Introduction As a result of a worldwide recession in the 1980’s the machinery industry suffered a decrease in demand. This was caused mainly by the cost reduction strategies that most of their major consumers were assuming at the time. Harnischfeger Corporation (HC), one of the oldest manufactures in the machinery industry was among the several companies that had to restructure their strategy in order to survive the economic downturn. After suffering a $77 million loss in 1982, HC decided to restructure their strategy for the upcoming years.
Some of the major changes that the HC considered were: changes in top management, cost reductions to lower the break-even point, reorientation of the company’s business and debt restructuring and recapitalization. Although these changes had a great impact on HC 1984 profits, it is clear in the case that the changes in accounting policies had an even greater effect on HC profitability during the fiscal year of 1984 Step 1: Identify Principal Accounting Policies
First, it is important to point out some key accounting policies noted in the financial statements of Harnischfeger Corporation for later analysis. The company uses a straight line depreciation method on its capital assets, but just began using this method in 2004; this will be the subject of later analysis to discuss the impact of the change on the company’s financial status. Harnischfeger Corporation funds its pension accounts at the minimum funding required by ERISA (Employee Retirement Income Security Act of 1974).
Step 2: Assess Accounting Flexibility The next section of this analysis is to assess the accounting flexibility within the business model of Harnischfeger Corporation and assess the extent to which management utilizes this flexibility. The company has elected to, for bookkeeping purposes, use the LIFO inventory cost method for its US inventory costs and FIFO for the inventory cost of its foreign subsidiaries. As previously discussed, the company changed its depreciation method in 1984 from an accelerated method to the straight line method.
This subsequently increased the company’s net income by $11m. This also changed the estimated lives of depreciable assets which increased net income by another $3. 2m. Financial statements of certain consolidated subsidiaries, principally foreign, had fiscal years ending September 30 while previously these subsidiaries had fiscal years ending July. By changing the fiscal year of foreign subsidiaries (ending period of September 30 instead of July 31), the 1984 reporting period for the subsidiaries increased from 12 months to 14 months.
This increased sales by $5. 4 million. The Corporation added products purchased from Kobe Steel, which were re-sold by the Corporation, into its net sales in 1984. 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 Step 3: Evaluate Accounting Strategy Continuing the discussion of the change in depreciation method, this strategy reduced the annual depreciation expense, increasing net income.
The potential rationale behind this change will be discussed later in this analysis. Another large increase in net income is the result of an IRS evaluation of Harnischfeger’s previous tax returns. This evaluation resulted in a credit for taxes paid that completely cancelled out the company’s tax expense for the year. In addition to the IRS evaluation, Harnischfeger restructured its pension plan under the Salaried Employees’ Retirement Plan due to overfunding. This resulted in a significant reduction in the company’s pension liability and reduced the pension expense for the year from $6. m in 1983 to $1. 9m in 1984. The reduction in funding, and consequent increase in cash, is treated as income amortized over 10 years. Step 4: Evaluate the Quality of Disclosure Harnischfeger disclosures were in accordance with GAAP and, in addition, the company included all the changes in accounting in the financial notes. It is clear in the case that most of the profits in 1984 were due to the change in the depreciation method, but they also had other means and positive changes that contributed to their financial position at the end of the year.
As financial analysts, we can state the notes to the financials were very clear and all changes were addressed in the management’s discussion & analysis. Step 5: Identify Potential Red Flags A major red flag in the Harnischfeger financial statements is the exception to the unqualified opinion from the auditors. The auditors, though, seem to agree with the change as the most accurate method of reporting for the company. It appears as though many of the accounting changes made in 1984 are to increase net income, but the impact appears to be short term benefits for most of the changes.
Top management is compensated based on net after-tax profit and the top seven members of the management team can earn up to an additional 80% of their salaries through bonuses based on the company’s performance, so the incentive to inflate net income is apparent. The company is also looking to portray a strong financial performance for the company’s 100 year anniversary in 1984. The change in depreciation method was one of the changes with the most impact on Harnischfeger’s financials with an increase in net income of over $14m for 1984 and reduced accumulated depreciation on the balance sheet which increases the value of capital assets.
Harnischfeger also restructured its pension plan in 1984 due to overfunding which saved the company $4m in pension expense for 1984 and the rest of the dollars that were previously part of the pension plan will now be treated as amortized income for the next 10 years. An operational issue that is important to note is that accounts receivable were significantly reduced and accounts payable significantly increased in 1984. This could mean that accounts receivable are being collected more quickly, but the impact on accounts payable indicates that Harnischfeger is paying its suppliers more slowly.
