4.4 ACCOUNTING IMPLICATIONS FOR THE METHODOLOGY. The key concept
in this section is that accounting principles and policies that are used in a particular
country are likely also to be used in developing pro forma financial statements for a
particular project. These pro forma financial statements, in turn, are likely to be the
database from which financial executives estimate future cash flows as they try to de-
termine whether or not the proposed project has a positive or a negative net present
value. If financial executives are not aware of how the foreign accounting system dif-
fers from the home system, they may base their analysis on faulty cash flow data.
Accounting differences can be grouped by type. Specifically, we can think of (1)
asset costs which become expenses as they are allocated to specific time periods, (2)
operating costs of the current time period which do not flow through in the calculation
of current income, (3) changes in the recorded amount of debt not matched by cash
payments, and (4) basic differences in underlying accounting principles and methods.
Some of these differences are relevant only when estimating cash flows for a phys-
ical investment, such as a new machine or a building. Others are relevant only when
investing in an entire foreign corporation, in which case past and pro forma financial
statements may be the base for estimating future cash flows.
Accounting differences, by type, are discussed in the following paragraphs.
(a) Asset Cost Allocation to Income Periods
(i) Fixed Asset Depreciation. Variations between historical cost depreciation and
some types of replacement cost depreciation lead to different net income calcula-
tions. The difference in depreciation method may influence income tax payments and
consequently cash flow after taxes.
(ii) Inventory Costing. Variations between historical costing and replacement cost-
ing, and also between first in, first out (FIFO) and last in, first out (LIFO) as alterna-
tive methods of historical costing, have an influence on reported income, on taxes on
that reported income, and on income allocation between time periods. The first two of
these influence measures of cash flow, and the third influences the timing of total cash
flow, with a possible consequence for any valuation method based on discounting.
(iii) Amortization of Purchased Goodwill. In some countries, purchased goodwill is
amortized, reducing net income and possibly income taxes. However, goodwill amor-
tization is not a cash cost. In other countries, purchased goodwill cannot be amor-
tized. In either case, cash flow must be adjusted to account for the amortization or
nonamortization of goodwill, or any similar cost. Such amortization, it will be noted,
is a noncash expense similar to depreciation.
(iv) Asset Revaluation. In some high-inflation countries, such as Argentina, Brazil,
and Israel, fixed assets are revalued upward to bring accounts closer to reality. The
related expenses, such as depreciation, are also restated. Care must be taken not to let
such revaluations influence estimates of cash flow.
(b) Nonallocation of Current Operating Costs
(i) Charges of Expenses to Reserves. In many countries, arbitrary reserves are created,
against which certain expenses are charged. Examples are reserves for bad debts and
4 • 8 FOREIGN INVESTMENT ANALYSIS