Earnings contraction in the fourth quarter was worse than in any quarter since the last recession. Still, it wasn't quite as bad as analysts thought it would be.

With about 85% of the companies in the S&P 500 having already reported, and factoring in estimates of the remainder, fourth-quarter earnings look to have fallen 22.7% from a year ago, which would be the worst year-over-year result since a 24.2% drop in the second quarter of 1991, according to Thomson Financial. In the third quarter of last year, earnings fell 21.6% from the year-ago quarter.

The decline wasn't as bad as predicted; on average, fourth-quarter earnings beat estimates by 0.9%. That's a reflection of the vigor with which analysts slashed their forecasts following Sept. 11. Back on Sept. 10, analysts were expecting S&P 500 fourth-quarter earnings to fall just 2.5%.

The good news is that the worst of the earnings decline is probably behind corporate America. First-quarter earnings should show a smaller drop and second-quarter earnings will probably register positive growth, as companies reap the rewards of heavy cost-cutting last year and as the economy starts to get back on its feet. Improvements in consumer and business demand are encouraging, while downward revisions to estimates by both analysts and companies have slowed, said Wall Street experts.

So far, about 420 of the S&P 500 companies have reported earnings. Together, those earnings have fallen 23.2% from their year-ago numbers. Transports took the biggest hit in the fourth quarter, with earnings down 173%. The group was dragged down by the airline industry, which suffered from dwindling travel after Sept. 11. Meanwhile, health care had the strongest growth, showing gains of 11% in the fourth quarter. The only other sector that saw earnings grow last quarter was utilities, with a 2% increase.

Looking Out

Consensus estimates now call for an 8.2% drop in S&P 500 earnings in the first quarter, followed by 8.7% growth in the second quarter, 31.2% growth in the third quarter and 41% growth in the fourth quarter, according to Thomson Financial.

But these estimates will probably come down, said Thomson Financial analyst Ken Perkins, who ultimately sees a first-quarter drop in the low teens. For the rest of the year, it's harder to forecast. The outlook for the economy is still a bit cloudy, and CEOs are reluctant to talk about the future.

"We finally have an answer to when earnings will turn up, but the slope is still very fuzzy," says Thomson Financial research head Chuck Hill. "We don't know much more than we did at the start of the reporting season."

The results put the S&P 500's price-to-earnings ratio at 24.6 using a trailing 12 months and at 20.1 times estimated 2002 earnings.

Truth-Telling

In the meantime, intense scrutiny of accounting practices could result in reduced earnings estimates and even hurt some profitable business practices in coming quarters, analysts warned.

In the wake of the Enron blowup, companies and analysts will probably take a much more conservative approach to reporting and estimating results, said Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter.

Investors are already wary of pro forma results, or results that don't adhere to generally accepted accounting principles. A move toward GAAP use might become more pronounced now, and could actually pressure growth.

Indeed, last week, Goldman Sachs uber-bull Abby Joseph Cohen drew up a new set of estimates for 2002 earnings with GAAP numbers. She maintained a $42 estimate for S&P 500 earnings in 2002, based on "guidelines suggested by major data vendors, like First Call," but said under a more conservative GAAP basis, earnings would be more like $30. She did not change her year-end targets for the major indices, however.

But the impact of accounting concerns on the bottom line is the crucial issue, says Berner. "The more difficult question to answer is, will concerns about shady accounting actually start to rein in businesses that depend on leverage, that depend on using special entities?" he said. "Will the focus on more transparency in earnings actually change business models? The assumption is that it may, but the degree to which that will affect earnings activity is unclear."

Hill said he expects earnings will be lower in 2002 than they would have been. "Maybe it won't happen in the first quarter, but the impact will be more than trivial," he said. "For the full year, earnings could be 2% lower, possibly 5%, but it's hard to say."

On the other end of the scale, a new accounting rule governing acquisitions is already padding 2002 estimates. Charlie Reinhard, senior strategist at Lehman Brothers, estimates that the new rule will add as much as $2 to full-year S&P 500 earnings in 2002. "Analysts are entering their new estimates into the First Call systems, a process that revved up in January," he said. Reinhard says analysts have adjusted their estimates for over half of the companies in the S&P 500 already.

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.