Tax Man is Excited...Profits? are up...

The most recent "news" coming out of Washington D.C.'s cadre of new-age economic experts is that the recession is certainly over as corporate profits are up!

Wonderful...and even believable if you know nothing about corporate financials and how they work. Most people don't of course, and shouldn't be expected to ...it's not how they make a living. But economic advisors to the administration should understand exactly what is happening...their ignorance is both shocking and disturbing.

Corporate financials and tax returns are normally filed quarterly, unlike we normal folk who file after the year's over, so corporate financials give us a more up-to-date look at what is happening. But they're not too up-to-date.

Let me explain that contradiction. Most companies have what we call an operating cycle...an ongoing time period between taking in resources and raw materials, combining them with labor and machinery, then stocking finished goods, selling the goods, and eventually collecting for the goods.

This operating cycle might be a matter of days in length...like a restaurant for example...but manufacturers and distributors have to struggle with cycles that are months, or even years, in length.

What this means is that the company buys raw materials and pays for the stuff...racking up huge expenses...then uses labor to transform the stuff...again racking up expenses...yet doesn't show revenue from sales until long after the expenses have been paid out.

Ah-ha...some of you are already saying to yourselves...and you're right. When a company writes off expenses in their 1st quarter, then is forced to lay people off in the 2nd quarter, suddenly expenses go down dramatically. They are no longer buying raw materials and paying for labor...but now the revenues are coming in and the 3rd and 4th quarters look "great" on paper.

Voila!  Suddenly profits grow...Not!  When you understand business cycles and how they affect the financial statements in the first year or two of a recession, it all makes sense. And you suddenly realize that this "growth" in profits is simply a book keeping anomaly...and the reduction of raw materials and labor expenses indicates a future decline in revenue and profits. This "growth" is not growth...it's a one-time shot...and it's really just on paper! The company's bank accounts could very well be empty as most of the "profits" were pre-spent in quarters one and two and the remainder in quarter three. Very deceptive if you don't know what's happening.

Another question you might be asking...why wouldn't the business try to smooth out the expenses and this one-time profit for tax purposes? Why declare it now?

Firstly, they really can't of course. Generally Accepted Accounting Procedures, or GAAP, really don't allow this and the IRS doesn't care for it either. There is another reason to take the hit this year however...tax rates on business have been increased seriously but don't take full affect until 2010. A company can afford the hit now more easily.

Of course, politicians are drooling...big surprise. "Profits" they exclaim..."why, we must tax those immediately and declare emergency windfall taxes or something to get at that money." Being somewhat ignorant on business financials they don't realize the business cycle and that losses will follow the quarters of profit (or perhaps don't care). Companies cannot afford to spend these paper profits because they really don't exist as we normally think of profits, and they will be soaked up by losses in the following quarters.

"Nonsense," say the politicos...why we're experts in everything. That's simply pro-evil-business propaganda from a highly-paid special interest spokesperson."

Uh....I'm still waiting for the check...haven't received a dime yet.

Unfortunately; some of these businesses, despite these "profits" will be unable to stay afloat. Remember that much of this "profit" has already been spent and the remainder is waiting to be collected by the firm's creditors. Now that the firm is not producing revenue as it did, it may be in long term trouble at this point. If they cannot reduce expenses enough, or come up with enough sales revenue, they may very possibly end up closing their doors and laying off all remaining employees.

Not quite as exciting a picture as the pundits in WA D.C. have been painting...is it? Let's hope future administrations actually bring some business people on board...social workers and community organizers don't seem to get this reality stuff.

The Professor