Harnischfeger Corp Essay

I. IntroductionIn 1984 Harnischfeger Corporation was a leading producer of construction equipment. During the decade of the 1970s the c wholeer experienced tremendous growth. Annual sales grew from $150 cardinal in 1970 to $646 million in 1981. However the corporation began to experience financial trouble in 1979. This was caused by a variety of factors the troupe wasted a large amount of resources on an unsuccessful merger, the government of Iran defaulted on a $20 million order of equipment after the fall of the Shah, and the U.S. economy was in a period of recession with double digit rates of inflation. The telephoner posted an operate termination in 1979 for the first time since 1938. The fraternitys financial difficulties continued until 1984. At this time focussing decided that restructuring was necessary if the company wanted to survive. (Harnischfeger, 1985)II. Restructuring strategyThe overriding objective of restructuring the company was to return to sustained emo lumentability. The goals of the visualise were four-fold managerial/personnel changes, production cost reduction, change in overall business instruction (e.g. in foreign joint ventures, and high technology areas), and a restructuring of debt (Palepu, 2000). The virgin decision maker position of Chief Operating Officer was created. Two new members of the executive team were hired in order to help push the company in a new strategic direction. As a resolving power, engineering, manufacturing, and marketing divisions underwent momentous changes in order to cut costs and reorient the companys product offerings toward more than profitable markets. (Palepu, 2000).The company started to focus its business on more overseas markets, where demand for mining and construction equipment remained strong. A relationship was established with Kobe Steel, Ltd., in which Harnischfeger agreed to source all of its construction cranes for sale in the US through the Japanese company. In addition, a contract to sell $60 million worth of mining shovels was entered into with the Peoples Republic of China (Harnischfeger, 1985). Lastly, the company restructured its debt into three-year loans that required the company to maintain certain levels of cash, receivables, and net worth (Palepu, 2000).Accounting StrategyThe new management at Harnischfeger implemented aggressive changes in history policy in an effort to make the company appear more profitable. The major areas in which accounting policy was substantially effected were in changes in depreciation methods on assets, the use of LIFO liquidation in memorandum valuation, the restructuring of the employees award plan, a change in the mood some types of sales were recognized, and a change in the fiscal year for foreign subsidiaries. (Palepu, 2000). In addition, management significantly altered the part of sales allocated to allowance for bad debt. Analysis shows that management exercised a enceinte deal of flexibility allowe d under GAAP in order to raise net income for 1985.Motivation for Accounting StrategyThe new management has two long-term goals in mind. First, to affix the companys presence in high-tech areas much(prenominal) as aerospace and pharmaceuticals and second, to make the company more global. These goals seem to require the company to pursue an aggressive earnings management strategy. In the short term the company needs joint ventures to survive. These joint ventures allow entrust Harnischfeger access to many new foreign markets and could be a potential source for cheaper labor. tackive earnings management could convince partners like Kobe Steel to be more receptive to investment in Harnischfeger. In addition the company needs cash to be able to participate in joint ventures that whitethorn require cross investment to build factories, hire foreign employees etc. Cash is also needed to invest in high tech industries which unremarkably require large capital outlays in research and d evelopment.Management had strong motivation to show a profit in 1984. First, the company was preparing for its 100th anniversary celebration, and therefore needed a quick turnaround. As trivial as it sounds, this consideration probably sped up the timetable to recovery via aggressive accounting policy. Second, and more tangible, the restructuring plan included a provision which would award top executives an spare 40% of their base salary if the company achieved its financial goals for the year. Amazingly, management could receive another 40% of salary if the company outperformed those goalsIII. Accounting ChangesEffect of change in Sales Calculation Effective November 1, 1983, Harnischfeger incorporated products purchased from Kobe Steel, Limited and then re-sold by the company, into its net sales. During precedent accounting periods, only the gross margin on these products was recognized as sales. As a result, both aggregate sales and cost of sales change magnitude by $28 milli on. This accounting change did not have material impact on the overall net operating income as stated in the financial