A new accounting rule could pad some technology companies' earnings for 2002, but don't be fooled. What looks like a recovery on a company's bottom line might just be inflated numbers.

Analysts estimate a company's earnings could rise as much as 200% under the new rule with no fundamental change in its cash flow or growth. Where investors and analysts measure companies on a price-to-earnings basis -- as opposed to a standard based on cash or revenue -- valuations could be thrown way out of whack.

Under the new regulations, companies that made expensive acquisitions in the '90s will be able to stop taking regular charges on their quarterly earnings to amortize "goodwill," or pay down the value of assets bought at prices above fair value. Only if a company determines that its assets have fallen in value will it have to write down the difference. The new standards take effect Jan. 1 for outfits with fiscal years ending Dec. 31.

Technology companies might see earnings dressed up more than those in other sectors, because they tend to carry the most goodwill on their books, says Prudential analyst Ed Keon. During the bull market of the '90s, technology companies had few tangible assets, but very rich stock prices. Merger and acquisition activity ramped up in 1998-2000, and a lot of tech companies were stuck with a lot of goodwill that had to be written down fast.

"Tech is where an awful lot of the acquisition and consolidation was happening, and it was happening with very highly valued paper to buy highly valued paper," says Joe Cooper, manager of research for Thomson Financial/First Call. "These companies don't have a ton of assets and they're paying a ton of money for something that doesn't have a lot of assets. The accountants say, look, you've bought all this technology know-how and it's going to be obsolete in five years, so you've got five years to amortize this $2 billion of goodwill."

Under the old accounting rules, the Securities and Exchange Commission made technology companies spread their goodwill over a shorter period of time relative to other sectors. The rationale was that acquired technology could become outmoded faster than assets acquired by other companies.

"The general rule of thumb used to be that technology had to write down its goodwill over a 12-year period, but in the last five to seven years it was beginning to approach five years," says Patricia McConnell, head of accounting and tax research at Bear Stearns. By comparison, financial institutions were required to write down goodwill over a period of 25 years, while the "stable, core-type industries" like retail and manufacturing had an even roomier 40 years to do so, according to an Arthur Anderson publication called

Accounting for Business Combinations

.

Passing the Buck

The worst confusion is foreseen among industries measured on a price-to-earnings basis. Those judged on the basis of cash earnings -- which exclude amortization expenses -- weren't penalized by goodwill charges in the first place. The same is true of companies that are valued according to cash flow, EBITDA (earnings before interest, taxes, depreciation and amortization) or revenues.

Technology sectors most often measured on a price-to-earnings basis include information technology services and computer services, according to a Bear Stearns report titled "Goodbye, Goodwill."

Bear Stearns expects several companies in its IT services group to see major increases in reported EPS due to the new goodwill rule.

Sapient

(SAPE)

earnings should jump 80% under the new rule, while

Manpower

(MAN) - Get Report

should record a 5%-10% increase. The computer services sector, meanwhile, is forecast to record an average 24% increase in 2002 earnings from the change. In that group, the biggest beneficiary is

Pegasus Systems

(PEGS)

, which should score a 70% increase. Also in the sector,

Ceridian

(CEN) - Get Report

and

Sabre

(TSG) - Get Report

should report 20%-50% pops in 2002 earnings.

The Little Guys

The small-cap group may see the greatest overall boost to 2002 earnings, according to early data available on estimates under the new accounting rules. And smaller companies' earnings are more likely to be misinterpreted by investors, since they're less widely followed by analysts.

Based on a sample of 332 companies, a Prudential report using Thomson Financial/First Call data shows the accounting change could slap a 4.4% increase on 2002 earnings for the big-cap broad market

S&P 500. For small- and mid-cap companies, those increases jump to 14.6% and 7.4%, respectively.

One analyst reasons that smaller companies have generally been more vulnerable to big goodwill charges because their earnings bases are smaller. The elimination of those charges then would give a proportionately bigger boost to their earnings numbers.

"Take a company like Intel that earns billions of dollars anyways. It doesn't hurt them nearly as much as it would a smaller company," said Cooper.

While individual large-caps may see the biggest net increases in earnings, investors are likely to be better-informed as to why. In the data sample used by Prudential, the top 10 net changes in earnings apply to big-cap companies like

Clear Channel

(CCU) - Get Report

, which is expected to record a 223.8% increase in earnings under the new accounting rule;

Qwest Communications

(Q)

, which is expected to record a 151.7% increase in earnings; and

Lennar

(LEN) - Get Report

, which is supposed to see earnings jump 179.5%.

"It's very clear that people who follow and invest in a company like

Citigroup

(C) - Get Report

will know about the acquisitions. They know about the amortization of goodwill, especially reasonably sophisticated investors," says Prudential's Keon. "Since small- and mid-cap companies don't tend to be as widely followed, there is probably a greater risk to being lulled into a sense that their fundamentals might be getting somewhat better," he says.

Considering Wall Street has its heart set on a 2002 earnings recovery, right now may be an especially easy time for investors to be lulled.