Plan, was to reduce pension expense by approxi-
mately $4.0 million in 1984 and $2.0 million in
effect of account- $5,73 $(32,80 $(69,65
1983, and the actuarial present value of accumu- 8 3) 7)
lated plan bene´¬üts by approximately $60.0 million
in 1984. Pension expense in 1983 was also reduced Provision (credit) for income taxes, on income
$2.1 million from the lower level of active employ- (loss) before income tax effects, equity items and
ees. Other actuarial gains, including higher than cumulative effect of accounting change, consisted of
anticipated investment results, more than offset the (in thousands of dollars):
additional pension costs resulting from plan
changes and interest charges on balance sheet 1984 1983 1982
accruals in 1984 and 1983.
The CorporationÔÇ™s foreign pension plans do not Currently payable
determine the actuarial value of accumulated bene-
Federal $ ÔÇ” $(7,957) $(9,736)
´¬üts or net assets available for retirement bene´¬üts as
State 136 297 70
calculated and disclosed above. For those plans, the
Foreign 2,518 3,379 5,376
total of the plansÔÇ™ pension funds and balance sheet
2,654 (4,281) (4,290)
accruals approximated the actuarially computed
value of vested bene´¬üts at both October 31, 1984
Federal ÔÇ” 2,955 2,713
and 1983. State and foreign (229) (74) (23)
The Corporation generally provides certain health (229) 2,881 2,690
care and life insurance bene´¬üts for U.S. retired Provision (credit) for $2,42
employees. Substantially all of the CorporationÔÇ™s 5 $(1,400) $(1,600)
current U.S. employees may become eligible for
such bene´¬üts upon retirement. Life insurance bene- During 1983 an examination of the CorporationÔÇ™s
´¬üts are provided either through the pension plans or 1977ÔÇ“1981 federal income tax returns and certain
separate group insurance arrangements. The cost of refund claims was completed by the Internal Reve-
retiree health care and life insurance bene´¬üts, other nue Service, and as a result, a current credit for fed-
than the bene´¬üts provided by the pension plans, is eral income taxes of $8.0 million was recorded in
expensed as incurred; such costs approximated 1983, $3.0 million of which was applied to the
$2.6 million in 1984 and $1.7 million in 1983. reduction of prepaid income taxes.
126 Overview of Accounting Analysis
Overview of Accounting Analysis
In 1984, tax credits fully offset any federal income At October 31, 1984, the Corporation had fed-
tax otherwise applicable to the yearÔÇ™s income, and eral tax operating loss carry-forwards of approxi-
in 1983 and 1982, the relationship of the tax bene´¬üt mately $70.0 million, expiring in 1998 and 1999,
to the pre-tax loss differed substantially from the for tax return purposes, and $88.0 million for book
U.S. statutory tax rate due principally to losses from purposes. In addition, the Corporation had for tax
the domestic operations for which only a partial fed- purposes, foreign tax credit carry-forwards of $3.0
eral tax bene´¬üt was available in 1982. Conse- million (expiring in 1985 through 1989), and invest-
quently, an analysis of deferred income taxes and ment tax credit carry-forwards of $1.0 million (expir-
variance from the U.S. statutory rate is not pre- ing in 1997 through 1999). For book purposes, tax
sented. credit carry-forwards approximately $8.0 million.
Unremitted earnings of foreign subsidiaries which The carry-forward will be available for the reduction
have been or are intended to be permanently rein- of future income tax provisions, the extent and tim-
vested were $19.1 million at October 31, 1984. ing of which are not determinable.
Such earnings, if distributed, would incur income tax Differences in income (loss) before income taxes
expense of substantially less than the U.S. income for ´¬ünancial and tax purposes arise from timing dif-
tax rate as a result of previously paid foreign income ferences between ´¬ünancial and tax reporting and
taxes, provided that such foreign taxes would relate to depreciation, consolidating eliminations for
become deductible as foreign tax credits. No inter-company pro´¬üts in inventories, and provisions,
income tax provision was made in respect of the tax- principally, for warranty, pension, compensated
deferred income of a consolidated subsidiary that absences, product liability and plant closing costs.
has elected to be taxed as a domestic international
sales corporation. The De´¬ücit Reduction Act of 1984
provides for such income to become nontaxable
effective December 31, 1984.
