Harnischfeger Corporation

Financial Reporting & Analysis April 19th, 2013 Case Study- Harnischfeger Corporation 1. delimitate clearly the account contention potpourris Harnischfeger made in 1984 as stated in melodic phrase 2 of its mo realiseary statements. The speed derogation method was changed from to straight-line on all confederation assets that ca apply to cast up after-tax lettuce income for 1984 by $11. 005 gazillion. The cumulative exercise of change in 1984 thither en think be no decrement in the depreciation expense due to change. in 1984 striked by $7. 0 jillion over the previous family.Most of this reduction was a conduce of the comp alls agreement with Kobe Steel, Ltd. Under this agreement, Kobe agreed to reimburse Harnischfeger up to $17. 0 gazillion dollars of RD expense over a period of trey historic period. However, nearly students argue that Harnischfeger whitethorn be cutting its explore calculate since the actual reduction in Harnischfegers 1984 R&D expense is much than one- ternary of this amount. (See Exhibit 4, Notes 6 and 9, in the case. ) 8. Effective 1984, Harnischfeger began to include in its give nonice sales products purchased from Kobe Steel, Ltd. , and s darkened to third segmentationies by Harnischfeger.Previously only the arrant(a) margin on Kobe-originated equipment was included in Harnischfegers pecuniary statements. This increase Harnischfegers sales in 1984 by $28. 0 meg but had no tint on its boodle. near students would mis addnly argue that this had an fix on Harnischfegers give the axe income. (See Exhibit 4, Note 2, in the case. ) Although roughly(prenominal) of the above ar fine account statement decisions with no direct cash- string up consequences, the another(prenominal) decisions affect the associations describe earns as well as its cash flow. The instructor should ask the secernate to identify the latter-type decisions among the above.Discussion of Question 2 The above analysis shows that virtually, if not all, of the report dinero of Harnischfeger in 1984 argon produced by invoice changes. Therefore, the bill changes helped the counselling report a signifi turn outhouset profit rather than a grim loss. The instructor should academic degree this out to the class and ask Why do you figure the steering of Harnischfeger made these invoice changes? Students tier out a number of possible motives for the account statement changes 1. Boost the companions stock bell so that the caller-up could raise untried not bad(p), 2.Meet the earnings targets of the partys top circumspection honorarium plan, 3. Avoid the infringement of debt covenant restrictions, and 4. Improve the comp anys image with the customers, dealers, and prospective employees. Some students argue that the analysis in Question (1) shows that it is too complicated for an sightly investor to master through the impact of all the accountancy changes. They further point out that, even if ma ny analysts recognize the offspringuate of the beau mondes chronicle system decisions on the 1984 profits, it is quite a un believably that the analysts would be competent to assess the impact of these changes in future twelvemonths.Other students are likely to argue that the market place movees the reported profit numbers efficiently. They argue that there are some sophisticated analysts who could manage the analysis that was done in the class. The instructor should encourage this discussion. At some point in the discussion, the instructor should intervene and summarize the evidence from the research literature 1. There is considerable evidence in finance and accounting literature that shows that the outstanding markets are generally efficient. 2.For stock prices to reflect human beings in an unbiased manner, it is not necessary that everyone in the market has to process the information correctly. As long as there are some sophisticated investors who can see through the gilds accounting changes, the stock price volition reflect this due to the possibility of arbitrage by these investors. 3. The accounting studies that examine the stock market reaction to accounting changes conclude that the market is not fooled by the accounting decisions of firms. However, the evidence impersonateed in these studies is not conclusive. similarly, these studies do not examine whether the stock market recognizes the recurring tacks of accounting changes. Without additional research, it is difficult to commence conclusive statements on this issue. 4. Even if capital markets see through the effects of accounting changes, managers may believe other in making accounting decisions. This is likely to happen if there are no significant penalties associated with much(prenominal) behavior. Even if investors fully recognize the impact of Harnischfegers accounting decisions, there are other reasons for the participations managers to make these decisions.As Exhibit 2 i n the case indicates, the top management of the company is awarded significant bonuses base on the companys reported profits. This provides an incentive for the managers to boost profits through accounting changes. However, if the compensation committee of the companys board of directors recognizes this possibility, the committee could localise the reported profits before awarding management bonuses. The instructor should challenge the students by petition If investors can see through these changes from public information, why cant the board do it, especially when it has access to additional information in the firm?The third possible motive that is mentioned by the students is the desire of Harnischfegers management to avoid the misde averageor of debt covenant restrictions. Since the company recently experienced the painful consequences of violating these restrictions, it is plausible that the management