This can indicate an inability to pay suppliers for some reason, which is unusual since, if the company is collecting accounts receivable more quickly, the company should subsequently be able to pay suppliers more quickly. Inventory reductions in 1984, 1983 and 1982 resulted in liquidation of LIFO inventory quantities carried at lower costs compared with the current cost of their acquisitions. This resulted in increased net income for 1984 by 2. 4 million or $0. 0 per common share. The balance sheet also reflected an improvement in liquidity. The large decrease in research and development spending is another operational red flag for Harnischfeger. In regards to the reduction in R&D expense, the main issue is that they are reporting the figure net of the amounts funded by Kobe Steel. The agreement with Kobe Steel states that Kobe will fund R&D up to $17M over a 3 year period if that amount is actually spent by the company.
If they are reporting R&D net of amounts funded by Kobe, that means they must have spent more than what Kobe gave them, which can be estimated at $5. 67 ($17M/3 Yrs). Therefore it seems as though the company spent approximately $10. 77M on R&D, which is more in line with previous years (12. 1M in 1983 and 14. 1M in 1982). The convoluted corporate structure of Harnischfeger including foreign and unconsolidated subsidiaries makes it easy to hide financial issues off the financial statements of the main corporation.
Step 6: Undo Accounting Distortions As shown in Appendix 1, Harnischfeger still was operating at a loss in 1984. However, due to their operating, financial leverage and market based strategies, Harnischfeger has considerably reduced their loss as compared to previous years. In order to undo the accounting distortions we concentrated our attention on the following accounting issues: change in depreciation method in 1984, LIFO layer liquidation as indicated in the financials, research and development partnership adjustments and taxes.
As a result of the combined adjustments, (please refer to Appendix 1) net income decreased to ($1. 4) million or approximately $. 12 per shares outstanding. Conclusion Although most of the company’s success is due to accounting changes, Harnischfeger still improved from the prior year. Operating income increased about $28M, and although some of this can be attributed to accounting changes, there is still the fact that the company increased sales in mining equipment and material handling equipment, which have much higher margins.
The net income for 1984 is definitely misleading, but even after you account for the effects of the various accounting changes and estimates, they still seemed to perform better than the prior year. They were able to restructure their debt and give themselves some breathing room for the time being to focus on growth and how to improve operations. The move away from large construction equipment towards material handling and systems activities will improve margins and take advantage of growth opportunities. Appendix 1: Harnischfeger Corporation Revised Income Statement
Year Ended October 31, 1984 Net Income adjustment for the changes in Accounting Methods and LIFO Liquidation Net Income adjustment for changes in accounting methods, LIFO liquidation and Net Sales Revenues Revenues Net Sales $398,708 Net Sales/Less income from Kobe Steel and foreign subsidiary $ 365,308 Other Income $ 7,067 Other Income $ 7,067 Cost of Sales $315,216 Cost of Sales $ 297,726 Operating Income $ 90,559 Operating Income $ 74,649 Less:Less:
Product Development, Selling & Admin Expense $ 72,196 Product Development, Selling & Admin Expense $ 72,196 Interest Expense – NET $ 12,625 Interest Expense – NET $ 12,625 Income (loss) before equity items & cumulative effect of accounting changes $ 5,738 Income (loss) before equity items & cumulative effect of accounting changes $ (10,172) Provision for Income Taxes $ 2,425 Provision for Income Taxes N/A Income (loss) before equity items & cumulative effect of accounting changes $ 3,313 Income (loss) before equity items & cumulative effect of accounting changes $ (10,172) Equity ItemsEquity Items
Equity of unconsolidated companies $ 993 Equity of unconsolidated companies $ 993 Minority interest of consolidated subsidiaries $ (135)Minority interest of consolidated subsidiaries $ (135) Income before cumulative effect of accounting change $ 4,171 Income before cumulative effect of accounting change $ (9,314) Cumulative effect of change in depreciation $ 11,000 Cumulative effect of change in depreciation $ 11,000 Net Income $ 15,171 Net Income $ 1,686 Less:Less: Cumulative effect of change in depreciation method $ 11,000 Cumulative effect of change in depreciation method $ 11,000 Cumulative effect of change in estimated depreciation life $ 3,200 Cumulative effect of change in estimated depreciation life $ 3,200 cumulative effect of LIFO Liquidation $ 2,400 cumulative effect of LIFO Liquidation $ 2,400 Revised Net Income/Loss $ (1,429) Revised Net Income/Loss $ (14,914)
