In order to recover from losses, Harnischfeger made several changes starting in1983. He restructured the top management by creating the position of chief operating officer. To deal with the short term liquidity problem, he decided to cut costs by reducing staff from 6900 to 3800, reducing bonus to staff, liquidating the excess inventory, prolonging payment to creditors and permanent shutting down of an equipment plant at Escanaba.
In 1984, there was a liquidation of last in first out inventory quantities at lower costs compared to the current costs of their acquisitions. The effect was to increase income by $2.4 million. The company focused on providing minimum pension for its employees under the Employee Retirement Income Security Act of 1974. This was to reduce pension expenses by $4 million. The effect of the change in pension plans saw a reduction in pension expenses by $14 million, an increase in the net income by $3.9 million, and a positive cash flow. These changes helped to improve the cash position of Harnischfeger corporation.
The company came into long term (10 year) agreement with Kobe Steel to supply Harnischfeger with cranes as they stopped their own manufacture of cranes. This was aimed at reducing R&D, administrative and production costs for Harnischfeger. The R&D expenses were reduced to $5.1 million from $412 million in 1983. The effect of the change in R&D expenses in 1984 resulted in an increase in operating profit by $9.1 million.
The Industrial Technology Group was created to emphasize on high technology for future growth. Previously they added only the gross margin in the financial statement. As a result, both the aggregate sales and cost of sales increased by $28. From 1983 the company has included in its net sales the purchases from Kobe Steel and the sales by the Harnischfeger corporation to efficiently show their transactions with Kobe Steel.
Properties of Harnischfeger are always stated at cost. Expenses for renewals and betterment of assets were capitalized. With effect from 1984 depreciation of plant and equipment were charged on straight line basis which increased methods for tax reporting purposes. The impact of the changes in the method of depreciation on the income was insignificant. As a result, the corporation changed the depreciation policy of certain plants, machinery and equipment which in turn increased the net income. The balance sheet showed improvement in liquidity position. The changes in depreciation showed an increase of $2.4 million in operating income in 1984. Discontinued assets were taken as cost minus accumulated depreciation or realizable value- the lesser of the two.
In 1984, Harnischfeger negotiated with lenders to reorganize their debt obligations by providing 3-year term loans with an extension option of one year secured by fixed and other assets. With all these changes, the company began doing better. Their losses declined from $77 million to $35 million which brought in confidence to the management. In 1984 the company made profits in all its four quarters despite the intense price competition. The profit before tax was $15 million. Sales improved 24% and new orders totaled $451 million. The net interest rate increased to $2.9 million because of higher rates in interest on outstanding funded debt and reduction in interest income. They raised additional capital through public offering of 12% debentures and 2.15 million shares. Net proceeds totaled to $149 million which helped Harnischfeger to pay off their outstanding debts. The consolidated cash balances increased by $32 million. As a result they gained permanent long term capital to grow and explore new opportunities.
The temporary investments (includes treasury bills, money market funds, bank repurchase agreement, commercial paper and bankers acceptances) of the corporation were stated at cost plus accrued interest. This helped in approximating the market value. There was also a change in the allowance of doubtful debts account to 6.7% in 1984 from 10% in 1983. The change in the allowance for doubtful accounts was n $2.9 million in operating income for 1984.
Question 2
What do you think are the motives of Harnischfeger’s management in making the changes in its financial reporting policies? Do you think investors will see through the changes?
The annual report of 1983 expressed that the company would become profitable soon. They mentioned that as the company was completing their 100th year in operation they would make positive results in 1984. Harnischfeger’s management made changes in the financial reporting policies as they wanted to show that the company was making profits in 1984. In turn shareholders will be convinced that the company is doing well and invest more in Harnischfeger corporation. As the firm made profits in 1984, the stock prices would go up and as a result it would convince the shareholders to take up more shares. This would rise the share capital of Harnischfeger Corporation.
The management also set up an executive incentive compensation program to ensure Harnischfeger Corporation made progress. According to this program, the senior executives would be given a 40% incentive if they reached a specific profit after tax objective. This motivated the senior officials to work constantly to improve the financial position of the firm. The officials would also be given another 40% increment if the profits exceeded the set objective.
The company undertook a lot of changes in accounting strategies and financial reporting policies to show that the company was reviving. But the investors might turn suspicious as the time for all the changes to occur and the firm to start making profits was rather very short. They would just think that the company is trying its best to portray a good image of itself on its 100th year. These changes were made at the cost of the executive investment compensation (80% increment) to the top employees if the profits exceed the objectives.
There are possibilities that the investors feel doubtful that in spite of the research and development spending coming down, the company was exploring high technology, acquiring new products and equipment. They also expanded to provide computer integrated solutions.
A few investors might also feel that extending the depreciation lives of assets like plant and equipment to show greater income would not be a good idea.
The investors might not blindly believe all the strategies taken by the firm as the changes were made in a very short time. Hence, they might be suspicious and be more cautious before investing in Harnischfeger corporation.
Question 3
Assess the company’s future prospects, given your insights from questions 1 and 2 and the information in the case about the company’s turnaround strategy.
Harnischfeger corporation is making a lot of changes in its policies and financial reporting with an expectation that this one time boost in liquidity and income in 1984 will make the future smooth for the company and help them carry on business successfully and expand into new markets. But this might not be the case. The company can face problems in the long run. They have just come up with a temporary solution to make the firm profitable.
There might be uncertain economic and environmental conditions where Harnischfeger corporation might find difficult to combat. There is also a decreasing interest rate in the market which means that Harnischfeger corporation will have to deal with high interest rate in the future. The change in the depreciation policies will improve the profitability of the firm now but in the long run there would be higher depreciation costs which lead to greater operating costs. As the plant and equipment age, there would be higher maintenance costs which would further cause higher operating costs.
As the firm expands there would be more staff. Hence the salary and pension payable to them will rise in the long run increasing the costs of Harnischfeger corporation. The company has reduced the R&D expenditure but in the long run they will have to incur heavy R&D expenditure to cope up with the intense competition and diversification into new markets and products. In 1984, the company decided to eliminate bonuses and reduce pension, in the long run employees will not prefer working in the company without bonus and pension. Hence, they will have to provide bonus and pension.
Hence there is a high probability that Harnischfeger corporation might get into losses in the coming years as the strategies undertaken by the management are more short term in nature.