Harnischfeger Corporation
Harnischfeger Corporation, a large New York Stock Exchange company, faced a financial crisis in 1982. New management was appointed to turn the company around and as part of its restructuring strategy, the new management team made a number of financial reporting policy changes and accounting estimates in fiscal year 1984. Listed below are all of the changes and analysis on whether they might be real earnings management activities. In addition, the effect of these changes on the company’s revenue, pre-tax profits and cash flows for the year 1984 will also be shown.
1. Depreciation method of its US operating plants was changed from accelerated methods to straight line method for financial reporting purposes (Note 2).This change in depreciation accounting method increased the 1984 income by $11 million. Harnischfeger’s management explained that this change was to conform to the industry standard. Under normal circumstances, this change would be perfectly reasonable. However, in this case, the timing of this policy change is questionable. It occurred when Harnischfeger was in the midst of negotiating its debt restructuring process with the banks. And since changing to a straight line method will improve the company’s financial strength in the short run, it strongly suggests that move was performed by the management to artificially improve the balance sheet in favour of the negotiations.
2. As a result from the change in depreciation method, there was also an adjustment of the residual values and a change in the estimated depreciation lives on certain machinery and equipment (Note 2). This change resulted in an increase of net income by $3.2 million. Together with the increase of $11 million from change in depreciation method, this total increase of $14.2 million represented 93.5% (=14.2mil/15.176mil) of the net income. These reflected incentive for profit realisation. However, this move involved risks. Firstly, the extension of depreciation lives would increase
1. Depreciation method of its US operating plants was changed from accelerated methods to straight line method for financial reporting purposes (Note 2).This change in depreciation accounting method increased the 1984 income by $11 million. Harnischfeger’s management explained that this change was to conform to the industry standard. Under normal circumstances, this change would be perfectly reasonable. However, in this case, the timing of this policy change is questionable. It occurred when Harnischfeger was in the midst of negotiating its debt restructuring process with the banks. And since changing to a straight line method will improve the company’s financial strength in the short run, it strongly suggests that move was performed by the management to artificially improve the balance sheet in favour of the negotiations.
2. As a result from the change in depreciation method, there was also an adjustment of the residual values and a change in the estimated depreciation lives on certain machinery and equipment (Note 2). This change resulted in an increase of net income by $3.2 million. Together with the increase of $11 million from change in depreciation method, this total increase of $14.2 million represented 93.5% (=14.2mil/15.176mil) of the net income. These reflected incentive for profit realisation. However, this move involved risks. Firstly, the extension of depreciation lives would increase