changed the accounting policies to avoid future violations of the debt res trictions. If debt covenants are specified in frustratement of accounting numbers, managers hire an incentive to choose accounting policies to minimize the violation of the covenants.However, if lenders recognize this possibility, lending agreements would be modified to avoid this possibility as long as the cost of such a modification is not significant. The tetradth possibility is that the accounting decisions are motivated by a desire to convince the companys customers, suppliers, dealers, and employees that Harnischfeger is again back on track and is viable. disposed the nature of the companys products, a lack of confidence in the companys viability is likely to impair the companys ability to sell its products.In fact, the company was negotiating long-term contracts in 1984 with the governments of Turkey and China. It is quite possible that the companys return to profitability might allow helped the management in this respect. Similarly, the companys ability to attract and retain talented employees might have been helped by the image that the company was back on track. During my visit to the company, Harnischfegers management pointed out one additional factor in the companys accounting decisions the role of infixed management considerations.The company used the same set of accounting rules for extraneous reporting and for internal management accounting. The companys product pricing was based on fully allocated product costs, and therefore its accelerated depreciation policies apparently caused its products to be overpriced relative to competition. In addition, the high(prenominal)(prenominal) depreciation charges led to increased capital reinvestment demands from its divisions for maintaining and replacing the companys fixed assets.The companys management mentioned ternary principal reasons for its accounting decisions (1) a belief that the immaterial users of accounting data did not adjust for Harnischfegers conservative financial reporting when comparing the companys performance with other companies in the industry, (2) the unpleasant experience with its debt covenant restrictions, and (3) the interaction between management accounting and external reporting. These reasons are discussed in greater detail in my paper, The general anatomy of an Accounting Change. Underlying all the accounting changes was a reporting philosophical system outlined by the then chief financial military officer and the ongoing president of the company In accounting there is no such thing as absolute truth. The same underlying reality can be accounted for using a range of effronterys. The earlier philosophy of this company was to choose the conservative alternative whenever there was a choice. Now we have decided to change this. We would like to tell the world that we are unrecorded and well. We wish to tell the truth but do not inadequacy to be overly conservative in doing so.When the outside world compares our financial performance with t hat of other companies, they may or may not take the time and effort to untangle the effects of the differences in financial policies that sundry(a) companies follow. My own belief is that flock adjust for the obvious things like one-time gains and losses but have difficulty in adjusting for ongoing differences. In any case, these adjustments impose a cost on the user. If people adjust for the differences in accounting policies when they compare us with other companies, then it should not national whether we follow conservative or liberal policies.But suppose they do not adjust. Then clearly we are better off next the more(prenominal) liberal policies than conservative policies. I am not sure whether people make the adjustments or not, but either way we wish to present an optimistic version of the picture and let people figure out what to do with the numbers. As a company you have to put the surmount foot forward if you want to raise capital, convince customers that you are a viable company, and attract talented people to work for the company. I as sure that the financial reporting should help rather than seal off the implementation of our in operation(p) trategy. In my opinion, the changed accounting format highlights the effectiveness of our strategy better than the old policies do. The instructor can sum up the class discussion on enquiry (2) by mentioning the views of the management set forth above. Discussion of Question 3 After completing the analysis of Harnischfegers accounting insurance policy changes, the class should be asked to assess the companys future. At this point, I go back to my original question to the class, namely, Is it worthwhile to invest in the companys stock in early 1985? I call on a student who considers the companys stock a superb investment and ask him or her to explain why. Harnischfegers turnaround strategy consists of four elements (1) changes in top management, (2) cost reductions to lower the companys break-ev en point, (3) reorientation of the companys pedigree, and (4) restructuring the companys finances to accelerate the implementation of the reorientation strategy. The changes in the top management seem to be good. The natural chief executive officer ( chief executive officer) has considerable experience in Harnischfegers industry.The youthful CEO demonstrated his credibility with the financial community by successfully negotiating with the companys lenders to restructure the companys debt. The new management has taken several locomote in the right direction. The companys cost-reduction programs seem to be paying off. These programs were helpful in reducing the companys losses in 1984. The financial management of the company alike seems to be sound. The cost-reduction programs and the