[OPE-L:3125] Re: Clarity on IVA

andrew kliman (Andrew_Kliman@msn.com)
Wed, 25 Sep 1996 09:59:13 -0700 (PDT)

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I want to quote from the BEA publication _Corporate Profits: Profits Before
Tax, Profits Tax Liability, and Dividends_, Methodology Papers Series MP-2, of
May 1985, in order to
(a) help clarify the technicalities of the IVA, i.e., who is excluding and
who is including the IVA, when the IVA is negative or positive, etc.; and to
(b) ask a few questions about the BEA's concept of IVA and value added.

"The measure of corporate profits included in national income --- profits from
current production --- is shown in the NIPA tables as the sum of three
elements. The first, profits before tax (PBT) ... reflects the charges used
in tax accounting for inventory withdrawals and for depreciation. The other
two elements are the inventory valuation adjustment (IVA) and the capital
consumption adjustment (CCAdj), which restate the charges used in tax
accounting for inventory withdrawals and depreciation to the basis needed for
the NIPA's.

"The IVA converts the value of inventory withdrawals from the mixture of
historical and current replacement costs used in business in tax accounting to
current replacement costs. This adjustment removes from profits the
capital-gain-like element that arises during inflation from valuaing inventory
withdrawals at prices of earlier periods. (Likewise, in a period of
deflation, it removes a capital-loss-like element.) The CCAdj ....

"The relation of these three elements is illustrated below for 1981.
Corporate profits with IVA and CCAdj --- the term for profits from current
production in the NIPA's --- was *smaller* than PBT. Both the IVA and CCAdj
were *negative*. The IVA was *negative* because current replacement costs
were *higher* than the costs at which inventory withdrawals were valued in
determining PBT. The part of the CCAdj ... [p. 2, my emphases]."

Corporate profits added to other incomes equals National Income (NI). The BEA
uses corporate profits "with" IVA and CCAdj in this equation. That is, in
times of inflation, the BEA's corporate profits are *smaller* than PBT and
therefore NI is *smaller* than if the tax accountants' profit measure were
used. After some adjustment for certain taxes and subsidies, NI = NNP, which
can be interpreted as the BEA's measure of "value added" from current

What is the justification for this? Apparently, inflation. I took this for
granted in my post of the other day, but now I think I was wrong. If the
change in the value of inventories is removed, then so should inflation of the
rest of profits and the rest of incomes be removed, if one is doing current
dollar accounting. If one is doing constant dollar accounting, then also to
factor in the IVA (i.e., lower profits in times of inflation) is "double

What other justification besides inflation might there be? What the BEA is
trying to do with NNP and NI is not obtain a measure useful for planning and
investment purposes, but obtain an accurate measure of what has taken place,
how much value has been added. Do they do so? I think it all depends on how
the PBT is calculated.

Assume a year-long general strike, so that the amount of production that takes
place during the year is 0. Accurate measures of value added and profit from
current production (if wages, etc. = 0) should show that they both equal $0.
Assume also that the inventory withdrawals valued according to a mix of
historical and replacement costs is $1 billion. (How can there be inventory
withdrawals without production? Answer: all the inventories were
perishables.) And assume that the replacement cost of the inventory
withdrawals has plummeted to $0. The IVA will equal $1 billion > 0.

Now there are two possibilities. (1) PBT is measured as $0. Then the BEA's
adjusted measure of corporate profits (and, ceteris paribus, NI and NNP as
well) will equal $1 billion. This, I think, overstates the value added from
current production by $1 billion. (2) PBT is measured as - $1 billion. Then
the adjustments give accurate measures of $0 for corporate profits, NI, and
NNP. For PBT to be measured as - $1 billion, the accountants must be figuring
profits by taking the difference between end-of-year and beginning-of-year
assets without making price adjustment. They began with $1 billion and ended
with 0. Is this what PBT does?

Whichever is the case (I suspect (2) is), my equations do not compute the
difference between end-of-year and beginning-of-year assets, but work directly
with "data" from current production. Thus, they conform to (1), and any
adjustment to them produces wrong results. The computation of total value
(which equals total money price in current dollars after adjusting for the
possible change in the monetary expression of value) is

TV(t) = p(t)*X(t) = p(t-1)*a(t)*X(t) + l(t)*X(t)

and value added is

VA(t) = p(t)*X(t) - p(t-1)*a(t)*X(t) = l(t)*X(t)

for one or many sectors. If production of the "year" is X(t) = 0, total value
and value added both equal 0. Profits are computed by subtracting wages >= 0
from value added, so if wages = 0, so do profits. Only stocks *used in
production* enter into the equations, not all "inventories."

[One has my permission to change the "0"s in the preceding 3 paragraphs to a
very, very, very, very small number, and the "$1billion"s to a number very,
very, very, very close to $1 billion.]

Andrew Kliman