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Harnischfeger Corporation, Case Study Example

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Case Study

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 company’s 1984 reported profits.

Harnischfeger made the following changes to the company’s accounting policy

Recognition of Sales

Harnischfeger made some changes in the manner in which some kind of sales are recognized. Before 1984, the company only included the gross margin of all the products purchased from Kobe Steel Ltd. However, at the moment, the company opted to include all the products bought from Kobe Steel Ltd., selling them in its net sales. The company wanted to fairly reflect the nature of business transaction and relationship between the company and Kobe Steel Ltd. This has led to the increase of aggregate sales in FY 1984 by $28 million (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007). I believe that this is a move by the company to influence its profits as there is no other valid reason for the company changing from the accounting principles initially used.

Financial Year-End

The company has also engaged in changes to the financial year-end from 31st July to 30th September. This has resulted in the increase of net sales by $5.4 million in 1984, affecting the company’s consolidated income statement. This is because during the FY-1984, the trading period was increased to 14 months from the conventional 12 months. The effect of the change was considered as immaterial against the company’s pre-tax profit.

Valuation

The company started using the LIFO (last-in, first-out) liquidation in the valuations of its inventory. This caused a $2.4 million increase in the company’s net income. The company also made changes to its allowance for doubtful debts account and it recorded progress. This is because the allowance for doubtful debts accounted for 6.4% of the company’s sales, down from 10% experienced in the FY-1983 in its liquidity that is depicted in the company’s balance sheet (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007).

Depreciation

The company had initially employed an accelerated depreciation method to be applied on all its equipment, plants and machinery. The company then adopted the straight-line depreciation method and applied it to all assets. The cumulative net income of the company has as a result increased by $11 million as a result of neglecting the effect of the change to straight-line depreciation on the depreciation expense account. The consolidated statement of operations regarded this as a one-time gain. This was further enhanced by the change in the depreciation lives of some of its equipment, plants and machinery. This caused a $3.2 million increase in the company’s pre-tax profit (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007).

Employee Benefits

The company bought some securities and used them to provide benefits to its employees. The company adopted a 9% level of assumed rates of return in 1984, a 1% increase from the rate in 1983, whereas in 1982, it was at 7.25% (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007). These rates influenced the actuarial present value if the accumulated plan benefits and the annual pension expense. In 1984, pension expenses dropped by $4 million and $3.93 million was recovered in cash from the retirement plan assets. According to the rules, this was regarded as an actuarial gain and was going to be amortized over a 10-yr period beginning 1984. These changes would directly affect the cash flow, increasing it by $39.3 million.

Propose possible motives for Harnischfeger’s management to make the changes in its financial reporting policies and accounting estimates. Do you think investors will “see through” these accounting changes?

The company’s motive in the changes in the accounting policies is to portray the image of a company that has recorded profits in 1984 after a prolonged period of experiencing net loss. This was largely affected by the fact that the company was going to celebrate its 100th anniversary at the end of that financial year (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007). The intent of management was to convince investors that the company was performing according to their expectations and their continued financial support would not be in vain. This was also a move to attract potential investors by putting up a good image.

There are two events that triggered the changes in the company’s accounting and reporting policies; the introduction of a new management team and the 1982 financial downturn. The company’s CFO instigated the changes in the reporting policies and gained an approval from the company’s external auditor, Price Waterhouse.

Management provided three reasons to the changes in the accounting policies;

The accounting numbers that the company presented to the public caused their debt requirement to be set with strict standards. This was a huge contributor to the company’s earlier dismal performance, which upset the new management.The company had failed to acquire any unique or special benefits from its creditors when the company had to retain the initial debt covenant regulations.

The company’s management was of the opinion that the company’s competitors were the most suitable external parties that could reasonable judge the company’s performance. Harnischfeger Corporation had actually adopted a rather conservative method of accounting as compared to its competitors. Their accounting methods were predetermined to record lower profits. However, most of the competitors employed accounting methods that inflated their profits. It was generally held that the external stakeholders do not consider the differences and changes in the accounting policies across companies within the industry. The company therefore doubted how their current conservative accounting policies ensured their competitiveness in the market.

The initially prevailing accounting methods and techniques would have a negative consequence on the company’s new management. As a result of the accounting policy being employed for the internal and external usages, the company had fully derived the products’ pricing from the costs that had been allocated to them. The company had incurred larger costs as a result of using he accelerated depreciation policy. This also resulted in an increase in the company’s product price and as such making them less competitive in the market as the company over-prices their products as compared to their competitors. Additionally, in order for the company to manage its fixed assets, the company had to make a higher capital investment due to the larger costs that had been allocated. Also, the management believed that it was pertinent to their success and the success of the company that they are able to control the costs allocated to them while managing to account for each one. This depicted that management was properly motivated to make the changes in these accounting policies.

Assess the company’s future prospects using your insights from question 1 & 2 and the information given in the case on the company’s turnaround strategies.

The company should expect increase in its profits realized at the end of each consecutive financial year, given it performs at the same level as it is at the moment. The company has employed numerous strategies that are targeted at particularly managing or mitigating costs and increasing efficiency. They include;

  • closure of loss-incurring plants
  • reduction of the workforce to the minimum required for maximum output
  • reorientation of the company’s business by the creation and development of new products, equipment and technology
  • expanding the company’s level of ability to that of computer-integrated solutions and products

The conditions of the company’s internal financial environment are much better than before. This is because the company will realize an increase in capital through the issuing of new common stock and corporate bonds. This will however pose a decrease in shareholders’ equity as the shareholders will possibly realize a decrease in dividends issued after the first issuance (Palepu, Business analysis and valuation : IFRS edition, text and cases, 2007). However, this figure is set to increase in consecutive financial years as the company will arrive at the breakeven point as it realizes returns on the new equity available.

The R&D department has shown the initiative and will to venture into new technologies for the company. However, the expenditure on R&D is not sufficient to realize this objective. The company will have to increase expenditure on R&D so as to realize a good position relative to the competition. However, the information provided in the case is not sufficient to determine the company’s competitive position with regards to computer-integrates solutions and products, one of the company’s future targets.It is important to note that by virtue of the company implementing these changes to the accounting policy at such a given time, it may raise concern by shareholders. Potential investors may perceive the company in a bad light as they appear to be cooking the figures to attract their attention.

References

Bernard, V. L. (2012). Business analysis and valuation. Mason: South-Westerm College Publ.

Palepu, K. G. (2007). Business analysis and valuation : IFRS edition, text and cases. London: Thomson Learning.

Palepu, K. G., Healy, P. M., & Bernard, V. L. (1999). Step-by-step business analysis and valuation : using financial statements to value any business. Cincinnati: South-Western.

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