subsidy restructuring have improved the companys cash flow.The total cash-flow analysis, shown in Exhibit 1, indicates that the company has been able to generate confident(p) cash flow from its o perations in 1984. The company raised substantial new capital through a public offering of debentures and viridity stock and used the proceeds to pay off all of the companys restructured debt. Finally, the companys business strategy seems to be sound. The management recognized the latent to exploit the companys strength in the substantive handling equipment business.Through its Harnischfeger Engineers subsidiary, the company planned to expand in this area and bring down on the high margin systems business. This strategy is likely to help the company to move away from the mining and construction equipment business, which is a low-growth and cyclical industry, to a higher-growth and more stable business. Students who are optimistic about the companys future pay heed the above factors as the reasons for their support for the company and its management.They argue that these factors indicate that the companys new management has the right ideas and have a go at its how to turn the c ompany around. These students suggest that the managements accounting decisions were part of its attempt to implement the companys strategy and are therefore constructive. The instructor should drift up the case discussion by reviewing the companys motives for its accounting decisions. The instructor should point out that understanding these motives is essential for an analyst who is interested in assessing the companys flow performance and its future potential.The instructor may end the class by taking a second vote on the investment potential of the companys stock and sharing with the class the subsequent events described below. SUBSEQUENT DEVELOPMENTS The following events describe the developments subsequent to the time of the case. As can be seen, Harnischfeger seems to have succeeded in implementing its strategy effectively. Also, the company continued to liberalize its financial reporting policies. 1985 1. The company changed its accounting for duration patterns and tooling. Previously, the cost of the patterns and tooling was expensed in the year of acquisition.Under the new method, these costs are capitalized and amortized over their estimated useful lives. 2. Harnischfeger reported a net profit of $0. 74 per grapple for financial 1985. The accounting change described above contributed $0. 24 per share to the reported profits. 3. The company raised $147 one thousand thousand by issuing preferred stock. 1986 1. Mr. Goessel was appointed as the chairman and CEO of the company, and Mr. Grade was appointed as the president and chief operating officer (COO). Previously, Mr. Goessel was the president and COO, and Mr. Grade was the CFO. 2.Harnischfeger acquired Beloit Corporation, a producer of papermaking machinery and systems, for $175 one million million in cash. Later in the year, stock equivalent to a 20% impartiality interest in Beloit was sold to Mitsubishi Heavy Industries, Ltd. , for $60 million in cash. 3. The company acquired Syscon Corporati on, a firm based in Washington, DC for $92 million in cash. Syscon developed advanced computer systems for military markets. 4. Harnischfeger inform a plan to sell the companys Construction Equipment Division for approximately $17 million in cash and $55 million in debentures. . The company reported that Harnischfeger Engineers received a major order for the design of an automatize car assembly plant. 6. Harnischfeger reported a net loss of $1. 14 per share for pecuniary 1986. This consisted of a profit of $2. 15 per share from keep operations, a loss of $4. 45 per share from discontinued operations (Construction Equipment Division), and a gain of $1. 16 per share from the adoption of the new pension accounting rules. 1987 1. Harnischfeger received a takeover offer from Columbia Ventures, Inc. , for $19 per share in cash.The company considered the offer inadequate and rejected it. Exhibit 1 Total change-Flow Analysis ($ in thousands) 1984 1982 1981 Working capital from operations $ 2,961 $ 1,763 $ (55,902) (Increase)/ fall n accounts receivable (23,908) (5,327) 42,293 (Increase)/decrease in inventories 9,282 56,904 26,124 (Increase)/decrease in refundable income taxes and cerebrate interest 11,289 (2,584) (6,268) (Increase)/decrease in other reliable assets 259 10,008 (439) Increase/(decrease) in accounts payable 16,488 (1,757) (3,302) Increase (decrease) in employee compensation and benefits payable 698 (15,564) (3,702) Increase/(decrease) in accrued plant closing costs (3,888) (14,148) 20,496 Increase (decrease) in other current liabilities (3,181) (15,927) (3,030) Cash from operating cycle $ 10,000 $ 13,368 $ 16,270 Minus plant and equipment additions (5,546) (1,871) (10,819) Cash before dividends, investments, and external financing $ 4,454 $ 11,497 $ 5,451 Minus cash dividends 0 0 (2,369) Cash before investments and external financing $ 4,454 $ 11,497 $ 3,082 Minus advances to unconsolidated companies (2,882) 0 0 Plus other 269 1,531 848 Cash before external financing $ 1,841 $ 13,128 $ 3,930 External Financing Proceeds from senior notes and subordinated Debentures $ 120,530 $ 0 $ 0 renewal of export and factored receivable sales to debt 0 23,919 0 Restructured debt 0 158,058 0 Debt replaced, including conversion of receivable sales of 23,919 0 (158,058) 0 Repayments of debt (161,500) (760) (9,409) Increase (repayment) of short bank notes payable 2,107 (3,982) (2,016) Other increases in debt 1,474 0 25,698 Issuance of crude stock 21,310 0 449 Issuance of common stock warrants 6,663 0 0 paying(a) pension assets reversion 39,307 0 0 Cash from external financing $ 29,891 $ 19,177 $ 14,722 Net increase (decrease) in cash and temporary investments $ 31,732 $ 32,205 $ 18,652 2. What is the effect of the depreciation accounting method change on the reported income in 1984? How will this change affect profits in future years? It increased the net income to $11 million for 1984 or $. 