Finance, Fall 1991.
17. This is true by and large in the United States and in several other countries. However, in
some countries, such as Germany and Japan, tax accounting and financial reporting are closely
tied together, and this particular red flag is not very meaningful.
18. For research on accounting and economic incentives in the formation of R&D partnerships,
see ÔÇťMotives for Forming Research and Development Financing OrganizationsÔÇŁ by Anne Beatty,
Philip G. Berger, and Joseph Magliolo, Journal of Accounting & Economics 19, 1995.
19. For an empirical examination of asset write-offs, see ÔÇťWrite-offs as Accounting Procedures
to Manage PerceptionsÔÇŁ by John A. Elliott and Wayne H. Shaw, Journal of Accounting Research,
20. Richard R. Mendenhall and William D. Nichols report evidence consistent with the hy-
pothesis that managers take advantage of their discretion to postpone reporting bad news until the
fourth quarter. See ÔÇťBad News and Differential Market Reactions to Announcements of Earlier-
Quarter versus Fourth-Quarter Earnings,ÔÇŁ Journal of Accounting Research, Supplement, 1988.
21. This type of analysis is presented in the context of provisions for bad debts by Maureen
McNichols and G. Peter Wilson in their study, ÔÇťEvidence of Earnings Management from the Pro-
visions for Bad Debts,ÔÇŁ Journal of Accounting Research, Supplement, 1988.
22. This point has been made by several accounting researchers. For a summary of research on
earnings management, see ÔÇťEarnings ManagementÔÇŁ by Katherine Schipper, Accounting Horizons,
December 1989: 91ÔÇ“102.
23. See James Chang, 1998, ÔÇťThe Decline in Value Relevance of Earnings and Book Values,ÔÇŁ
Unpublished dissertation, Harvard University. Similar evidence is reported by J. Francis and K.
Schipper, 1998, ÔÇťHave Financial Statements Lost Their Relevance?,ÔÇŁ working paper, University
of Chicago; and W. E. Collins, E. Maydew, and I. Weiss, 1997, ÔÇťChanges in the Value-Relevance
of Earnings and Book Value over the Past Forty Years, Journal of Accounting and Economics 24:
24. See G. Foster, 1979, ÔÇťBriloff and the Capital Market,ÔÇŁ Journal of Accounting Research 17
25. See S. H. Teoh, I. Welch, and T. J. Wong, 1998a, ÔÇťEarnings Management and the Long-
Run Market Performance of Initial Public Offerings,ÔÇŁ Journal of Finance 53, No. 6, December
1998: 1935ÔÇ“1974; S. H. Teoh, I. Welch, and T. J. Wong, 1998b, ÔÇťEarnings Management and the
Post-Issue Underperformance of Seasoned Equity Offerings,ÔÇŁ Journal of Financial Economics
50, No. 1, October 1998: 63ÔÇ“99; and S. H. Teoh, T. J. Wong, and G. Rao, 1998, ÔÇťIncentives and
Opportunities for Earnings Management in Initial Public Offerings,ÔÇŁ Review of Accounting Stud-
26. See Patricia Dechow, Richard G. Sloan, and Amy P. Sweeney, 1996, ÔÇťCauses and Conse-
quences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the
SEC,ÔÇŁ Contemporary Accounting Research 13, No. 1: 1ÔÇ“36; and M. D. Beneish, 1997, ÔÇťDetecting
GAAP Violation: Implications for Assessing Earnings Management among Firms with Extreme
Financial Performance,ÔÇŁ Journal of Accounting and Public Policy 16: 271ÔÇ“309.
n February 1985, Peter Roberts, the research director of Exeter Group,
a small Boston-based investment advisory service specializing in turnaround stocks, was
reviewing the 1984 annual report of Harnischfeger Corporation (Exhibit 4). His atten-
tion was drawn by the $1.28 per share net pro´¬üt Harnischfeger reported for 1984. He Business Analysis and
knew that barely three years earlier the company had faced a severe ´¬ünancial crisis. Har- Valuation Tools
nischfeger had defaulted on its debt and stopped dividend payments after reporting a
hefty $7.64 per share net loss in ´¬üscal 1982. The companyÔÇ™s poor performance continued
in 1983, leading to a net loss of $3.49 per share. Roberts was intrigued by Harnisch-
fegerÔÇ™s rapid turnaround and wondered whether he should recommend purchase of the
companyÔÇ™s stock (see Exhibit 3 for selected data on HarnischfegerÔÇ™s stock).
COMPANY BUSINESS AND PRODUCTS
Overview of Accounting Analysis
Harnischfeger Corporation was a machinery company based in Milwaukee, Wisconsin.
The company had originally been started as a partnership in 1884 and was incorporated
in Wisconsin in 1910 under the name Pawling and Harnischfeger. Its name was changed
to the present one in 1924. The company went public in 1929 and was listed on the New
York Stock Exchange.
