CEG GSB 703 Mini Case Assignment #3 Adam Ohanesian Email: Adam.Ohanesian@nichols.

edu

Table of Contents
I. 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 receivables 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. Earnings 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. Restructuring

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. First, the depreciation method was changed from accelerated to straight line, applied retroactively to all assets. The effect of this change, not including the reduction in the current years depreciation expense, increased after tax net income for 1984 by $11.005 million. The company did not report the reduction in the depreciation expense in 1984 due to this change. Second, 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 effect 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, after tax income also increased by the same amount. Third, the company changed its rate of return assumption for determining pension expense. The rate assumed was 9 percent in 1984, 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 the plan restructuring reduced the pension expense by around $4 million in 1984. Fourth, the liquidation of LIFO inventories resulted in a net income increase of $2.4 million.

Fifth, the companys provision for doubtful accounts receivables as a percentage of total receivables 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 bad expense debt expense in 1984 would have been $1.5 million more that the reported expense. Sixth, the company changed the financial year ending form July 31st to September 30th for certain foreign subsidiaries. This means that the 1984 consolidated income statement included the results of 15 months of operations of these subsidiaries resulting in increased net sales in 1984 by $5.4 million. Seventh, the companys research and development expense in 1984 decreased by $7 million from 1983 mostly because of the companys agreement with Kobe Steel. Finally, in 1984, the company started to include in its net sales products purchased from Kobe Steel, and sold to third parties by the company. Prior to 1984, only the gross margin of equipment for Kobe was included in the financials. This increased sales in 1984 by $28 million however it did not impact the profits.

2. What do you think are the motives of Harnischfegers management in making the changes in its 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. First, is to increase the companys stock price and in return raise new capital. Second, is to meet the earnings targets of upper managements compensation plan. Third, is to avoid the violation of debt covenant restrictions. Fourth, is to improve the companys image with clients, dealers, and hopeful employees.

Even if investors recognize the impact of the accounting decisions, there are other reasons for the companys managers to make these decisions. For example, the top management of the company is given significant bonuses based on the companys reported profits. This gives an incentive for the managers to boost profits via changing their accounting policies. 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.

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. 1. Changes in top management 2. Cost reductions to lower the break-even point 3. Reorientation of the companys business 4. Restructuring the companys finances to facilitate the start of the reorientation strategy In conclusion, I feel that the changes in top management are great. The new CEO has a lot of experience in the industry, and has shown credibility by negotiating with lenders to restructure debt effectively. The cost reduction program as well as the pension restructuring was helpful in reducing losses in 1984 and improving cash flow. The company raised new capital via a public offering of debentures and common stock, using the proceeds to pay off all the restructured debt.

Reference Material Sources Text book: Business Analysis & Valuation Using Financial Statements, Palepu & Healy, 2008, Thomson Sout-Western.