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The Commerce Department recently reported that pre-tax cor porate profits had soared at a 40percent annual rate (to $140 billion) in the first quarter of the year, following strong gains in the 1971-72 period and a whopping 29-percent increase in 1973. However, the news generated few smiles in cor porate boardrooms, partly because the gains were very uneven among industries, and for other reasons as well. Profits typically rise sharply during business expansions (and fall sharply in recessions), in con trast to the relatively steady long term uptrend in wages. Moreover, recent statistics may not be as strong as they appear; many analysts, in fact, now question the "quality" of the profits data re ported by corporations, claiming that they are overstated by onefourth or more because of their inflation-swollen inventory com ponent and insufficient write-offs for older plant arid equipment. The situation disturbs corporate treasurers because they foresee the need for a continued high level of profits in the years ahead to supply investable funds for the nation's myriad needs, such as breaking capacity bottlenecks, developing new energy sources, and cleaning up the environment. However, in ventory profits don't provide a reliable source of investment funds, and neither do the profits derived from the underdepreciation of existing capital assets. Corporations thus are under growing pressure, not only to improve their earnings1 1 Digitized for FR A SER position but also to make reported profits a more accurate and economically meaningful measure. Poor accounting Inventory profits in the first quarter of 1974 amounted to a massive $31 billion (annual rate)— more than one fifth of total earnings— as suc cessive price increases added retro actively to the value of goods in stock. Even so, a large share of that total resulted simply from the choice of accounting system made by most firms. Especially during an inflation period, the size of reported profits is strongly influenced by the ac counting method chosen— last-in first-out (LIFO), first-in first-out (FIFO) or whatever. The UFO method, in which the in ventories that are sold or otherwise used up are charged with the cost of the most recently acquired stocks, works to reduce reported profits when prices are rising. It does so because recently purchased goods are usually higher priced than earlier acquisitions. But only about onefourth of all major corporations utilize UFO, and most use other accounting methods that tend to overstate profits. The widely-used FIFO method suffers from this failing because it includes in reported profits a sizable amount of what essentially are capital gains on inventories— and by enlarging profits in this way, it also expands tax liabilities, leaving smaller amounts available for future investment. (continued on page2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. The same type of exaggeration results from the impact of inflation on depreciation allowances. Ac counting tradition and tax law both favor the use of original-cost depre ciation, even though use of that method could lead to the understatement of the value of business capital (and therefore of depreciation) in inflationary periods such as today. The situation has been helped only partially by the legislative liberalization of de preciation allowances in 1954,1962 and 1971. By failing to take full ad vantage of methods appropriate to an inflationary period— such as accelerated depreciation— non financial corporations may have under-depreciated their plant and equipment by as much as $7 billion in 1973. Poor record Beyond the problem of measure ment, there stands the basic ques tion of the adequacy of profits for motivating— and financing— the necessary expansion of productive investment. Increasing doubts are surfacing on this score, although few observers would yet agree with the perennial pessimist, George Terborgh, who recently said, "The rein2 2 Digitized for FR A SER vestment of corporate earnings, realistically measured, has almost ceased." A straw in the wind is the growing tendency for internally generated funds (retained profits and depre ciation allowances) to fall short of corporate spending for plant, equip ment and inventories. During the 1971-73 expansion, internal funds fell 30 percent short of such ex penditures. In contrast, the shortfall amounted to only 14 percent and 3 percent, respectively, in the com parable business expansions of the mid-1950's and early 1960's. The problem was attributable not to depreciation but rather to retained earnings, which amounted to only 91 percent of net funds raised by /2 corporations in the 1971-73 expan sion, compared with a 20-percent contribution in each of the earlier expansions. Poor future? Thus, no matter how well corpora tions counteract the effects of infla tion by adopting LIFO accounting and accelerated depreciation methods— and they have a long way to go in this respect— they still may not be generating a sufficient flow of earnings to meet essential invest ment needs of the coming decade. In past periods, the relative shares of capital and labor in the national income tended towards long-term stability, with the real return to each of those factors of production rising about 3 or 4 percent a year. But al though the capital (profits) share rose in 1973 for the third year in a row— to 11.7 percent of gross corporate product— it still remained lower than at any other time since World War II. The capital share lagged behind its pre-1970 performance even with the inclusion in that measure of net interest, a return to capital whose importance has risen sharply in the past decade. A number of reasons could be cited for this apparent decline in the return to capital. One hypothesis, advanced by Alan Greenspan, is that the labor-management balance has shifted in favor of labor in the postwar period. According to this view, the wage-bargaining process now generates a higher average wage than formerly because of the decreasing incidence of actual hard ship during unemployment periods, what with the availability of such income supplements as unemploy ment compensation, welfare pay ments and food stamps. Another argument suggests that profits have been hurt by the changing legal environment surrounding busi ness activity, because of the sub stantial cost increases generated by environmental, consumer, fac tory-safety and equal-opportunity legislation. An alternative explanation, developed by Albert Burger, 3 Digitized for FR A SER relates the low profit share in the early 1970's to the length of the previous business expansion. During the prolonged period of growth of the 1960's, total spending (and prices) accelerated, giving firms a strong incentive to expand their capital stock. Further incentive came from the liberalization of asset depreciation rules and the several changes in investment tax credits. The resulting increases in capacity which came on line in the late 1960's and early 1970's were not . fully utilized. Consequently, the average cost of production rose and the profit rate fell. But this depressing factor may have been overcome during the strong 1972-73 expansion, with firms experiencing a rise in output per person and a consequent improvement in profits, as would be expected as they moved down along their average cost curve. No one knows how well corporate profit margins— and the profit share of income— will hold up in the face of all the diverse factors noted above. Suffice it to say that the task will remain difficult as long as the economy remains distorted by inflation, with its resultant misallocation of resources. William Burke ®/2) o c= 3 uojSumsEM • MPifl • uoSaJO • epeA3f\| . oqepi M EM EH • E | U JO p | E 3 . EU O ZU V •JJ|B3 'O D S p U E J J U B S ZSL ON llW R3d aivd aovisod sn nvw s s v i d isaid BANKING DATA— TW ELFTH FEDERAL RESERVE D ISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Com m ercial Banks Amount Outstanding 6/5/74 Change from 5/29/74 Change from year ago Dollar Percent + + + - + 8,974 + 8,428 + 86 + 2,687 + 2,942 + 880 - 542 + 1,088 + 6,989 + 618 6 + 6,237 - 372 + 6,858 - 328 + 4,598 12.19 15.04 6.84 13.23 18.06 10.50 9.48 9.18 9.75 2.92 1.35 12.83 2.04 33.64 — 4.42 + 49.09 82,600 64,479 1,343 23,003 19,232 9,258 5,176 12,945 78,653 21,809 440 54,864 17,858 27,247 7,087 13,964 Weekly Averages of Daily Figures Week ended 6/5/74 Week ended 5/29/74 Comparable year-ago period 86 256 170 30 415 385 134 193 - 59 + 1,371 + 1,316 + 487 + + + 116 Member Bank Reserve Position Excess Reserves Borrowings Net free (+ ) / Net borrowed (—) Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases (+ ) / Net sales (—) Transactions: U.S. securities dealers Net loans (+ ) / Net borrowings (—) - 401 290 45 144 79 22 1 56 — 189 + 113 + 446 — 226 - 219 + 10 — 57 — 238 — 198 + + + + + + + + + — + + Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) - 287 *Includes items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. Digitized for FR A SER • B>|SE|V
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