The companyÔÇ™s two major segments were the P&H Heavy Equipment Group, con-
sisting of the Construction Equipment and the Mining and Electrical Equipment divi-
sions, and the Industrial Technologies Group, consisting of the Material Handling
Equipment and the Harnischfeger Engineers divisions. The sales mix of the company in
1983 consisted of: Construction Equipment 32 percent; Mining and Electrical Equip-
ment 33 percent, Material Handling Equipment 29 percent, and Harnischfeger Engi-
neers 6 percent.
Harnischfeger was a leading producer of construction equipment. Its products, bear-
ing the widely recognized brand name P&H, included hydraulic cranes and lattice boom
cranes. These were used in bridge and highway construction and for cargo and other
material handling applications. Harnischfeger had market shares of about 20 percent in
hydraulic cranes and about 30 percent in lattice boom cranes. In the 1980s the construc-
tion equipment industry in general was experiencing declining margins.
Professor Krishna Palepu prepared this case as the basis for class discussion rather than to illustrate either effective
or ineffective handling of an administrative situation. Copyright ┬© 1985 by the President and Fellows of Harvard
College. Harvard Business School case 9-186-160.
102 Overview of Accounting Analysis
Overview of Accounting Analysis
Electric mining shovels and excavators constituted the principal products of the Min-
ing and Electrical Equipment Division of Harnischfeger. The company had a dominant
share of the mining machinery market. The companyÔÇ™s products were used in coal, cop-
per, and iron mining. A signi´¬ücant part of the divisionÔÇ™s sales were from the sale of spare
parts. Because of its large market share and the lucrative spare parts sales, the division
was traditionally very pro´¬ütable. Most of the companyÔÇ™s future mining product sales
were expected to occur outside the United States, principally in developing countries.
The Material Handling Equipment Division of Harnischfeger was the fourth largest
supplier of automated material handling equipment, with a 9 percent market share. The
divisionÔÇ™s products included overhead cranes, portal cranes, hoists, monorails, and com-
ponents and parts. The demand for this equipment was expected to grow in the coming
years as an increasing number of manufacturing ´¬ürms emphasized cost reduction pro-
grams. Harnischfeger believed that the material handling equipment business would be
a major source of its future growth.
Harnischfeger Engineers was an engineering services division engaged in design,
custom software development, and project management for factory and distribution au-
tomation projects. The division engineered and installed complete automated material
handling systems for a wide variety of applications on a fee basis. The company ex-
pected such automated storage and retrieval systems to play an increasingly important
role in the ÔÇťfactory of the future.ÔÇŁ
Harnischfeger had a number of subsidiaries, af´¬üliated companies, and licensees in a
number of countries. Export and foreign sales constituted more than 50 percent of the
total revenues of the company.
FINANCIAL DIFFICULTIES OF 1982
The machinery industry experienced a period of explosive growth during the 1970s.
Harnischfeger expanded rapidly during this period, growing from $205 million in reve-
nues in 1973 to $644 million in 1980. To fund this growth, the company relied increas-
ingly on debt ´¬ünancing, and the ´¬ürmÔÇ™s debt/equity ratio rose from 0.88 in 1973 to 1.26
in 1980. The worldwide recession in the early 1980s caused a signi´¬ücant drop in demand
for the companyÔÇ™s products starting in 1981 and culminated in a series of events that
shook the ´¬ünancial stability of Harnischfeger.
Reduced sales and the high interest payments resulted in poor pro´¬üt performance
leading to a reported loss in 1982 of $77 million. The management of Harnischfeger
commented on its ´¬ünancial dif´¬üculties:
There is a persistent weakness in the basic industries, both in the United States
and overseas, which have been large, traditional markets for P&H products. En-
ergy-related projects, which had been a major source of business of our Construc-
tion Equipment Division, have slowed signi´¬ücantly in the last year as a result of
lower oil demand and subsequent price decline, not only in the U.S. but through-
out the world. Lack of demand for such basic minerals as iron ore, copper and
Overview of Accounting Analysis
3-21 Part 2 Business Analysis and Valuation Tools
bauxite have decreased worldwide mining activity, causing reduced sales for min-
ing equipment, although coal mining remains relatively strong worldwide. Dif´¬ü-
cult economic conditions have caused many of our normal customers to cut
capital expenditures dramatically, especially in such depressed sectors as the steel
industry, which has always been a major source of sales for all P&H products.