REPORT OF INDEPENDENT ACCOUNTANTS
November 29, 1984
To the Directors and Shareholders of Harnischfeger Corporation:
In our opinion, the ´¬ünancial statements, which appear on pages 18 to 34 of this report,
present fairly the consolidated ´¬ünancial position of Harnischfeger Corporation and its
subsidiaries at October 31, 1984 and 1983, and the results of their operations and the
changes in their ´¬ünancial position for each of the three years in the period ended October
31, 1984, in conformity with generally accepted accounting principles consistently
applied during the period except for the change, with which we concur, in the method of
accounting for depreciation expense as described in Note 2 on page 23 of this report.
Our examinations of these statements were made in accordance with generally accepted
auditing standards and accordingly included such tests of the accounting records and
such other auditing procedures as we considered necessary in the circumstances.
4 As s e t An a ly s is
A ssets are resources owned by a ´¬ürm that are likely to produce future
economic bene´¬üts and that are measurable with a reasonable degree of certainty. Assets
can take a variety of forms, including cash, marketable securities, receivables from
customers, inventory, ´¬üxed assets, long-term investments in other companies, and
Business Analysis and 2
The key principles used to identify and value assets are historical cost and conserva-
tism. Under the historical cost principle, assets are valued at their original cost; conser-
vatism requires asset values to be revised downward if fair values are less than cost.
Analysis of assets involves asking whether an outlay should be recorded as an asset
in the ´¬ürmÔÇ™s ´¬ünancial statements, or whether it should be reported as a current expense.
This requires analysts to understand who has the rights of ownership to the resource,
whether it is expected to generate future bene´¬üts, and whether those bene´¬üts are mea-
surable with reasonable certainty. Finally, asset analysis involves evaluating the value of
the assets reported in the ´¬ünancial statements, requiring an evaluation of amortization,
allowances, and write-downs.
In this chapter we discuss the key principles underlying the recording of assets. We
also show the challenges in asset reporting and opportunities for analysis.
HISTORICAL COST AND CONSERVATISM
Assets are used to generate future pro´¬üts for owners. Investors are interested in learning
whether the resources they have invested in the ´¬ürm have been spent wisely. The balance
sheet provides a useful starting point for this type of analysis because it provides infor-
mation on the value of the resources that management acquires or develops. In most
countries the assets reported in the balance sheet are valued at historical exchange prices.
Historical exchange prices rather than fair values, replacement values, or values in use,
are used to record assets because they can typically be more easily veri´¬üed. From the
perspective of investors, this is important because managers have an incentive to present
a favorable view of their stewardship of the ´¬ürmÔÇ™s resources. By requiring that transac-
tions be recorded at historical exchange prices, accounting places a constraint on man-
agersÔÇ™ ability to overstate the value of the assets that they have acquired or developed.
Of course, historical cost also limits the information that is available to investors about
the potential of the ´¬ürmÔÇ™s assets, since exchange prices are usually different from fair
values or values in use.
128 Asset Analysis
The conservatism principle establishes one exception to the use of historical cost val-
ues. It requires management to write down to their fair value assets that have been im-
paired. The lower of cost or market rule for valuing inventory, the estimation of expected
receivable losses from uncollectible accounts, and write-downs of operating assets that
are not expected to recover their cost are all applications of this concept. Conservatism
therefore provides additional assurance for investors that managementÔÇ™s estimate of the
value of the ´¬ürmÔÇ™s resources is not overstated. As a result, asset values reported on the
balance sheet can be considered a lower bound on the value of future bene´¬üts resulting
from managementÔÇ™s current business strategy.
Adherence to the principles of historical cost and conservatism has been challenged
recently. In the U.S., some ´¬ünancial instruments are required to be valued at fair values
rather than historical cost. Further, in the U.K., Australia, and several other countries,
other classes of tangible and intangible assets are permitted to be valued at fair values.
