Harnischfeger Corporation

Question 1

Harnischfeger’s corporate recovery plan was a four pronged approach that involved (1) changes in top management, (2) cost reductions to lower the break-even point, (3) reorientation of the company’s business and (4) debt restructuring and recapitalization. These changes at first glance appear to have allowed Harnischfeger to improve its financial performance from a net loss of $3.49 per share in 1983 to a net gain of $1.28 per share in 1984. In addition, Harnischfeger has appeared to have achieved a majority of its desired outcomes from each of its four changes as shown below.

• Harnischfeger’s desired outcomes from hiring a new COO and Vice President of Finance and Administration were to re-build investor and creditor faith in the company and show them that it is taking serious actions to improve its performance starting with a new executive team. Investors’ new interest in the company, such as Mr. Peter Roberts, and bankers willing to re-extend credit to Harnischfeger’s after not meeting its working capital, quick ratio, and net worth requirements, illustrated that Harnischfeger was able to improve its image.

• The desired outcomes from cost reductions, such as reducing the workforce by almost half and eliminating management bonuses, are to reduce cost of goods and increase operating income. Although Harnischfeger’s cost of sales (COS) has increased from 1983 to 1984, the company appears to have reduced COS in comparison to sales from 81% to 79%. In addition, it has increased its Operating Income from $62 million in 1983 to $90 million in 1984.

• The desired outcomes from reorientation of the company’s business were to reduce risk of increasing prices, decrease costs and increase sales. These desired outcomes have appeared to be achieved. By entering in a long term agreement with Kobe Steel Ltd. of Japan, where Kobe would be manufacturing Harnischfeger’s cranes, Harnischfeger would be able to reduce its manufacturing costs through completing the manufacturing in a country that can produce similar products for less. It would also reduce the risk of price increases by negotiating future prices. As shown previously, Harnischfeger was able to successfully reduce its cost to sales ratio. Through targeting new growth, emphasizing the high technology portion of its business and developing the Industrial Technologies Group, would create new business and ultimately increase sales for the company, which is shown in its financials, a 24% increase in sales from 1983 to 1984.

• The desired outcome of its debt restructuring and recapitalization was to continue to receive credit from companies. After negotiations with its bankers, Harnischfeger was able to convince them to restructure its debt obligations into three year terms.

Although Harnischfeger’s appears to have achieved a majority of its desired outcomes from its corporate recovery plan, you will see from the following in-depth financial analysis that Harnischfeger’s outcomes are really a result of creative financial manipulation.

Question 2

a. Accounting Changes and the Effect to 1984 Reported Earnings

Accounting changes Effect to 1984 reported earnings

1. Change to depreciation method from straight-line to accelerated Increase to net income of $11.0 million

2. Change estimated depreciation lives on certain U.S. plants, machinery and equipment Increase to net income of $3.2 million

3. Reduced inventories to costs on LIFO method (relative to current costs of acquisition) Increase to net income of $2.4 million

4. Net sales now include the full price (previously

only gross margin included) of equipment

purchased from Kobe Steel, Ltd. and sold by

Harnischfeger Increase to pre-tax income (net sales) of $28.0 million

5. Fiscal year end for certain consolidated subsidiaries now ending September 30th (previously fiscal years ending July) Increase to pre-tax income (net sales) of $5.4 million

6. Changes in the investment return assumption rates for all US plans and the restructuring of the U.S. Salaried Employees’ Plan Increase to pre-tax income (through reduction of pension expense) of $4.0 million

b. Assumptions:

Reported net income in 1984 $15,176,000

2 Change to depreciation method (11,000,000)

2 Change to salvage life on assets (3,200,000)

2 Change to inventory valuation method (2,400,000)

3 Change to equipment sales recognition (16,167,200)

4 Change to fiscal year end for subsidiaries (3,117,960)

5 Change to pension plan and rates (2,309,600)

Estimated net income (loss) in 1984 excluding accounting and other charges identified in part A $(23,018,760)

1 The effective tax rate used in 1984 = 0.4226 (2,425/5,738) вЂ" used formula from case

2 Effective tax rate not applied here вЂ" these are already net income numbers

3 Equipment sales subject to effective tax rate = 16,167,200 [28,000,000 * (1 вЂ" 0.4226)]

4 Fiscal year change subject to effective tax rate = 3,117,960 [5,400,000 * (1 вЂ" 0.4226)]

5 Pension plan change subject to effective tax rate = 2,309,600 [4,000,000 * (1 вЂ" 0.4226)]

c. The difference between conservative and aggressive accounting choices centers around how revenues, expenses, assets and liabilities are recorded as shown below:

Conservative: Aggressive:

Record revenues later Record revenues sooner

Record expenses sooner Record expenses later

Record lower levels of assets now Record higher level of assets now

Record higher level of liabilities now Record lower