Accounting

policy changes and accounting estimates made in 1984 a. Depreciation method b. Estimated depreciation lives c. Rate of return assumption for pension expense d. Liquidation of LIFO e. Provision for doubtful accounts receiveables f. Date of financial year ending g. Research and development expense h. Net sales products purchased from Kobe Steel II. Motives of management in making accounting changes a. Stock price b. Earning targets c. Avoid debt covenant restrictions d. Improve image III. Future prospects and turnaround strategy a. Changes in top management b. Cost reductions c. Reorientation d. Resturcturing

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 Guo Jing ID:3357849 1. Identify all the accounting policy changes and accounting estimates that Harnischfeger made during 1984. Estimate, as accurately as possible, the effect of these on the companys 1984 reported profits. There are several aspects to be noticed: 1) Changes that affect the Harnischfeger Revenues: a. Change on estimated depreciation and residual values of certain machinery In 1984, the company changed its estimated depreciation lives of certain United States plants, machinery, and equipment, and the estimated residual values of certain machinery and equipment, which affect the start of fiscal year 1984. This change increased the pretax reported profit by $3.2 million. Since the company did not pay domestic federal income taxes in 1984, the after tax income also increased by the same amount. b. Change on assumption when determine pension expense The initial rate was 9 percent, , in comparison to 8 percent in 1983 and 7.5 percent in 1982. During 1984, the company additionally restructured its pension plan and recaptured $39.3 million in excess plan assets. The effect of the change in the rate of return assumption for the pension plan and plan restructuring reduced the pension expense by around $4 million in 1984. c. Change on provision for doubtful accounts The companys provision for doubtful accounts receivables as a percentage of total receivable was 8.4 percent in 1984, while it was 11.3 percent in 1983. If the company maintained the same percentage provision in the two years, the bay expense debt expense in 1984 would have been $1.5 million more that the reported expense. d. Sales to a foreign subsidiary starts to be consolidated as a net revenues (this sales represents $5,4 Millions) The company made a long-term contract about purchasing equipment with Kobe Steel, Ltd, As a result, firm begin to account its subsidiary Kobe Steel sales account, previously it only add the gross margin in the financial statement. This sale represents $28 millions and the profit margin was decreased to 1.44%. Moreover, the company changed the financial year ending form July 31st to September 30th for certain foreign subsidiaries, which shows that the 1984 consolidated income statement included the results of 15 months of operations of these subsidiaries resulting in increased net sale in 1984 by $5.4 million. Besides that, the companys research and development expense in 1984 decreased by $7 million from 1983 mostly due to the companys agreement with Kobe Steel. 2) Changes that affect the Harnischfeger profitability: Change in the depreciation accounting method from accelerated to straight-line method. Increase of $11 million in 1984 income. Harnischfeger Corporation had changed

from accelerated to straight-line method, applied retroactively to all assets (including depreciation expenses on plants, machinery and equipment in 1984, which has an insignificant effect). The cumulative effect is that net income for 1984 increased by $11 million or $0.93 per common and equivalent share. But in long term, he changes in depreciation policy would cause higher depreciation costs, so the maintenance costs would be higher in the future 3) Inventories Liquidation: The liquidation of LIFO inventories therefore increased a net income for $2.4 million Harnischfeger Corporation liquidated excess inventories and stretching payments to creditors. This can decrease the amount of debts and reduce the debts/equity ratio. As a result the company may get an unqualified audit opinion in future years and could extent their loan term. 2. What do you think are the motives of Harnischfegers management in making the changes in tis financial reporting policies? Do you think investors will see through these changes? There are four possible motives I could think of for the accounting changes. 1. To meet the earning targets of upper managements compensation plan, management is reward by bonuses if the company get the target profit, which provides an incentive for managers try their best to get maximum profit as possible as they can. The top management of the company is given significant bourses based on the companys reported profits. This gives an incentive for the managers to boost profits via manipulate accounting strategy. On the contrary, if the compensation committee of the board of directors notices this, the committee could simply adjust the reported profits before awarding the bonuses. 2. The risk related to the violation of debt covenant restriction. Harnischfeger experienced a default on certain covenants of its loan agreements caused by operating losses and credit losses. The most restrictive provisions of the companys loan agreements required it to maintain a minimum working capital of 175 million, consolidated net worth 180 million, and a ration of current assets to current liability of 1.75. In order to meet this requirement, company has to make some change to against the effect of the worldwide recession in early 1980. 3. Assess the companys future prospects, given your insights from questions 1 and 2 and the information in the case about the companys turnaround strategy. The following is the four components to Harnischfegers turnaround strategy. a. Build up effective compensation plan at expense of shareholders profit. b. Cost control to lower the break-even point c. Reorientation of the companys business d. Restructuring the companys finances to facilitate the star of the reorientation strategy. In conclusion, the new appointed CEO has a lot of experience in the industry, and has shown credibility by negotiating with lenders to restructure debt effectively. The cost control program was quite successful as well as the pension restructuring. New capital was issued via a public offering of debentures and common stock, using the proceeds to pay off all the restructured debt.