ASSET REPORTING CHALLENGES
The critical challenge for ´¬ünancial reporting is to determine which types of expenditures
qualify as assets. Figure 4-1 shows the major criteria for recognizing an asset. Not sur-
prisingly, these are related to the criteria used for recognizing expenses, discussed in
Chapter 7. The key questions for recognizing an asset involve assessing who has owner-
ship of the resources in question, whether those resources are expected to provide future
economic bene´¬üts, and whether bene´¬üts can be measured with reasonable certainty.
Figure 4-1 Criteria for Recognizing Assets and Implementation
First Criterion Second Criterion Third Criterion
Resources are owned by Resources are expected to The future economic
the ´¬ürm. provide future economic bene´¬üts are measurale
bene´¬üts suf´¬ücient to recover with a reasonable
their cost. degree of certainty.
Record an asset.
1. Ownership of the resource is uncertain
2. Future bene´¬üts from outlays are uncertain or dif´¬ücult to measure.
3. Resource values have changed.
4-3 Part 2 Business Analysis and Valuation Tools
As we discuss throughout this chapter, asset recognition creates a number of oppor-
tunities for management to exercise ´¬ünancial reporting judgment. These opportunities
are particularly prevalent for transactions where ownership of a resource is uncertain.
They can also arise when the economic bene´¬üts from outlays are uncertain or dif´¬ücult
to quantify, or when resource values have changed. Below we discuss these types of re-
Challenge One: Ownership of Resources Is Uncertain
For most resources used by a ´¬ürm, ownership is relatively straightforward: the ´¬ürm using
the resource owns the asset. However, for some transactions the question of who owns
a resource can be subtle. We discuss two examples of transactions that provide interest-
ing challenges for deciding on ownership. The ´¬ürst is for a leased resource. Who is the
effective owner of the assetÔÇ”the lessor or the lessee? The second transaction is for em-
ployee training. Who effectively owns the bene´¬üts created by a training programÔÇ”the
company providing the training or the employee?
EXAMPLE: LEASED RESOURCES. On December 31, 1998, American Airlines re-
ported that it leased 42 percent of its ´¬‚eet of aircraft (273 planes) for lease periods of 10
to 25 years. American Airlines reported that it had annual obligations under these leases
in excess of $1 billion for each of the next ´¬üve years and $13.4 billion thereafter. In its
annual report the company noted that ÔÇťaircraft leases can generally be renewed at rates
based on fair market value at the end of the lease term for one to ´¬üve years. Most aircraft
leases have purchase options at or near the end of the lease term at fair market value, but
generally not to exceed a stated percentage of the de´¬üned lessorÔÇ™s cost of the aircraft or
at a predetermined ´¬üxed amount.ÔÇŁ Who was the effective owner of these aircraft? Did
American Airlines effectively purchase them using ´¬ünancing provided by the lessor, or
were the leases really rental arrangements?
Assessing whether a lease arrangement is equivalent to a purchase or rental is subjec-
tive. It depends on whether the lessee has effectively accepted risks of ownership, such
as obsolescence and physical deterioration. In an attempt to standardize the reporting of
lease transactions, accounting standards have created clear criteria for distinguishing be-
tween the two types. Under SFAS 13, a lease transaction is equivalent to an asset pur-
chase if any of the following conditions hold: (1) ownership of the asset is transferred to
the lessee at the end of the lease term, (2) the lessee has the option to purchase the asset
for a bargain price at the end of the lease term, (3) the lease term is 75 percent or more
of the assetÔÇ™s expected useful life, and (4) the present value of the lease payments is 90
percent or more of the fair value of the asset. As noted above, American Airlines had pur-
chase options for many of its aircraft at estimated market prices. In addition, the com-
pany reported that the assumed life for aircraft that it owned was 25 years.
Lease contracts that satisfy the criteria for an effective purchase are recorded as cap-
ital leases at the present value of the lease payments. This same amount is also shown as
130 Asset Analysis