statement, however, it did have an figure out on the quality of earnings, which is reflected by profit margin. Profit margin dropped to 1.44% from 1.55%, reflecting a 7.1% change in profit margin, after such a change was in place.The management claimed that this change reflected more effectually the nature of the Corporations transaction with Kobe, (Palepu, 2000, p.3-39) and we agree with the managements grab for two major reasons. First, Harnischfeger was operating in a macro business environment in which the company had to significantly reduce cost to survive. Outsourcing, an effective dash of transferring production cost to more effective producers, could make the Harnischfeger focus on its core strength in product development capability and high cross off power penetration. Second, Harnischfeger did phase out its own manufacture of construction cranes in Mi chigan and enter into a long-term agreement, under which Kobe would supply construction cranes.Also, effective November 1, 1983, Harnischfeger adjusted some subsidiaries ending period to September 30 instead of the previous ending July 31. This had the effect of lengthening the 1984 reporting period for these companies from 12 months, to 14 months, and increased sales by $5.4 million. Assuming these companies had the same profit margin as the parent, the change increased cost of sales by $4.3 million. We agree that the influence on net income is immaterial and that this change reflects more effectively the subsidiarys business operation. But it does represent a one-time event which should be rectify for during analysis of the companys potential for future profitability.Effect of Changes in Depreciation MethodIn 1984, Harnischfeger changed its depreciation policy for financial reporting purposes to a straight-line method from a principally speed method. A net income of $11 million was realized for 1984 when the straight-line method was applied retroactively to all assets depreciated under the accelerated method. The management viewed this as an approach to match the companys standard with that of industry peers. We agree with the management in a way that this approach provides similar standard. However, the timing of this action is questionable.This approach artificially improved the companys financial strength in the short run and helped Harnischfeger negotiate its debt restructuring process with bankers. In the long run, however, the straight-line method will reduce profit in the years to come. Also, it was too aggressive to realize this income just in a one-year period, which reflected the inducement for management to achieve profit. In addition, Harnischfeger extended its estimated depreciation lives on certain US plants, machinery and equipment, and increased residual value on certain machinery and equipment.These changes resulted in an increase of $3. 2 million in net income in 1984. Again, this reflected incentive for profit realization. The then-current high interest rate environment was supportive for residual value upward-adjustment, however, there were great risks involved. First, interest rate was on a down-trend after it peaked in 1982. Second, the liquidity of Harnischfeger machinery, for heavy-machinery manufacture, was low. Also, extension of depreciation lives would increase the maintenance costs and reduce profit in the years to come. Therefore, we suggest that Harnischfegers depreciation policies be closely watched when the economic environment changesEffect of LIFO Inventory LiquidationHarnischfeger reduced its inventory level in 1984, 1983 and 1982, resulting in a liquidation of LIFO inventory. This liquidation process led to gains when inventory, acquired at a lower cost in the preliminary years, were sold at a higher(prenominal) price, resulting from higher inflation. Net income in 1984 increased by $2.4 million (in the form of gains), and liquidity was improved on the labyrinthine sense sheet. We view this as a sound business decision when the management can reduce operating cost by decreasing inventory level.Effect of Changes in Allowance for Doubtful AccountsHarnischfeger, for some reasons, adjusted its allowance for doubtful accounts to 6.7% of sales for 1984 from 10% of sales in 1983, resulting in $2.9 million in operating income for 1984. The company might try to increase sales by aggressively extending credit to doubtful customers, risking losing all of relevant sales. This is very skeptical as Harnischfeger gives no explanation.Effect of Changes in R&D ExpensesHarnischfeger significantly cut its research and development expenses to $5.1 million in 1984, from $12.1 million in 1983 and $14.1 million in 1982. In 1984, operating profit was pumped up by $9.1 million when Harnischfeger didnt follow the same level of R&D activities in 1983, reflected in the percentage of R&D as of sales. This is controversial to managements strategy of focusing on the high technology part of its business and will equipment casualty its strength in the future. We conclude, therefore, that the management managed to increase profit by reducing R&D expenses