93 per common and common equivalent share. The straight-line method will allow the assets to continue to deprecate in the same amount for the life of the asset.This change will increa se profit in future years even thought the depreciation expense in strait-line will be higher that wouldve been with accelerated method. 3. What is the effect of the depreciation lives change? How will this change affect future reported profits? As a top of going to strait-line the company overly has changed its estimated depreciation lives on certain U. S. plants, machinery and equipment and residual harbors on certain machinery and equipment, which increased net income for 1984 by $3. 2 million or $. 27 per share. No income tax effect was applied to this change. This change should report higher profits in the coming years. $3. 2 million or $. 27 per share. No income tax effect was applied to this change. This change should report higher profits in the coming years. 4.The depreciation accounting changes assume that Harnischfegers plant and machinery will last longer and will lose their nurse more slowly. Given the business conditions Harnischfeger was facing in its primary indu stries in 1984, are these scotch assumptions justified? Not necessarily, they can not fully predict the outcome of these changes but narration shows them that as long as their plant machinery are more up to date production will perform at a better rate which should lead to priceless resources needed to conduct good business. 5. In Note 7, Harnischfeger describes the effect of last in first out inventory liquidation on its reported profits in 1984. light upon what is meant by last in first out liquidation and how liquidation affects a companys income statement and balance sheet. By LIFO liquidation means when a companys accounting sells its oldest inventory since the current sales are higher then current purchases then the liquidation will occur, meaning that senior(a) inventory will be sold. The effect of the LIFO liquidation on the companys income statement is an increase in net income by $2. 4 million or $. 20 in fiscal year 1984. There is no income tax effect. On the balance sheet there is a decrease of inventory, due to liquidation. 4. The depreciation accounting changes assume that Harnischfegers plant and machinery will last longer and will lose their value more slowly.Given the business conditions Harnischfeger was facing in its primary industries in 1984, are these economic assumptions justified? They cannot fully predict the outcome of these changes but history shows however, we know they were experiencing a drop in sales this would also mean that they were large-minded less use to their machinery, and that would cause less wear and tide rip to the machinery justifying and increase on the useful life of the asset. 5. In Note 7, Harnischfeger describes the effect of LIFO inventory liquidation on its reported profits in 1984. Describe what is meant by LIFO liquidation and how liquidation affects a companys income statement and balance sheet.The liquidation means selling of quondam(a) inventory since the current sales are higher then current purch ases then the liquidation will occur and as result any inventory not sold in previous periods must be liquidated. The company will benefit by an increase in net income by $2. 4 million or $. 20 in fiscal year 1984. Meaning that the net loss of previous year 1983 was reduce by approximately 15. 6 million. The balance sheet would have decrease of inventory from 12. 6 mil in 1983 to 5. 5 mil in 1984. 6. Note 8, states Harnischfegers payment for doubtful accounts. Compute the ratio of the allowance to gross receivables (receivables before the allowance) in 1983 and 1984.What would the allowance have been if the company retained the ratio at the 1983 level? How much did the pre-tax income increase as a result of the changed ratio in 1984? The companys provision for doubtful accounts receivables as a percentage of total receivables was 8. 4% in 1984. The corresponding percentage in 1983 was 11. 3%. If the company maintained the same percentage provision in the two years, the bad debt e xpense in 1984 would have been $1. 5 million more than the reported expense. 7. Note 9, page 216, states that Harnischfeger decreased R&D expense in 1984 relative to the previous two years. Do you think this change was motivated by business considerations or accounting considerations?How did this change affect the companys reported profits in 1984? Also R&D expense in 1984 decreased by $7. 0 million over the previous year. Most of this reduction was a result of the companys agreement with Kobe Steel, Ltd. Under this agreement, Kobe agreed to reimburse Harnischfeger up to $17. 0 million dollars of RD expense over a period of three years plus the company was reduced in its size so there was no need to that big expenditures on RD. 8. Note 11, describes a number of changes in Harnischfegers pension plans in 1984. Describe these changes as clearly as you can. What are the economic consequences of these changes to Harnischfeger and its workers?The reduction in benefits and wedges were sig nificant from 1982 to 1984. In 1984 the pension expenses accounted for 1. 9 million, 1983 for 6. 5 million and 1982 for 12. 