Harnischfeger Corporation

Financial Statement Analysis and Business Valuation Group No: 1 Members Deepanker Agarwal Divya Sethi Neha Shandilya Parikshit Jain Sushan Rungta Varun Sharma 08EM-014 08EM-016 08EM-023 08EM-028 08EM-048 08EM-051

Contents 1. Accounting policy changes that Harnischfeger had made during 1984 and the effect of ....................... 4 Effect of change in Sales Calculation ........................................................................................................ 5 Effect of Changes in Depreciation Method ............................................................................................... 5 Effect of LIFO Inventory Liquidation ......................................................................................................... 6 Effect of Changes in Allowance for Doubtful Accounts ............................................................................ 7 Effect of Changes in R&D Expenses .......................................................................................................... 7 Effect of Changes in Pension Plan ............................................................................................................. 7 2. The motives of the management in making the change of these financial changes................................ 8 3. Access the futures prospects, given your insights about the companys strategy ................................... 9

1. Accounting policy changes that Harnischfeger had made during 1984 and the effect of these on the companys 1984 reported profits 1) From Financial Note 2, we know that, in 1984, the corporation had computed depreciation expenses on plants, machinery and equipment using straight-line method for financial reporting purpose. Prior to 1984, the corporation used principally accelerated methods for its U.S operating plants. The cumulative effect of this change, which was applied retroactively to all assets previously subjected to accelerated depreciation, increased net income for 1984 by $11.0 million or $0.93 per common and common equivalent share. The impact of the new method on income for the year 1984 before the cumulative effect was insignificant. 2) Also from Financial Note 2, we know that, as a result of the review of its depreciation policy, the corporation, effectively November 1, 1993, had changed its estimated depreciation lives on certain US plants, machinery and equipment and residual values on certain machinery and equipment, which increased net income for 1984 by $3.2 million or $0.27 per share. No income tax effect was applied to this change. 3) From Financial Note 7, we know that the Salaried Employees Retirement Plan, which covered substantially all salaried employees in the U.S., had been restructured during 1984 due to overfounding of the plan. Effective August 1, 1984, the Corporation terminated the existing plan and established a new plan, which is substantially identical to the prior plan except for an improvement in the minimum pension benefit. The effect of the change in the investment return assumption rates for all US plans, together with the 1984 restructuring of the US Salaried Employees Plan, was to reduce pension expense by approximately $4.0 million in 1984 and 20. Million in 1983, and the actuarial present value of the accumulated plan benefits by approximately 6.0 millions. So, all these three changes had increase the profit by approximately 20.2 millions. So, actually, if the company hasnt made these changes, the financial report would still show a net loss.

Effect of change in Sales Calculation Effective November 1, 1983, Harnischfeger incorporated products purchased from Kobe Steel, Limited and then re-sold by the company, into its net sales. During previous accounting periods, only the gross margin on these products was recognized as sales. As a result, both aggregate sales and cost of sales increased by $28 million. This accounting change did not have material impact on the overall net operating income as stated in the financial statement, however, it did have an influence on the quality of earnings, which is reflected by profit margin. Profit margin dropped to 1.44% from 1.55%, reflecting a 7.1% change in profit margin, after such a change was in place. The management claimed that this change reflected more effectively the nature of the Corporations transaction with Kobe, (Palepu, 2000, p.3-39) and we agree with the managements view for two major reasons. First, Harnischfeger was operating in a macro business environment in which the company had to significantly reduce cost to survive. Outsourcing, an effective way of transferring production cost to more effective producers, could make the Harnischfeger focus on its core strength in product development capability and high brand power penetration. Second, Harnischfeger did phase out its own manufacture of construction cranes in Michigan and enter into a long-term agreement, under which Kobe would supply construction cranes. Also, effective November 1, 1983, Harnischfeger adjusted some subsidiaries ending period to September 30 instead of the previous ending July 31. This had the effect of lengthening the 1984 reporting period for these companies from 12 months, to 14 months, and increased sales by $5.4 million. Assuming these companies had the same profit margin as the parent, the change increased cost of sales by $4.3 million. We agree that the influence on net income is immaterial and that this change reflects more effectively the subsidiarys business operation. But it does represent a one-time event which should be corrected for during analysis of the companys potential for future profitability Effect of Changes in Depreciation Method In 1984, Harnischfeger changed its depreciation policy for financial reporting purposes to a straight-line method from a principally accelerated method. A net income of $11 million was

realized for 1984 when the straight-line method was applied retroactively to all assets depreciated under the accelerated method. The management viewed this as an approach to match the companys standard with that of industry peers. We agree with the management in a way that this approach provides comparable standard. However, the timing of this action is questionable. This approach artificially improved the companys financial strength in the short run and helped Harnischfeger negotiate its debt restructuring process with bankers. In the long run, however, the straight-line method will reduce profit in the years to come. Also, it was too aggressive to realize this income just in a one-year period, which reflected the incentive for management to achieve profit. In addition, Harnischfeger extended its estimated depreciation lives on certain US plants, machinery and equipment, and increased residual value on certain machinery and equipment. These changes resulted in an increase of $3.2 million in net income in 1984. Again, this reflected incentive for profit realization. The then-current high interest rate environment was supportive for residual value upward-adjustment, however, there were great risks involved. First, interest rate was on a down-trend after it peaked in 1982. Second, the liquidity of Harnischfeger machinery, for heavy-machinery manufacture, was low. Also, extension of depreciation lives would increase the maintenance costs and reduce profit in the years to come. Therefore, we suggest that Harnischfegers depreciation policies be closely watched when the economic environment changes

