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Harnischfeger Corporation Case Study 1) Changes in Depreciation Method According to Financial Note 2 on page 17, prior to 1984, the

corporation used principally accelerated methods for its U.S. operating plants. In 1984, the Corporation has computed depreciation expense on plants, machinery and equipment using the straight-line method for financial reporting purposes. The cumulative effect of this change increased net income for 1984 by $11 million/$.93 per common and common equivalent share. The impact of the new method on income for the year 1974 before the cumulative effect was insignificant. In addition, because of the review of this depreciation policy, the Corporation changed its estimated depreciation lives on certain U.S. plants, machinery and equipment and residual values on certain machinery and equipment, which increased net income for 1984 by $3.2 million or $.27 per share. No income tax effect was applied to this change. Effect of these changes for Harnischfegers future performance: Although the Corporation claims that they changed their depreciation policy because of similar industries and to provide a more equitable allocation of the costs of plants, machinery and equipment over their useful lives, I think the timing of these changes is still questionable. The change improved the companys financial position for the current year and maybe even helped Harnischfeger negotiate with its bankers regarding its debt, which makes this change seem fabricated. I think in the long-run, this new depreciation policy will reduce profits. I also think that the changes in the estimated depreciation lives on certain U.S. plants, machinery and equipment is another effort to inflate profits because if the economic life is increased then the depreciation expense is lowered resulting in higher net income. In addition, a longer depreciation life will increase maintenance expense along with it. Overall, for the future, these policy changes related to depreciation will have a negative effect on the profitability of the firm in the future, and are just helping them in the short-run to make it seem as if the Corporation is financially better than it actually is. 2) Change in Inventory valuation to LIFO method According to Note 7, Inventory reductions in 1984, 1983, and 1982 resulted in a liquidation of LIFO inventory quantities carried at lower costs compared with the current cost of their acquisitions. In addition, the effect of these liquidations was to increase net Income by $2.4 million or $.20 per common share in 1984. LIFO is a method of valuing inventory where the latest costs of raw materials are used in determining cost of goods sold. Since inventory is liquidated at lower cost than current cost, cost of goods sold is lowered and Net Income is, therefore, higher.

Effect of these changes for Harnischfegers future performance: I think this change will have positive effects for the Corporation in the future. Since this change increased the liquidity on the balance sheet, it will help the business in its entirety being able to decrease its inventory level when needed. In addition, I think the LIFO method will also help increase Net income for the future because cost of goods sold is lowered and will continue to be lower. 3) Changes in Pension Plan The company has pension plans covering all of its employees. The company decided that the previous pension plan was too high. As a result, the Corporation policy has been changed to fund at a minimum the amount required under the Employee Retirement Income Security Act of 1974. Harnischfeger also got restructured its Salaried Employee Retirement plan in 1984 due to overfunding of the Plan. This new plan includes higher minimum pension benefits. In addition, cash that came from ridding of the old plan was divided up, $36.7 million toward purchasing individual annuities to cover the obligations of the original plan and $39.3 million actuarial gain which resulted from the restructuring is included in Accrued Pension Costs in the accompanying Balance sheet and is being amortized to income over a ten-year period commencing in 1984. These changes have drastic effects on the financial statements of Harnischfeger. The pension expense is reduced in 1984 by $4 million, net income increased by about $3.9 million, and the company is able to show a positive cash flow for 1984. Effect of these changes for Harnischfegers future performance: I think these changes will have a positive effect for Harnischfegers future performance. Because these pension expenses have been cut down along with the workforce, Harnischfeger can constantly be more profitable in the future. However, it is important to note the effect of these changes on keeping employees satisfied. It is possible that because of these cuts, some employees feel undermined which may result in a negative effect on the company. 4) Changes in R&D Expenses Harnischfeger cut down its research and development expense to $5.1 million in 1984, which is a significant cut because they put $12.1 million in 1983 and $14.1 million in 1982 (Note 9 in Financial Notes). Because of this, operating profit increased by about $9 million which can be seen in the percentage of R&D as of sales. Effect of these changes for Harnischfegers future performance: I think this cut in R&D expenses is a little suspect on Harnischfegers part. First of all, in the corporate recovery plan, the company decided to emphasize the high technology part of its

business by targeting for future growth. It seems contradictory that they would cut-down R&D after stating this. Although Harnischfeger is getting funding of R&D expenses in the construction equiment segment pursuant to the October 1983 agreement with Kobe Steel, I think this cut-down in R&D expenses will hurt the companys efficiency in the future because they will not be able to keep up with the new technology and lag behind. In addition, I think a strong reason for why this expense was cut down was to increase profit. Although the effects of this cut-down will not have a big effect in the short-run, I think it will hurt the company a good bit in the future. 5) Changes in Allowance for Doubtful Accounts Harnischfeger changed its allowance for doubtful accounts in 1984 to 6.7%(5.9/(87.648)) of accounts receivable from 10%(6.4/(63.740)) of acc. rec. in 1983. The allowance for doubtful accounts is an estimate of accounts receivable that will not be collected. If the company had kept its allowance for doubtful accounts at 10% of its accounts rec. in 1984, its bad debt expense would have been ((87.65)*.10) - $5.9 = $2.9 million. This decrease in allowance for Bad debt resulted in higher accounts receivable and, as a result, a $2.9 million increase in net income. Effect of these changes for Harnischfegers future performance: I think this decrease in the allowance for doubtful accounts was another strategy that Harnischfeger used to artificially increase their net income. Since management has a lot of power over how much bad debt expense is, it is an easy accrual for management to change. I think in the future, the company might try to increase sales by accepting customers with low credit, further damaging their business. Overall analysis of Harnischfegers future: When looking at 1984 holistically, one can see how Harnischfegers management practiced earnings management. From changes in the depreciation method, inventory valuation to the LIFO method, changes in the pension plan, decrease in R&D spending, to lowering the allowance for doubtful accounts, one has to be suspicious of Harnischfegers statements for 1984. Although most of these changes can be justified (the pension plan restricting being authorized, cutting employees being logical, etc), it is interesting that these accounting changes all occurred in just one year when the executives will be making more money with more incentives. When looking from the viewpoint of an analyst, I think Harnischfeger is taking a big risk going into the future with this artificial boost in profits/net income and it will catch up to them. As an analyst, I would not feel comfortable investing in a company after knowing all these facts because there is still a great deal of uncertainty for the future of this company.