2 million The change in the return on investment assumption is for all US plans. The economic consequence is that there will be less expenditure made by these pension owners during the lifetime of their pension. The company established a new plan, which goal was an improvement in the stripped-down pension benefit. This constituted in a restructure of the Salaried Employees loneliness Plan. From one side that decision could help the company to rebuild the trust of customers and suppliers for continuing in business.From the other side, the workers would suffer a significant economic lost and could lose the motivation to work for the company. But there is a possibility that a positive view could emerge because they could appreciate the companys efforts to keep them working there, and then cooperate to take the company to the next level. 9. How did the pension pl an changes affect Harnischfegers financial statements in 1984? Are these changes likely to affect future profits? The effect of the changes in the investment return assumption rates for all U. S. plans, together with the 1984 restructuring of the U. S. Salaried Employees Plan, was to reduce pension expense by approximately $4. 0 million in 1984 and $2. million in 1983, and the actuarial present value of stash away plan benefits by approximately $60. 0 million in 1984. This may have an effect on future profits. The pension plan changes touched positively the statements in 1984. Less assets were available for benefits therefore, more income was reflected in the financial statements, which contributed to the cash to pay debt obligations. Furthermore, if reducing the debt, company could recover the banks and shareholders trust. 10. Summarize all the accounting changes Harnischfeger made in 1984, and their effects on pre-tax profits and cash flows in 1984. 1. Change in the recognition o f some types of sales. This resulted in a change in sales calculation.Harnischfeger incorporated products purchased from Kobe Steel, which were re-sold by the company, into its net sales. This increased aggregate sales and cost of sales by $28 million. The effect of the change in sales calculation was an increase in both aggregate sales and cost of sales by $28 million. Also, profit margin dropped from 1. 55% to 1. 44%, which represented a 7. 1% change in profit margin. 2. Change in the fiscal year for some foreign subsidiaries. By changing the fiscal year of foreign subsidiaries (ending period of September 30 instead of July 31), the effect was the protraction of the 1984 reporting period for the subsidiaries from 12 months to 14 months.This increased sales by $5. 4 million. 3. Change in the depreciation methods on assets. The depreciation policy for financial reporting purposes was changed to a straight-line method from a principally accelerated method. The effect of the change i n depreciation method (straight-line method) was a net income of $11 million realized in 1984. Overall, depreciation charges resulted in an increase of $3. 2 million in net income in 1984. 4. Change in the use LIFO liquidation in inventory valuation. The effect of LIFO inventory liquidation was an increase in 1984 net income by $2. 4 million, as gains. 5. Change in the allowance for doubtful accounts.The company familiarised its allowance for doubtful accounts to 6. 7% of sales for 1984 from 10% of sales in 1983. The effect of the change in the allowance for doubtful accounts was that it resulted in $2. 9 million in operating income for 1984. 6. Change in the R&D expenses. Harnischfeger significantly reduced its R&D expenses to $5. 1 million in 1984, from 412. 1 million in 1983. The effect of the change in R&D expenses was an increase in operating profit by $9. 1 million. 7. Change in employee pension plans. The effect of the change in pension plans was a reduction in pension expens es by $14 million and increase in net income by $3. 9 million, and a positive cash flow. 11.Accounting statements are used by investors, lenders, customers, employees, and governments in dealing with Harnischfeger. Among these groups, who is some likely to see through the above accounting changes, and who is least likely to do so? The least likely to see through the accounting changes are just normal people who dont know accounting concepts because some methods of reporting can overstate or play down the numbers without a sustainable change so investors, lenders, and governments should be the ones to most likely see through the change and based on what they see they make a decisions. Employees in accounting, finance, and upper management should be able to see through the changes. 12.Are the accounting changes likely to help or to hinder Harnischfegers ability to implement its business plan? Be as specific as possible. Even thought the changes indicate an optimistic move, it does n ot guarantee that the company is going to be able to implement its business plan. The changes made strongly justify companys boost in the periods analyzed. From my point of view, company reflects a positive result on management through its financial reports. Basically the mission to satisfy shareholders and business associate entities such as banks and suppliers was accomplished by showing the ability to strike financial problems through management based on the financial statements.However, the accounting practice can be a matter of numbers thingmabob and it can be altered just to show easy actions. 13. Overall, what is your sound judgment of Harnischfegers future as of 1984? The company is taking a seek by expecting that the one-time boost in income and cash in 1984 will enable the company to successfully expand internationally and grow in new high tech areas and become profitable once again. They wanted to make their financial statements look pretty so that investors would bu y their stocks and suppliers would continue giving credit for being able to produce product and sell. They need to barricado playing with accounting methods and hiding the true story otherwise they will be in danger to not survive in a long run.