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
$0.93per 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 over
founding 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 million. So, all these three changes had
increase the profit by approximately 20.2 million.
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 a7.1% 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 the1984
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 in1984, 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 $3.9million. 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 another 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 1982,1983and 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 outside 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