Harnischfeger

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Harnischfeger
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Harnischfeger

• We recommend the stock of Harnischfeger
  Corporation for purchase in speculative accounts
  because we expect the company to report a modest
  profit this year and untaxed earnings of 3 per
  share in 1985, following ten years of
  deteriorating financial statements and two years
  of large losses. Earnings power, assuming a
  sustained recovery of the companys markets,
  could be 4.00-6.00 per share in the 1986-1987
  time period. The Harnischfeger stock is selling
  at less than three times these peak earnings
  (were they taxed) and at a slight discount to
  book value.

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Harnischfeger
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Harnischfeger

• What was responsible for Harnischfegers turn
  around?
• Identify all the accounting policy changes and
  accounting estimates that Harnischfeger made
  during 1984. Estimate, as accurately as possible,
  the effect of these changes on the companys 1984
  reported profits.

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Harnischfeger

• Accounting Changes
• Depreciation method add 11M
• Depreciation estimate add 3.2M
• Pension gain rate of return assumption for
  pension add 3.9M and 0.1M
• LIFO liquidation add 2.4M
• Provision for doubtful accounts add 2.6M

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Harnischfeger

• Harder to determine for these changes
• Fiscal year change for subsidiary 15 months in
  1984, insignificant change to net income, sales
  increase by 5.4M
• RD expense reduced expenditures to below Kobe
  reimbursement
• Included sales from Kobe Steel why? Help build
  topline

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Harnischfeger

• What do you think are the motives of
  Harnischfegers management in making the changes
  in its financial reporting policies?
• Do you think investors will see through these
  changes?

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Harnischfeger

• Incentives
• Boost stock price to raise new capital
• Meet earnings targets for compensation
• Avoid violating debt covenants
• Improve image with customers, suppliers, etc.
• Internal pricing tied to external reporting
  numbers. Accelerated depreciation makes cost
  appear too high.

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Harnischfeger

• Investors see through?
• Considerable evidence in finance and accounting
  that capital markets are generally efficient
• For stock prices to reflect reality in an
  unbiased manner, not necessary to have everyone
  see through marginal investors are the price
  setter.

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Harnischfeger

• From the management side - why manage earnings
• Investors didnt adjust their original
  conservative accounting
• Unpleasant experience with debt covenant
• Interaction between mgmt accounting and external
  accounting.

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Harnischfeger

• Harnischfeger managements perspective on
  earnings management
• In accounting there is no such thing as absolute
  truth. The same underlying reality can be
  accounted for using a range of assumptions. The
  earlier philosophy of this company was to choose
  the conservative alternative whenever there was a
  choice. Now we have decided to change this. We
  would like to tell the world that we are alive
  and well. We wish to tell the truth but do not
  want to be overly conservative in doing so.

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Harnischfeger

• Harnischfeger managements perspective on
  earnings management
• As a company you have to put the best foot
  forward if you want to raise capital, convince
  customers that you are a viable company, and
  attract talented people to work for the company.
  I feel that the financial reporting should help
  rather than hinder the implementation of our
  operating strategy. In my opinion, the changed
  accounting format highlights the effectiveness of
  our strategy better than the old policies do.

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Harnischfeger

• Harnischfeger managements perspective on
  earnings management
• When the outside world compares our financial
  performance with that of other companies, they
  may or may not take the time and effort to
  untangle the effects of the differences in
  financial policies that various companies follow.
  My own belief is that people adjust for the
  obvious things like one-time gains and losses but
  have difficulty in adjusting for ongoing
  differences. In any case, these adjustments
  impose a cost on the user.

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Harnischfeger

• Harnischfeger managements perspective on
  earnings management
• If people adjust for the differences in
  accounting policies when they compare us with
  other companies, then it should not matter
  whether we follow conservative or liberal
  policies. But suppose they do not adjust. Then
  clearly we are better off following the more
  liberal policies than conservative policies. I am
  not sure whether people make the adjustments or
  not, but either way we wish to present an
  optimistic version of the picture and let people
  figure out what to do with the numbers.

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Harnischfeger

• Assess the companys future prospects given your
  insights and the information in the case on the
  companys turnaround strategy.

