Harnischfeger Corporation 1. Identify all the accounting policy changes and the accounting estimates that Harnischfeger made during 1984. Estimate, as accurately as possible, the effect of these on the company’s 1984 reported profits. a. Changes that affect the Harnischfeger Revenues: • The company start to account Kobe Steel sales in US, previously it only add the gross margin in the financial statement. (this sales represents $28 millions) • Sales to a foreign subsidiary starts to be consolidated as a net revenues (this sales represents $5,4 millions) b. Changes that affect the Harnischfeger profitability: • Change in the depreciation accounting method from accelerated to straight line method. Increase of $11 million in 1984 income • Change on the company’s net residual value. Increased net income in $ 3,4 millions c. Inventories Liquidation: • The company had a $ 2,4 million increase in its net income, as a result of LIFO inventory liquidation. 2. 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 seems that the company had a better accounting result, not a better “operating” result. In order to report a better financial Statement (and increase its bonus based on accounting net income) the management decrease depreciation “levels”, increase revenues and switch inventories method of accounting. In my point of view, the expense reduction in SG&A might be not enough to change the scenario. Worst than that is the cut on... • The principal motive for the Harnischfeger management was to show profit in 1984. This was necessary since the company was preparing to celebrate 100 years of doing business and management was eager to prove to investors that the company was doing well. Management was also motivated by incentive compensation; the board of directors established an Executive Incentive Plan which provided an incentive compensation opportunity of 40% of annual salary for 11 senior executive officers only if the Corporation reached a specific net after-tax profit objective for the year. Management could also receive another 40% of salary if the company exceeds the objective (1985 Executive Incentive Plan). • An aggressive accounting strategy and earnings management as implemented by Harnischfeger’s management in 1984 is not a bad idea. However, for all of these changes to occur within a year is rather suspicious and will raise a lot of questions from investors. Investors may think the company is trying so hard because it wants to look good for its 100th anniversary. Also all these changes come at a cost of incentive compensation for the top executives (80% of their salaries if they exceed the objective). Investors may also be concerned with the contradiction of the decrease in R&D spending and the new strategy to explore different high technology product lines and services. Some investors might be able to see that the extension of depreciation lives for plant and equipment, to reflect an increase in net income, might not be a smart strategy. 3. Assess the company’s future prospects, given your insights from questions 1 and 2 and the information in the case about the company’s turnaround strategy. • Harnischfeger is taking a huge risk by relying and expecting that the one-time boost in income and cash in 1984 will enable the company to successfully expand internationally and grow in new high tech areas and become profitable once again. • Because of a prevalent decreasing interest rate environment, it is expected that Harnischfeger will have to deal with the problem of high interest expense in the future. • Also, the aggregate effect of the changes in depreciation policy might mean higher depreciation costs in future years and thus higher operating costs. • As equipment ages, higher maintenance costs as well as depreciation costs will mean there could be significantly higher operating costs. • Thus it is highly probable that Harnischfeger might show a loss in the proceeding years.