1. Describe clearly the accounting changes Harnischfeger made in 1984 as stated in Note 2 of its financial statements. The accelerated depreciation method was changed from to straight-line on all company assets that caused to increase after-tax net income for 1984 by $11.005 million. The cumulative effect of change in 1984 there will be no reduction in the depreciation expense due to change.
in 1984 decreased by $7.0 million over the previous year. Most of this reduction was a result of the company's agreement with Kobe Steel, Ltd. Under this agreement, Kobe agreed to reimburse Harnischfeger up to $17.0 million dollars of R&D expense over a period of three years. However, some students argue that Harnischfeger may be cutting its research budget since the actual reduction in Harnischfeger's 1984 R&D expense is more than one-third of this amount. (See Exhibit 4, Notes 6 and 9, in the case.)
8. Effective 1984, Harnischfeger began to include in its net sales products purchased from Kobe Steel, Ltd., and sold to third parties by Harnischfeger. Previously only the gross margin on Kobe-originated equipment was included in Harnischfeger's financial statements. This increased Harnischfeger's sales in 1984 by $28.0 million but had no impact on its profits. Some students would mistakenly argue that this had an impact on Harnischfeger's net income. (See Exhibit 4, Note 2, in the case.)
Although some of the above are pure accounting decisions with no direct cash-flow consequences, the other decisions affect the company's reported profits as well as its cash flow. The instructor should ask the class to identify the latter-type decisions among the above.
Discussion of Question 2
The above analysis shows that most, if not all, of the reported profits of Harnischfeger in 1984 are produced by accounting changes. Therefore, the accounting changes helped the management report a significant profit rather than a modest loss. The instructor should point this out to the class and ask: Why do you think the management of Harnischfeger made these accounting changes?
Students point out
a number of possible motives for the accounting changes:
1. Boost the company's stock price so that the company could raise new capital,
2. Meet the earnings targets of the company's top management compensation plan,
3. Avoid the violation of debt covenant restrictions, and
4. Improve the company's image with the customers, dealers, and prospective employees.
Some students argue that the analysis in Question (1) shows that it is too complicated for an average investor to "see through" the impact of all the accounting changes. They further point out that, even if many analysts recognize the effect of the company's accounting decisions on the 1984 profits, it is quite unlikely that the analysts would be able to assess the impact of these changes in future years. Other students are likely to argue that the market processes the reported profit numbers efficiently. They argue that there are some sophisticated analysts who could perform the analysis that was done in the class.
The instructor should encourage this discussion. At some point in the discussion, the instructor should intervene and summarize the evidence from the research literature:
1. There is considerable evidence in finance and accounting literature that shows that the capital markets are generally efficient.
2. For stock prices to reflect reality in an unbiased manner, it is not necessary that everyone in the market has to process the information correctly. As long as there are some sophisticated investors who can "see through" the company's accounting changes, the stock price will reflect this due to the possibility of arbitrage by these investors.