Q1.

Identify all the accounting policy changes and accounting estimates that
Harnischfeger made during 1984. Also consider any one-time or temporary real actions.
Estimate, as accurately as possible, the effect of these changes on the company’s 1984
profits.

1) Effective November 1, 1983 the Corporation started including in its net sales products
it purchased from Kobe Steel. Earlier only the gross margin on the Kobe originated
equipment was included. During Fiscal year 1984, such sales aggregated to $28
Million.
2) Effective November 1,1983 the corporation started including certain foreign
subsidiaries, leading to additional sales of $5.4 Million
3) Impact of changes in points 1 & 2 were insignificant.
4) Depreciation Methodology – The company retroactively changed their depreciation
methodology for plants, machinery and equipment from accelerated methods to
straight line method for all assets. Cumulative effect of these changes was
insignificant and it increased Net Income for 1984 by $11 Million or $0.93 per
common and common equivalent share.
5) Useful Life of Equipment – Company changed the depreciation lives on certain US
plants, machinery and equipment leading to increase in Net Income for 1984 by $3.2
Million or $0.27 per share.
6) Inventory & LIFO Liquidation – Inventory reductions from 1982 through 1984,
resulted in LIFO liquidation. This increased Net Income by $2.4 million or $0.20 per
common share in 1984. It also reduced Net Loss by $15.6 million or $1.54 per share
in 1983 and by $6.7 million or $0.66 per share in 1982. No Income Tax effect applied
in 1984 and 1983.

Q2. What do you think are the motives of Harnischfeger’s management in making the
changes in its financial reporting policies? Do you think investors will “see through”
these changes?

It’s difficult to actually put a clear motive to the management’s intention just on the account
of the accounting policy changes that they have made because they have infact been open
about these changes in various documents which were public. They have talked about
changing their depreciation methodology in the 1984 Annual Report. They have also talked
about including the full sales price of construction and mining equipment from Kobe Steel.
They have also talked about LIFO liquidation in their MD&A report. The fact that they have
been open and public about these accounting changes points to the fact that they do not
necessarily have wrong intentions.

Coming to the question whether the investors will “see through” these changes, it really
depends on who the investor is. A retail investor does not have sufficient knowledge of
accounting and might be misled if he only looks at the change in EPS through the years,
whereas an institutional investor will understand these accounting changes and adjust his
recommendation for the stock.
Q3. Assess the company’s future prospects given your insights from questions 1 and 2
and the information in the case on the company’s turnaround strategy.

The accounting changes that the management undertook add up to improving the net income
of the company quite significantly.

The company improved its finances by retiring all the old debt and raising an additional $149
Million by issuing stock, 10-year long term debt at low interest rates, giving them additional
headway to fulfil the backlog on the order book and also make investments into the business.
The fact that they have taken on more debt, even though its long term, increases the risks for
the company given how the macro environment remains challenging and if the sales don’t
improve by as much then the company could default again when the new debt becomes due.

The Mining Division of the company, which is the most profitable division and accounts for
33% of revenue, showed 62% improvement in sales mainly from sales outside the US. The
order book of the company doubled in 1984 after October 31. But the other divisions of the
company did not improve by as much which could be troublesome.

Despite all of the above, the future prospects for the company look challenging given the
macro demand environment in the US and across the globe remains subdued and the fact that
there is competition which is causing margin pressure for the company.

Q4. Try to assess quantitatively what the impact of the accounting changes would be on
Harnischfeger’s credit rating if credit ratings agencies do not adjust for the changes in
accounting methods.

The company made various accounting changes over the past 2 year effecting the reported
numbers for Sales and Net Income.

Accounting changes related to Sales numbers were for the equipment that the company sold
which came in from Kobe Steel. Earlier they used to only include the Gross Profit from the
sales of the equipment from Kobe Steel but now they include the full sale price of the
equipment. Such sales aggregated to $28 Million in 1984. Effective November 1983, the
company also started including certain subsidiaries which inflated the Net Sales of the
company by $5.4 Million.

The company also made certain other accounting changes which made the Net Income better
by a total of $1.4 per common share (Change of Depreciation Methodology $0.93 + Change
of Useful Life for Equipment $0.27 + Change in Inventory and LIFO Liquidation $0.20). The
company reported a Net Income of $1.28 per common share in 1984. If you negate the
impact of accounting changes, then the company basically suffered a loss of $0.12 per
common share in 1984 (Reported Net Income $1.28 – Accounting Changes Impact $1.40 =
- $0.12)

All these accounting changes negatively impact the Credit Rating of the company if we
assume that the credit rating agencies do not adjust for the changes in the accounting
methods.