International Finance and Accounting Handbook

(avery) #1

reserves for pensions or other unfunded retirement obligations. In some cases a non-
specific “reserve for contingencies” is created against very vague future uncertainties.
The intent is often to manipulate income (called “income smoothing”) by arbitrarily
subtracting from good years and adding to bad years. The creation of such reserves
reduces reported net income without reducing cash flow, and the charging of expenses
to the reserves usually involves a cash outflow not recorded in the current year.


(ii) Deferred Taxes Shown as a Liability. Treatment varies among countries between
reported incomes taxes for accounting purposes and actual income taxes paid. The
difference usually arises when additional expenses (such as extra depreciation or a
credit for taxes paid) are allowed by the government as a “tax incentive” but are not
recognized as current income by the accounting process. In any case, a bottom-up
calculation which approximates cash flow from the sum of net income and noncash
expenses must include as additional cash flow any increase in the deferred tax liabil-
ity, because actual payments are less than the accrued expense. The capital-budget-
ing process must recognize the possibility of different treatment of actual and accrued
taxes in various countries.


(iii) Flow Through of Translation Gains. Translation gains which flow through in-
come statements or which are taken directly to a cumulative translation reserve must
be subtracted because they do not reflect cash flows. In the United States, under
Statement of Financial Accounting Standards (SFAS) No. 8, which was issued in
1975, translation gains or losses were recognized in current quarterly income. This
rule was replaced by SFAS No. 52 in 1981, under which translation gains and losses
are charged to a reserve account and notpassed through the income statement. Each
country has its own approach, not only as to howto measure such gains and losses
but also where to record the gains and losses. An analyst evaluating a foreign project
from past financial records must be sure that measures of cash flow exclude that im-
pact of translation gains and losses.


(iv) Severance Pay If the Foreign Affiliate Is Closed. In many countries, local social
laws require severance pay of up to several years’ annual earnings for workers who
are released. Thus, if a firm decides to close a foreign operation, it may face a large
cash outflow related to severance benefits to workers who lose their jobs. Such sev-
erance payments represent a large cash outflow in the last year of a project and must
be considered carefully, not only when a decision to stop operations is made but also
when an operation that has some risk of economic failure is started.


(c) Debt Changes Not Matched by Cash Payments


(i) Foreign Exchange Translation Gains or Losses on Long-Term Debt. If a project is fi-
nanced with foreign currency debt, the book amount of that debt will change as for-
eign exchange rates change. The resulting charge or gain may show as a decrease or
an increase in current income, depending upon the translation rules in effect. How-
ever, restatement of the book amount of debt has no cash flow implications until the
year in which the debt is repaid.


(ii) Noncapitalization of Financial Leases. Some countries in the world, such as the
United States, require that financial leases be capitalized as debt on the balance sheet.
In other countries, financial leases are not capitalized. A change in accounting proce-


4.4 ACCOUNTING IMPLICATIONS FOR THE METHODOLOGY 4 • 9
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