CORPORATE PROFITS

The term "corporate profits" refers to the amount of revenue remaining from a corporate enterprise after all expenses—including labor, materials, and taxes —have been paid. Corporate profit is also known as return on capital, or earnings. A company can register a profit only if its revenue from goods sold and/or services rendered is greater than the amount of expenses that the firm has incurred in conducting business. Another measure that is often used to measure corporate worth is cash flow, which refers to the cash receipts or net income of a business—after taxes and other costs —from one or more assets for a given period of time.

Measurement of an establishment's earnings can be determined via a number of accounting methods. Most individuals and many businesses—especially those involved in service industries—use the cash method of accounting, while most corporations use the accrual method. The Internal Revenue Service requires that the accounting method used be implemented fairly and in a way that reflects actual income.

ACCOUNTIN G METHODS

Under the cash method, also known as the cash receipts and disbursements method, a company or individual determines taxable income solely on the basis of transactions that have been completed. Income is included in the taxpayer's gross income in the year in which it is received, even if the income was not earned that year. Similarly, the expenses of users of the cash method are deductible only in the year in which payment is actually made (even if the funds are borrowed); a mere obligation to make payment at a future time is not deductible. The cash method is popular because it often allows the company to choose the year in which it claims the deduction; it can either postpone or accelerate payments of expenses in accordance with its business strategy. Historical users of the cash method have included C corporation service providers with average annual gross receipts of less than $5 million, partnerships owned by individuals, S corporations, and certain personal service corporations.

The accrual method of accounting is used by businesses if they purchase or sell merchandise. Under the accrual method, an establishment figures its gross income for the year by including all payments earned and deductions earned during that year, regardless of when the income is actually received. Income and deductions may be counted under the accrual method if (1) the company has adequately completed all tasks for which it was to receive payment, and (2) the amount due can be determined fairly accurately.

A third method of determining earnings is also available. Known as the hybrid method, it incorporates elements of both the cash and accrual methods. As with the other accounting methods, the Internal Revenue Service (IRS) has imposed limitations on its use. An establishment may change its method of accounting if it gains the permission of the IRS.

In recent years, "the IRS has increasingly challenged the use of the cash receipts and disbursements method of accounting by taxpayers in service businesses," noted Carol Conjura and Jay Kalis in Tax Advisor, because "the cash method of accounting fails to clearly reflect income." Several tax court decisions have favored the IRS in this matter, but Conjura and Kalis observed that in one case "the court found that the Service's determination was an abuse of discretion." The magazine speculated that the decision "may help to forestall and resolve some of the recent challenges taxpayers have faced on examination" of their chosen accounting method.

CORPORATE PROFITS IN THE UNITED
STATES

Profits reported by U.S. corporations grew at an impressive 14 percent rate in 1996 but slowed to 9 percent in 1997, as Nanette Byrnes reported in Business Week. Further reductions seemed likely in 1998 as U.S. companies were increasingly affected by the global economic crisis. Fortune contributor Vivian Brownstein and other analysts attributed much of the recent growth in corporate earnings to cost-cutting measures introduced in the late 1980s and early 1990s. "Many U.S. manufacturers and some retailers are … starting to rake in the payoff from earlier efforts aimed at reducing costs and improving productivity—the slashed employment as well as the investment in automation, inventory monitoring equipment and the like." Corporate efforts to cut or hold the line on operating costs, coupled with rising sales, gradually translated into higher corporate profits.

Economists were initially heartened by such earnings growth. As university economist Fred Moseley stated in Business Week, "profitability is the most important determinant of the health of the economy." Analysts reasoned that high profits spurred increased investment, which contributed to productivity gains. At the same time, however, inflationary pressures were lowered because of already sizable profit margins.

By the late 1990s, however, regulators and investors began to express concern about "the quality of corporate earnings—and the tactics companies are using to calculate them," Byrnes noted. It became increasingly common for companies to use a variety of controversial, yet technically legal, accounting techniques in order to bolster their earnings. One common method involved writing off "in-process research and development charges" at the time of an acquisition. The purchasing company thus takes a large, one-time expense rather than spreading expenses over succeeding years, which has the effect of making future earnings appear much higher. Another common method involved creating a "restructuring reserve—a combination of several years of expected future expenses associated with restructuring a company. By writing off these expenses all at once as an "extraordinary one-time charge," companies are able to increase future reported profits. Finally, many companies chose to use the "pooling" method of accounting for mergers and acquisitions. This method combines the assets of the two companies involved at book value, rather than attributing an excess purchase price to "goodwill" that must be depreciated over several years. Once again, this tactic has the effect of increasing future reported earnings.

' Nervous regulators and investors fear that such huge multiyear write-offs are increasingly distorting corporate earnings—so much so, in fact, that some question whether the underlying meaning of profit numbers and their value as a true reflection of corporate performance is getting trampled," Byrnes contended. "Fueling the trend is the fact that stock traders tend to ignore big 'one-time' charges, focusing instead on prospects. So even if the total dollars spent are the same, companies have a far greater incentive to take one large charge rather than stretch expenses out as money is actually spent. Indeed, the market's reaction encourages executives to make charges as big as possible." Analysts have attributed this problem, at least in part, to the fact that accounting principles have failed to keep up with today's technology-driven economy. In 1998 the Securities and Exchange Commission announced that it would review the accounting methods in question and possibly increase disclosure requirements for companies that apply them.