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The Starting Line: Goodwill change may boost techs

It wasn't supposed to happen, but gains from new accounting rules seem to have helped some companies, at least temporarily, on the stock market.

Tech Industry
It wasn't supposed to happen, but gains from new accounting rules seem to have helped some companies, at least temporarily, on the stock market.

Analysts and others in the industry expected the rules, which promise to overhaul the way companies account for goodwill, to provide a short-term boost to some companies' bottom lines, but they weren't expected to affect the companies' stock.

The rules eliminate the pooling of interest merger--in which two companies combine their balance sheets--and prohibit the amortization of goodwill by those companies.

Goodwill is the amount of money over and above the real value of the assets that one company pays when it buys another. Previously, goodwill had been amortized, or written off over time, but under the new rules companies will test the value of that goodwill annually, and write off the entire amount when it's determined to have been "impaired."

The upshot is that many companies with lots of goodwill sitting on their books will get a short-term boost to their earnings per share figures, because they will no longer have to deduct that quarterly amortization cost.

The new rules will affect just about every company in the technology world, which has seen a boom in mergers and a subsequent boom in the amount of goodwill sitting on books.

The goodwill effect
New accounting rules eliminating the amortization of goodwill may boost earnings-per-share figures of some stocks. Here are a few of the possible early adopters of the new rules with the largest intangible assets per share:
Company (ticker) Adoption permitted Intangibles per share
Computer Sciences (CSC) 2Q 9.80
Computer Associates (CA) 2Q 9.17
Walt Disney (DIS) 4Q 7.36
Conexant Systems (CNXT) 4Q 5.43
Lucent Technologies (LU) 4Q 1.43

Source: UBS Warburg

For instance, a Bear Stearns report analyzing the impact of the new rules produced several examples of tech companies expected to see gains of 25 percent or more in their 2002 earnings-per-share figure. But since most of those companies are evaluated on an EBITDA (earnings before interest, taxes, depreciation and amortization) basis, analysts expect there to be little impact for investors and Wall Street.

But that may not be what ends up happening.

"This is a purely noncash boost to earnings which has no effect on the economic value of the enterprise. Therefore, the stock market, that ever-efficient discounter of future cash flows, should 'look through' this purely cosmetic boost to earnings. Right? Not quite," said UBS Warburg strategist Edward Kerschner.

In a new report, Kerschner and his team analyzed the effect that some of these short-term boosts had on companies' stock prices. Many companies in the tech sector are still preparing for the accounting change. Indeed, Yahoo said in its quarterly filing with the Securities and Exchange Commission that it is still evaluating the new goodwill accounting rules.

While most companies will be required to stop amortizing goodwill as of Jan. 1, 2002, some will be able to switch to the new accounting earlier than that, and some will switch after that period. The early adopters provide a peek at how the stock market may react to the new rules.

• Pharmaceutical distributor McKesson HBOC adopted the new rules in its most recent quarter, announcing earnings per share of 31 cents, which beat the First Call consensus of 28 cents. But most of the upside surprise came from a 2.5-cent benefit from eliminating goodwill amortization.

• Parker Hannifin, a manufacturer of motion and control systems, recently revised its guidance for fiscal 2002 to between $2.90 and $3.35 per share, compared with First Call's consensus of $2.90 per share. But the new forecast includes the elimination of 44 cents worth of goodwill amortization.

• Compuware reported earnings per share for its most recent quarter of 12 cents, excluding goodwill amortization, and 9 cents including goodwill. At least one news report then credited the company with beating the First Call consensus of 11 cents per share.

All of the examples listed saw their stocks pick up after the announcements, even though, as both Bear Stearns and UBS Warburg point out, the gains were merely a reflection of the new accounting rules, and were not related to the underlying performance of the companies.

Topsy-turvy road ahead
The confusion over the new earnings figures is likely to get worse. It will be difficult for investors to compare the number the company is reporting to analyst estimates.

First Call, which compiles analyst recommendations and earnings estimates, recently issued a note detailing how it will handle goodwill estimates going forward, pointing out that "most of the technology companies with goodwill have already been converted, since the majority of analysts had previously chosen to exclude amortization."

But as the Compuware case illustrates, not everyone has caught up to speed with the new rules just yet.

Other companies haven't been as lucky.

Kerschner pointed to Computer Associates, which recently recorded a 25-cent goodwill accounting expense in its fiscal first-quarter figures. While CA reported both the pre-goodwill and post-goodwill figures, the company, which is taking heat over its switch to a new method of sales recognition, didn't get any short-term boost from the results.

"Smaller firms where (the new rules) make the headline number look better may be most likely to benefit from this one-time noncash increase in earnings," Kerschner wrote. "On the other hand, the benefit is likely to be ignored for companies whose earnings releases receive careful scrutiny from skeptical investors."

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