on purpose.Effect of Changes in Pension PlanThe company states, in the footnotes of its 1984 financials, that its salaried employee pension plan was well over-funded. The policy of Harnischfeger was to fund at a minimum the amount required under the Employee Retirement Income tribute Act of 1974. (Palepu, 2000, p.3-38) This probably meant, in light of recent financial difficulties, that the company intended to fund at the minimum. Over-funding most likely came about as a result of the company reducing its workforce by about 45% in 1983. Harnischfeger terminated its Salaried Employee Retirement Plan in 1984, and created a new plan. This new plan included in increased minimum pension benefit, which probably served to make the pension restructuring more appetizing to employees.Cash resulting from the liquidation of the master key plan was divided into two groups $36.7 million went toward purchasing individual annuities in order to cover the obligations of the original plan, and $39.3 million went into an account called Accrued Pension beto be amortized to income over a ten-year period (Palepu, 2000, p.3.42) This pension plan change has three significant effects on the financial statements. First, pension expense was reduced in 1984 by $4 million. Second, net income increased by $3.9 million.Third, and most importantly, the company was able to show a positive cash devolve for the year. Without this one-time injection, cash flow would have been ($7.6 million). Bottom Line Financial Performance, Net of Accounting Changes The purpose of our analysis is to arrive at an estimated net income based only on the companys core operations. That is, to determine its financial health without the distraction of one-time eve nts and earnings management. The first step is arrive at a revised sales figure. The side by side(p) step is to construct a table summarizing our estimation of Harnischfegers net income, net of the effects of all the accounting policy changes Note that our analysis has tax-affected the result of changes in the fiscal year of subsidiaries, and the annual amortization amount for pension fund gains.Critique of Accounting ChangesOur issue is not with the fact that Harnischfeger management today has an aggressive accounting strategy and is engaged in earnings management. Indeed, it seems perfectly reasonable to bring all subsidiaries under one fiscal year timetable. This will result in administrative efficiency. Also, the change in recognition of costs and revenues of Kobe Steel equipment is logical. Next, the company claims that all changes in depreciation policy are do to conform with other manufacturers in the industry. Further, the pension plan restructuring was authorized by the P ension Benefit Guaranty Corporation, and we have no other sources of information which string the move in doubt. It seems logical that cutting the number of employees by 50% should cause a similar change in pension plan funding.In short, these accounting changes may be largely justifiable even though they represent aggressive earnings management. We do take issue with the fact that all of these accounting changes occurred in one year. That is, it seems suspicious that financial stability is neatly restored just in time for the 100th anniversary of the company, when executives stand to make an additional 80% of their salaries if goals are surpassed.As further proof of the validity of this concern, we see a contradiction between the decrease in R&D spending, and the companys new strategy to explore different high technology product lines and services. Further, extension of depreciation lives for plant and equipment seems like a shameless way to increase net income. Finally, a dramati c decrease in the percentage allowance for doubtful accounts is difficult to justify, especially in a period of acclivity receivables. In conclusion, it seems that the company is taking a huge risk by betting that this one-time boost in income and cash will allow the company to success all-embracingy expand internationally and grow in new high tech areas and become profitable once again.IV. Financial OutlookRather than a full recovery, it seems 1984 performance may be simply an aberration. Management cannot hide the effects of operations inefficiencies and uncooperative markets for long. We are encouraged by the fact that our estimated net $.41 termination per share far outshines the 1983 loss of $3.49. But we support to see a negative cash flow in 1985, brought on by the absence of the one-time pension plan change. Contributing to this is a high balance in accounts receivable, which rose by 37.5% from 1983 to 1984. And at the onset of a decreasing interest rate environment, we persuade the company to be burdened with high interest expense well into the future. Note, too, that the aggregate effect of the changes in depreciation policy will mean higher depreciation costs in future years. This, coupled with higher maintenance costs as equipment ages, will mean significantly higher operating costs. Finally, we expect the company to show a loss for 1985.