As a result of a worldwide recession in the 1980’s the machinery industry suffered a decrease in demand. This was caused mainly by the cost reduction strategies that most of their major consumers were assuming at the time. Harnischfeger Corporation (HC), one of the oldest manufactures in the machinery industry was among the several companies that had to restructure their strategy in order to survive the economic downturn. After suffering a $77 million loss in 1982, HC decided to restructure their strategy for the upcoming years. Some of the major changes that the HC considered were: changes in top management, cost reductions to lower the break-even point, reorientation of the company’s business and debt restructuring and recapitalization. Although these changes had a great impact on HC 1984 profits, it is clear in the case that the changes in accounting policies had an even greater effect on HC profitability during the fiscal year of 1984
Step 1: Identify Principal Accounting Policies
First, it is important to point out some key accounting policies noted in the financial statements of Harnischfeger Corporation for later analysis. The company uses a straight line depreciation method on its capital assets, but just began using this method in 2004; this will be the subject of later analysis to discuss the impact of the change on the company’s financial status. Harnischfeger Corporation funds its pension accounts at the minimum funding required by ERISA (Employee Retirement Income Security Act of 1974).
Step 2: Assess Accounting Flexibility
The next section of this analysis is to assess the accounting flexibility within the business model of Harnischfeger Corporation and assess the extent to which management utilizes this flexibility. The company has elected to, for bookkeeping purposes, use the LIFO inventory cost method for its US inventory costs and FIFO for the inventory cost of its foreign subsidiaries. As previously discussed, the company changed its depreciation method in 1984 from an accelerated method to the straight line method. This subsequently increased the company’s net income by $11m. This also changed the estimated lives of depreciable assets which increased net income by another $3.2m. Financial statements of certain consolidated subsidiaries, principally foreign, had fiscal years ending September 30 while previously these subsidiaries had fiscal years ending July. By changing the fiscal year of foreign subsidiaries (ending period of September 30 instead of July 31), the 1984 reporting period for the subsidiaries increased from 12 months to 14 months. This increased sales by $5.4 million. The Corporation added products purchased from Kobe Steel, which were re-sold by the Corporation, into its net sales in 1984. The effect of the change in sales calculation was an increase in both aggregate sales and cost of sales by $28 million. Also, profit margin dropped from 1.55% to 1.44%, which represented a 7.1% change in profit margin
Step 3: Evaluate Accounting Strategy
Continuing the discussion of the change in depreciation method, this strategy reduced the annual depreciation expense, increasing net income. The potential rationale behind this change will be discussed later in this analysis. Another large increase in net income is the result of an IRS evaluation of Harnischfeger’s previous tax returns. This evaluation resulted in a credit for taxes paid that completely cancelled out the company’s tax expense for the year. In addition to the IRS evaluation, Harnischfeger restructured its pension plan under the Salaried Employees’ Retirement Plan due to overfunding. This resulted in a significant reduction in the company’s pension liability and reduced the pension expense for the year from $6.5m in 1983 to $1.9m in 1984. The reduction in funding, and consequent increase in cash, is treated as income amortized over 10 years.
Step 4: Evaluate the Quality...