Effect of LIFO Inventory Liquidation Harnischfeger reduced its inventory level in 1984, 1983 and 1982, resulting in a liquidation of LIFO inventory. This liquidation process led to gains when inventory, acquired at a lower cost in the earlier years, were sold at a higher price, resulting from higher inflation. Net income in 1984 increased by $2.4 million (in the form of gains), and liquidity was improved on the balance sheet. We view this as a sound business decision when the management can reduce operating cost by decreasing inventory level.

Effect of Changes in Allowance for Doubtful Accounts Harnischfeger, for some reasons, adjusted its allowance for doubtful accounts to 6.7% of sales for 1984 from 10% of sales in 1983, resulting in $2.9 million in operating income for 1984. The company might try to increase sales by aggressively extending credit to doubtful customers, risking losing all of relevant sales. This is very skeptical as Harnischfeger gives no explanation. Effect of Changes in R&D Expenses Harnischfeger significantly cut its research and development expenses to $5.1 million in 1984, from $12.1 million in 1983 and $14.1 million in 1982. In 1984, operating profit was pumped up by $9.1 million when Harnischfeger didnt follow the same level of R&D activities in 1983, reflected in the percentage of R&D as of sales. This is controversial to managements strategy of focusing on the high technology part of its business and will damage its strength in the future. We conclude, therefore, that the management managed to increase profit by reducing R&D expenses on purpose. Effect of Changes in Pension Plan The company states, in the footnotes of its 1984 financials, that its salaried employee pension plan was well over-funded. The policy of Harnischfeger was to fund at a minimum the amount required under the Employee Retirement Income Security Act of 1974. (Palepu, 2000, p.3-38) This probably meant, in light of recent financial difficulties, that the company intended to fund at the minimum. Over-funding most likely came about as a result of the company reducing its workforce by about 45% in 1983. Harnischfeger terminated its Salaried Employee Retirement Plan in 1984, and created a new plan. This new plan included in increased minimum pension benefit, which probably served to make the pension restructuring more appetizing to employees. Cash resulting from the liquidation of the original plan was divided into two groups: $36.7 million went toward purchasing individual annuities in order to cover the obligations of the original plan, and $39.3 million went into an account called Accrued Pension Costs*to be+ amortized to income over a ten-year period (Palepu, 2000, p.3.42)

This pension plan change has three significant effects on the financial statements. First, pension expense was reduced in 1984 by $4 million. Second, net income increased by $3.9 million. Third, and most importantly, the company was able to show a positive cash flow for the year. Without this one-time injection, cash flow would have been ($7.6 million).

2. The motives of the management in making the change of these financial changes 1) From Exhibit 1, we can see that the most of the Corporation Board members held certain quantities of shares of the corporations common stock. So, a positive profit will drive the stock price high. 2) Executive incentive Plan was established for fiscal 1985 which provide an incentive compensation opportunity of 40% of annual salary for 11 senior executive officers only if the Corporation reaches a specific net after-tax profit objective. The corporate also provided anther incentive compensation of 40% of the annual salary for seven of them if the corporate exceeds the objective 3) Three-year term loan agreement with its lenders required specified minimum levels of cash and unpledged receivables, working capital and net worth.

3. Access the futures prospects, given your insights about the companys strategy I think the company can operate more profitable in the future than what it got in 1982,1983 and 1984. It found a great strategy such as reducing workforce, closing plants losing money and reorientation its business by developing and acquiring new products, technology and equipment and expanding its ability to computer-integrated products and solutions. The financial surroundings are much better now than before because its successful issuing of new stock and corporate bonds. However, cutting employee benefits, freezing wages and establishing alliance with foreign companies are all double-edged strategies. One potential problem will be the negative impact on the employees morale and dependence upon out resources brought by these activities. Also the Executives Incentive was declared almost 40 % which is contradicting to the strategy Regarding, improving the cash flow, the company is delaying payments and negotiating hard with bank loans. However, there is no strategy to realize payments faster or improve the inflow from customers As concerning the R&D, the company has a strategy to get into new technology however, the R& D expenditure does not match with this objective The future prospects also depend on the implementation of the business reorientation strategy. It is often a more risky job to enter a new field than staying at your previous station. So, there is still considerable level of uncertainty of the companys future. From the limited source of information, we are not sure about this companys competitive position in the computer-integrated products and solutions, which it will focus on in the future.