Harnischfeger Corporation Case Solution

1. Describe clearly each of the accounting changes Harnischfeger made in 1984 as stated in Note 2 of its financial statements.

According to Note 2, Harnischfeger incorporated some changes in its accounting policies regarding three major categories, i.e., revenue recognition, depreciation, and asset valuation, the details of which are as follows.

1. As a part of its corporate recovery plan to remedy the problems which had stemmed from the financially difficult year of 1982, the company went into a long-term contract with a Japanese steel manufacturer “Kobe Steel”. It was agreed with Kobe that they would supply the company with the necessities for the construction cranes Harnischfeger plans to sell in the United States; this would greatly reduce the costs incurred in the manufacturing of its equipment and, consequently, allow it to set a domestically competitive price for the products. In November 1983, Harnischfeger set into effect a change of revenue recognition regarding the purchases from Kobe. Until then, it was including just the gross margin on the sales of equipment that had been bought from Kobe in its Income Statement. However, it decided to now include the complete prices of Kobe-bought equipment in its Net Sales section on Income Statement. In addition, Harnischfeger also started to include in its Sales section the sales of its “foreign subsidiaries”. These changes lead to a rise in Harnischfeger’s net sales of $33.4 million in total, but the change in net income was not significant in 1984. The purpose was to accurately represent the nature of the sales and transactions of foreign subsidiaries and Kobe.

2. Previously, Harnischfeger depreciated its plants and equipment, which were being used in the US, using the “principally accelerated method”. In 1984, they switched to the “straight-line method” for depreciation for all the plants and equipment. The change was applied retrospectively for assets previously depreciated using principal acceleration. 

3. Because of the change in the depreciation method, the company, 1983, also reviewed and edited the estimated useful lives of some of its assets operating in the US, which lead to a change in asset valuation. The purpose of this change (and of the foregoing one), as described in Note 2, was to align the company’s depreciation policy with that of others in the industry so to allow for a better comparison and analysis of the assets. 

2. What is the monetary effect of the depreciation accounting method change on the reported income in 1984? How and by how much ($) will this change affect profits in future years?

Once the change was set into effect, the depreciation charges were reduced by 40%, dropping from $13.552 million in 1983 to just $8.077 million in 1984. We mentioned, as per Note 2, in the foregoing answer: 

“In 1984, they switched to the “straight-line method” for depreciation for all the plants and equipment. The change was applied retrospectively for assets previously depreciated using principal acceleration.”

An important point to notice here is that the change was a retrospective one, not just a prospective one. The difference between a retrospective and a prospective change is that only the financial statements of future years are impacted because of the latter while the former leads to a change in the financial statements of the previous years as well. Therefore, in looking for the effect of the change, since it was retrospective, the required modifications in the financial statements of the previous year will also have to be accounted for. Now, as Note 2 mentions, the depreciation method change did not have a significant effect on the statements for 1984 itself but the total effect, including that on the past statements, resulted in a substantial increase in net income of $11 million in 1984, and $0.93 per each common share. In future years, the change in profit due to depreciation will stay the same as that of this year but decrease if compared to hypothetical profit under accelerated depreciation. This is because the depreciable amounts decrease going forward under accelerated depreciation, but the straight-line method gives the same depreciation expenditure throughout the years. Therefore, now that they have switched, they would be accounting for the same amount each year in depreciation which will have zero effect on the profits over the coming years but compared to the hypothetical depreciation under principal acceleration, would result in a greater depreciation expense, and in turn, lesser profits. 

As to the amount of change in future profits in dollars, it is not possible to calculate with the information available in the case since the details regarding depreciation rates have not been provided. 

3. What is the monetary effect of the depreciation lives change? How and by how much ($) will this change affect future reported profits?

The succeeding question states:

“The depreciation accounting changes assume that Harnischfeger’s plant and machinery will last longer and will lose their value more slowly.”

It can be observed that the company has increased the estimated useful lives of their machinery. When a company increases the estimated useful life of an asset, it decreases the annual depreciation expense on it. This is because the same depreciable base, that was being divided by a lesser number of years, is now being divided by a greater number of years, thereby yielding a smaller amount of expense.

Depreciation Expense=  (Depreciable Base (or Total Value - Salvage Value) )/(Estimated Useful Life in Years)

Since the depreciation expense, along with other expenses, is subtracted from the revenue to arrive at the net income, a smaller depreciation expense means a greater net income. Therefore, it can easily be said that the net income must have increased. This is confirmed by Note 2 as well:

“Corporation … has changed its estimated depreciation lives on certain U.S. plants, machinery and equipment, and residual values on certain machinery and equipment, which increased net income for 1984 by $3.2 million or $.27 per share.”

Now, regarding the future effects of this change, there are two possibilities: 

1. The machinery’s actual useful life turns out to be less than its estimated useful life, and it is used for a smaller number of years than intended. This will mean that the company will be incurring depreciation expenses on the machinery without deriving any economic benefit from it, leading to lower profits than intended.