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Harnischfeger SCF
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Harnischfeger

• Assessing their turnaround strategy
• Changes in top management
• Cost reductions to lower the companys breakeven
  point
• Reorientation of the companys business
• Restructuring the companys finances to
  facilitate the implementation of the
  reorientation strategy

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Harnischfeger

• Subsequent events
• 1985
• Changed accounting for the cost of duration
  patterns and tooling, from expensing to
  capitalizing
• Reported a net profit of 0.74 per share for
  fiscal 1985. The accounting changes described
  above contributed 0.24 per share to the reported
  profits.
• Raised 147M by issuing preferred stock.

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Harnischfeger

• Subsequent events
• 1986
• Mr. Goessel was appointed the chairman and CEO of
  the company Mr. Grade as president and COO. Mr.
  Goessels previous appointment was president and
  COO and Mr. Grade CFO.
• Acquired Beloit corporation for 175 million in
  cash. Later sold 20 of the stake for 60 million
  in cash.

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Harnischfeger

• Subsequent events
• 1986
• Report a 1.14 per share loss (2.15 profit from
  continuing operations 4.45 loss from
  discontinued operations and 1.16 per share from
  the adoption of new pension accounting rules.)

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Harnischfeger
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Harnischfeger

• Wrap up
• Managers exert significant discretion in choosing
  accounting method and estimates.
• These choices affect the reported financial
  statements.
• Various incentives exist for earnings management
• Understanding these incentives is essential for
  evaluating current performance and assessing
  future aspects of a firm.
• Stock market may or may not see through these
  managements.
• A sophisticated and diligent analyst can uncover
  more information than average investors.

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Corporate Governance and SOX

• Effect on Auditors
• Auditors must register with PCAOB
• Annual quality inspections every year for
  registrants that audit more than 100 issuers
• Lead and reviewing partners must rotate off every
  5 years
• no movement by auditor into CEO/CFO/Chief
  Accountant position for two years

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Corporate Governance and SOX

• New audit committee requirements
• members must be independent
• financial expert financially literate
• responsible for appointment, compensation and
  oversight of independent auditors

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Corporate Governance and SOX

• Management assessment of internal controls,
  Section 404
• Management is responsible for Internal controls
• annual assessment of effectiveness (section 404)
• Benefit - fewer misleading and fraudulent
  financial statements assuming...

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Corporate Governance and SOX

• Cost vs. Benefit
• Cost from Foley and Lardner 2005 study
• average cost of being public in 2004 increased
  33 over 2003 for a company with annual revenue
  under 1B 223 in total since SOX
• for companies with revenues over 1B cost of
  being public 14.3M, 1M in lost productivity

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Corporate Governance and SOX

• Cost from Foley and Lardner 2005 study
• Small cap audit fees rose 84 to 1.04M in 2004
  from 2003
• Mid-Cap audit fees rose 92 to 2.18M in 2004
  from 2003
• Large cap audit fees rose 55 to 4.81M in 2004
  from 2003
• Self reported results

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Corporate Governance and SOX

• Corporate Responsibility for financial reports
• CEO CFO must certify
• They reviewed the financial reports
• report (to their knowledge) does not contain any
  untrue statement or omit material information
• Disclosures present operations and financial
  condition fairly
• Internal controls were evaluated and are
  effective
• Have disclosed material deficiencies and frauds
  to auditors

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Corporate Governance and SOX

• Limitations on auditor services
• Specified non-audit services cannot be provided
  to client
• Financial information systems design and
  implementation
• Investment management securities services
• Legal, actuarial and expert services unrelated to
  the audit
• tax preparation allowed, tax strategies not
  allowed

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Corporate Governance and SOX

• Limitations on auditor services
• Cost vs. Benefit
• Raises the cost of both audits and other services
  as it reduces the economies of scale and
  knowledge enjoyed by the auditor
• There is no evidence that auditor performing
  other services led to substandard auditing
  (although a lot of anecdotal evidence, but is
  this what we should base policy on...)

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Corporate Governance and SOX

• How big was the problem?
• First point - not all restatements are a result
  of fraudulent information or inadequate audits
• GAO study of restatements 1997-2002 found on
  average 169 restatements per year
• restatements have increased in recent years,
  but probably due changes in rules conservatism