With the recent announcements by WorldCom and Xerox that
billions of dollars have suddenly disappeared from their previously
announced earnings, investors are now focusing as much on the quality of
corporate profits as their size. Economists are also wondering whether the
rash of restated earnings is corrupting national economic data, such as for
the gross domestic product.
It appears that the problems of investors are more serious than
those for the economists. That is because investor data come from corporate
reports mandated by the Securities and Exchange Commission, while the
Commerce Department's data on corporate profits, which are used to calculate
GDP, come from tax returns.
The distinction is important because the accounting is quite
different in company reports and on tax returns. These distinctions are
perfectly legal. Normally, however, they are not important, except when
someone tries to exploit them for short-term gain, as WorldCom appears to
have done.
What WorldCom did is take advantage of the difference in
accounting for capital and operating expenses. The former would include
equipment and buildings that will last and produce profits for many years.
The Internal Revenue Services requires that they be depreciated over their
useful lives and not deducted all at once. The latter, such as salaries to
workers, are used up in the production process and can be deducted
immediately.
Normally, companies fight with the IRS to be able to "expense"
or write-off as much of their costs in the year in which they occurred.
Bigger write-offs mean lower taxes. Thus companies tend to resist
depreciating investments that they can get away with expensing, while the
IRS tries to force companies to depreciate just about everything, thereby
raising their tax bills.
What WorldCom did was to turn this situation upside down.
Instead of trying to expense capital, it capitalized expenses. It took
operating expenses that should have been deducted from profits immediately
and treated them like capital to be written off over a period of years. The
effect was to artificially lower their costs, thus increasing their reported
profits.
Companies usually don't do this sort of thing because anything
that artificially increases their profits also increases their taxes. The
interesting question, therefore, is what did WorldCom report on its tax
return? My guess is that it did the opposite of what it did on its financial
statements and reported its expenses as expenses and not as capital. In
effect, the company tried to have its cake and eat it, too -- reporting
inflated profits to investors and real profits to the IRS.
For this reason, it is likely that the IRS data on corporate
profits are pretty firm relative to the softer numbers on financial
statements. This is good news because the GDP data are calculated from tax
returns and not from financial statements. Consequently, we can rely to a
much greater extent on the profits data published by the Commerce Department
than those calculated from financial statements, such as those reported by
Standard and Poor's for the 500 largest companies.
Normally, S&P 500 profits move up and down symmetrically with
those reported by the Commerce Department. Since the Commerce data cover all
U.S. corporations and not just the top 500, its figure is always much
larger. In most years, S&P 500 profits equal about 40 percent of total
profits in the U.S. economy. But in 1999 and 2000, they got up to 50
percent. Last year, they fell to just 32 percent, but have rebounded to 52
percent in the first quarter of this year.
If the first quarter data hold up, it suggests that corporate
profitability is stronger than the stock market currently believes. However,
the data are likely to be revised significantly in coming months. Complete
tax data are only available to the Commerce Department through 1999, and the
first data from 2000 are just coming in. Revised corporate profit data will
be available from the Commerce Department later this month.
I believe that a very useful reform would be to require major
corporations to release their tax returns to the public. This would give
financial analysts and investors important data on company operations and
prevent the kind of games that WorldCom played. It will require a change in
law, but in the current political climate that should not be too hard.
Alternatively, organizations like the New York Stock Exchange could require
the release of tax returns as a condition for listing.
Companies will complain bitterly about privacy and the loss of
competitive advantage. But at a time when all corporations are deemed guilty
until proven innocent and investors are desperate for numbers they can
trust, I think it is a small price to pay.
In the meantime, there is nothing to stop a company from
voluntarily releasing its tax returns as a sign of good faith. I would
certainly be much more willing to buy stock in such a company, and I'm sure
that many other investors would, too.
