EARNINGS COULD SUFFER SOME WEAR AND TEAR / THE WALL STREET JORNAL

Heard on the Street

Earnings Could Suffer Some Wear and Tear

Aug. 28, 2014 4:12 p.m. ET

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According to the Commerce Department, it is the best of times and the not-so-best of times for corporate America.

Official data put out Thursday show that U.S. corporate profits reached a high in the second quarter. Yet the same release reported that profits were about 10% below their 2013 peak.

It is a discrepancy worth paying attention to.

Alongside its revised estimate for gross domestic product, the Commerce Department reported that total after-tax corporate profits rose to $1.84 trillion last quarter, at an annual rate, a record. That was equal to 10.6% of GDP, not far from the record 10.7% that this broad measure of profit margins achieved in the third quarter of last year.

But a measure of economic profit told a different story. This showed after-tax profits of $1.5 trillion. That amounted to 8.6% of GDP, down from a peak of 10.1% in 2011.

The economic profit figures involve two important adjustments. The first strips out gains and losses due to changes in the value of inventories. But this amounted to just $13.5 billion of the $344.8 billion difference between unadjusted and economic profits, so is immaterial.

The remaining $331.3 billion resulted from the second adjustment. This converts the depreciation for plants and equipment that companies calculate for tax purposes to a more consistent measure of wear and tear. Apart from the $330.5 billion this adjustment subtracted from profits in the first quarter, it has never been close to being so large.

The big shift in the depreciation adjustment comes as a result of the expiration at the end of last year of a bonus-depreciation rule. This allowed companies to write off half of their equipment purchases in a single year. Such rules, which had been a feature of the tax code since the economy began to sour in 2008, were aimed at boosting capital spending. It isn't clear how successful they were at doing that, but they did allow companies to front-load depreciation, thereby reducing reported profits and the taxes paid on those.

The stepped-up depreciation companies were able to use from 2008 through 2013 left them with less to expense. This year, when the tax break expired, the effect was stark. Put differently, a not insignificant share of the profits that companies have been booking this year would have counted as depreciation expenses if it hadn't been for the bonus-depreciation rule. The economic profit figures adjust for that.

The implication for investors is that the wide profit margins that companies have been showing may not be quite as impressive as they seem. Eventually, the investment and depreciation cycle will normalize. And as the lagged effects of five years of tax breaks fade, depreciation expenses will climb, leaving less revenue flowing to the bottom line.