The signi´¬ücant operating losses recorded in 1982 and the credit losses experienced
by its ´¬ünance subsidiary caused Harnischfeger to default on certain covenants of its loan
agreements. The most restrictive provisions of the companyÔÇ™s loan agreements required
it to maintain a minimum working capital of $175 million, consolidated net worth of
$180 million, and a ratio of current assets to current liabilities of 1.75. On October 31,
1982, the companyÔÇ™s working capital (after reclassi´¬ücation of about $115 million long-
term debt as a current liability) was $29.3 million, the consolidated net worth was $142.2
million, and the ratio of current assets to current liabilities was 1.12. Harnischfeger
Credit Corporation, an unconsolidated ´¬ünance subsidiary, also defaulted on certain cov-
enants of its loan agreements, largely due to signi´¬ücant credit losses relating to the ´¬ü-
nancing of construction equipment sold to a large distributor. As a result of these
covenant violations, the companyÔÇ™s long-term debt of $124.3 million became due on de-
mand, the unused portion of the bank revolving credit line of $25.0 million became un-
available, and the unused short-term bank credit lines of $12.0 million were canceled. In
addition, the $25.1 million debt of Harnischfeger Credit Corporation also became im-
mediately due. The company was forced to stop paying dividends and began negotia-
tions with its lenders to restructure its debt to permit operations to continue. Price
Waterhouse, the companyÔÇ™s audit ´¬ürm, quali´¬üed its audit opinion on HarnischfegerÔÇ™s
1982 annual report with respect to the outcome of the companyÔÇ™s negotiations with its
CORPORATE RECOVERY PLAN
Harnischfeger responded to the ´¬ünancial crisis facing the ´¬ürm by developing a corporate
recovery plan. The plan consisted of four elements: (1) changes in the top management,
(2) cost reductions to lower the break-even point, (3) reorientation of the companyÔÇ™s
business, and (4) debt restructuring and recapitalization. The actions taken in each of
these four areas are described below.
To deal effectively with the ´¬ünancial crisis, Henry Harnischfeger, then Chairman and
Chief Executive Of´¬ücer of the company, created the position of Chief Operating Of´¬ücer.
After an extensive search, the position was offered in August 1982 to William Goessel,
who had considerable experience in the machinery industry. Another addition to the
management team was Jeffrey Grade, who joined the company in 1983 as Senior Vice
President of Finance and Administration and Chief Financial Of´¬ücer. GradeÔÇ™s appoint-
ment was necessitated by the early retirement of the previous Vice President of Finance
in 1982. The engineering, manufacturing, and marketing functions were also restruc-
tured to streamline the companyÔÇ™s operations (see Exhibits 1 and 2 for additional infor-
mation on HarnischfegerÔÇ™s current management).
104 Overview of Accounting Analysis
Overview of Accounting Analysis
To deal with the short-term liquidity squeeze, the company initiated a number of cost
reduction measures. These included (1) reducing the workforce from 6,900 to 3,800;
(2) eliminating management bonuses and reducing bene´¬üts and freezing wages of sala-
ried and hourly employees; (3) liquidating excess inventories and stretching payments to
creditors; and (4) permanent closure of the construction equipment plant at Escanaba,
Michigan. These and other related measures improved the companyÔÇ™s cash position and
helped to reduce the rate of loss during ´¬üscal 1983.
Concurrent with the above cost reduction measures, the new management made some
strategic decisions to reorient HarnischfegerÔÇ™s business. First, the company entered into
a long-term agreement with Kobe Steel, Ltd., of Japan. Under this agreement, Kobe
agreed to supply HarnischfegerÔÇ™s requirements for construction cranes for sale in the
United States as Harnischfeger phased out its own manufacture of cranes. This step was
expected to signi´¬ücantly reduce the manufacturing costs of HarnischfegerÔÇ™s construction
equipment, enabling it to compete effectively in the domestic market. Second, the com-
pany decided to emphasize the high technology part of its business by targeting for fu-
ture growth the material handling equipment and systems business. To facilitate this
strategy, the Industrial Technologies Group was created. As part of the reorientation, the
company stated that it would develop and acquire new products, technology, and equip-
ment and would expand its abilities to provide computer-integrated solutions to han-
dling, storing, and retrieval in areas hitherto not pursuedÔÇ”industries such as distribution
warehousing, food, pharmaceuticals, and aerospace.
While Harnischfeger was implementing its turnaround strategy, it was engaged at the
same time in complex and dif´¬ücult negotiations with its bankers. On January 6, 1984,
the company entered into agreements with its lenders to restructure its debt obligations
into three-year term loans secured by ´¬üxed as well as other assets, with a one-year ex-
tension option. This agreement required, among other things, speci´¬üed minimum levels
of cash and unpledged receivables, working capital, and net worth.
The company reported a net loss of $35 million in 1983, down from the $77 million
loss the year before. Based on the above developments during the year, in the 1983 an-
nual report the management expressed con´¬üdence that the company would return to
We approach our second century with optimism, knowing that the negative events
of the last three years are behind us, and with a ´¬ürm belief that positive achieve-
ments will be recorded in 1984. By the time the corporation celebrates its 100th
birthday on December 1, we are con´¬üdent it will be operating pro´¬ütably and at-
taining new levels of market strength and leadership.
During 1984 the company reported pro´¬üts during each of the four quarters, ending
the year with a pre-tax operating pro´¬üt of $5.7 million, and a net income after tax and
extraordinary credits of $15 million (see Exhibit 4). It also raised substantial new capital
through a public offering of debentures and common stock. Net proceeds from the of-
fering, which totaled $150 million, were used to pay off all of the companyÔÇ™s restruc-
Overview of Accounting Analysis