first time, a comprehensive annual financial report for the federal government — an audited report like those published every year by corporations. These laws have dramatically improved federal financial reporting. Today, 18 of 24 departments and agencies produce annual reports certified by auditors. (The others, including the Defense Department, still have record-keeping troubles so severe that auditors refuse to certify the reliability of their books, according to the government's annual report.) The culmination of improved record-keeping is the "Financial Report of the U.S. Government," an annual report similar to a corporate annual report. (The 158-page report for 2005 is available online at fms.treas.gov/fr/index.html.) The House Budget Committee has tried to increase the prominence of the audited financial results. When the House passed its version of a budget this year, it included Cooper's proposal asking Bush to add the audited numbers to the annual budget he submits to Congress. The request died when the House and Senate couldn't agree on a budget. Cooper has reintroduced the proposal. The Federal Accounting Standards Advisory Board, established under the first President Bush in 1990 to set federal accounting rules, is considering adding Social Security and Medicare to the government's audited bottom line. Recognizing costly programs Adding those costs would make federal accounting similar to that used by corporations, state and local governments and large non-profit entities such as universities and charities. It would show the government recording enormous losses because the deficit would reflect the growing shortfalls in Social Security and Medicare. The government would have reported nearly $40 trillion in losses since 1997 if the deterioration of Social Security and Medicare had been included, according to a USA TODAY analysis of the proposed accounting change. That's because generally accepted accounting principles require reporting financial burdens when they are incurred, not when they come due. For example: If Microsoft announced today that it would add a drug benefit for its retirees, the company would be required to count the future cost of the program, in today's dollars, as a business expense. If the benefit cost $1 billion in today's dollars and retirees were expected to pay $200 million of the cost, Microsoft would be required to report a reduction in net income of $800 million. This accounting rule is a major reason corporations have reduced and limited retirement benefits over the last 15 years. The federal government's audited financial statement now accounts for the retirement costs of civil servants and military personnel — but not the cost of Social Security and Medicare. The new Medicare prescription-drug benefit alone would have added $8 trillion to the government's audited deficit. That's the amount the government would need today, set aside and earning interest, to pay for the tens of trillions of dollars the benefit will cost in future years. Standard accounting concepts say that $8 trillion should be reported as an expense. Combined with other new liabilities and operating losses, the government would have reported an $11 trillion deficit in 2004 — about the size of the nation's entire economy. The federal government also would have had a $12.7 trillion deficit in 2000 because that was the first year that Social Security and Medicare reported broader measures of the programs' unfunded liabilities. That created a one-time expense. The proposal to add Social Security and Medicare to the bottom line has deeply divided the federal accounting board, composed of government officials and "public" members, who are accounting experts from outside government. The six public members support the change. "Our job is to give people a clear picture of the financial condition of the government," board Chairman David Mosso says. "Whether those numbers are good or bad and what you do about them is up to Congress and the administration." The four government members, who represent the president, Congress and the Government Accountability Office, oppose the change. The retirement programs do "not represent a legal obligation because Congress has the authority to increase or reduce social insurance benefits at any time," wrote Clay Johnson III, then acting director of the president's Office of Management Budget, in a letter to the board in May. Ways of accounting Why the big difference between the official government deficit and the audited one? The official number is based on "cash accounting," similar to the way you track what comes into your checking account and what goes out. That works fine for paying today's bills, but it's a poor way to measure a financial condition that could include credit card debt, car loans, a mortgage and an overdue electric bill. The audited number is based on accrual accounting. This method doesn't care about your checking account. It measures income and expenses when they occur, or accrue. If you buy a velvet Elvis painting online, the cost goes on the books immediately, regardless of when the check clears or your eBay purchase arrives. Cash accounting lets income and expenses land in different reporting periods. Accrual accounting links them. Under cash accounting, a $25,000 cash advance on a credit card to pay for a vacation makes the books look great. You are $25,000 richer! Repaying the credit card debt? No worries today. That will show up in the future. Under accrual accounting, the $25,000 cash from your credit card is offset immediately by the $25,000 you now owe. Your bottom line hasn't changed. An accountant might even make you report a loss on the transaction because of the interest you're going to pay. "The problem with cash accounting is that there's a tremendous opportunity for manipulation," says University of Texas accounting professor Michael Granof. "It's not just that you fool others. You end up fooling yourself, too." Federal law requires that companies and institutions that have revenue of $1 million or more use accrual accounting. Microsoft used accrual accounting when it reported $12 billion in net income last year. The American Red Cross used accrual accounting when it reported a $445 million net gain. Congress used cash accounting when it reported the $318 billion deficit last year. Social Security chief actuary Stephen Goss says it would be a mistake to apply accrual accounting to Social Security and Medicare. These programs are not pensions or legally binding federal obligations, although many people view them that way, he says. Social Security and Medicare are pay-as-you go programs and should be treated like food stamps and fighter jets, not like a Treasury bond that must be repaid in the future, he adds. "A country doesn't record a liability every time a kid is born to reflect the cost of providing that baby with a K-12 education one day," Goss says. Tom Allen, who will become the chairman of the federal accounting board in December, says sound accounting principles require that financial statements reflect the economic value of an obligation. "It's hard to argue that there's no economic substance to the promises made for Social Security and Medicare," he says. Social Security and Medicare should be reflected in the bottom line because that's the most important number in any financial report, Allen says. "The point of the number is to tell the public: Did the government's financial condition improve or deteriorate over the last year?" he says. If you count Social Security and Medicare, the federal government's financial health got $3.5 trillion worse last year. Rep. Mike Conaway, R-Texas, a certified public accountant, says the numbers reported under accrual accounting give an accurate picture of the government's condition. "An old photographer's adage says, 'If you want a prettier picture, bring me a prettier face,' " he says. Enlarge By Win McNamee, Getty Images Rob Portman, director of the Office of Management and Budget, presents "The Mid-Year Budget Review" at the National Press Club on July 11. Due to increased tax receipts, the Bush administration says it's goal of cutting the federal deficit in half by 2009 is a year ahead of schedule. But deficit numbers vary depending on who's counting.