Using the Euro—A Good Bet?

Look first before deciding whether to adopt Europe’s new currency.
BY ANETTE W. ESTRADA

EXECUTIVE SUMMARY
WHEN THE EURO REPLACES THE NATIONAL CURRENCY of 12 European nations on January 1, 2002, it also will affect commerce with nonparticipating countries including the United States, where thousands of companies contribute one-fifth of EMU imports.

COMPANIES MUST BALANCE EUROPEAN CUSTOMERS’ demands for euro billing with the cost of enhancing their systems and employees’ skills accordingly.

TO SERVE AS ADVISERs, CPAs MUST UNDERSTAND foreign exchange risk and techniques—such as currency hedging—for mitigating it. They also must be familiar with the costs and benefits of modifying accounting and reporting systems to do business in euros and know whether their companies or clients can afford such enhancements.

ONE FACTOR THAT COMPLICATES DOING BUSINESS in euros is the passage of time between invoicing and collection, which can negatively impact receivables, making it difficult for companies to budget cash flow. Companies’ accounting and reporting systems must provide accurate information on such factors.

COMPANIES DECIDING TO DO BUSINESS IN EUROS and engaging in hedging as part of their strategy will have to ensure compliance with FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities, for their U.S. financial statements.

AMONG THE QUESTIONS FACING COMPANY management and the CPAs advising them is whether exposure to foreign taxes offsets any potential savings from moving administrative staff closer to the customers they serve.

ANETTE W. ESTRADA, CPA, is a senior manager working with international clients at BDO Seidman, LLP, Grand Rapids, Michigan. She can be reached by e-mail at aestrada@bdo.com .
 
ince 1999, when the EMU introduced the euro, its member nations have been preparing for January 1, 2002, when they will replace their national currencies with euro notes and coins. (For information about the euro’s introduction, see “Are You Euro-Fluent,” June99, JofA , page 22.)

Historically, American companies and their EU trading partners have done business in dollars. But since the euro’s introduction and subsequent decline in value relative to the dollar, some European customers have been pressing U.S. suppliers to bill in euros and thus assume the cost and risk of foreign currency transactions. Before agreeing to euro-denominated transactions, though, American companies must examine several aspects of their operations to determine whether that’s feasible for them. This article explains how CPAs can help companies perform that analysis and develop a strategy that meets their needs.

To illustrate how companies and their CPAs should proceed, this case study traces the decision-making process a fictitious U.S. magazine publisher used to answer these questions:

How would invoicing European customers in euros affect the company’s business?

Is the company capable of making the changes necessary to bill in euros?

Can the company afford to make such adjustments?

What will happen if the company decides not to do business in euros?

HYPOTHETICAL CASE STUDY: A TRADE PUBLISHER

Companies unsure of whether to do business in euros may find the following example instructive. Ace Publishing Inc. publishes several trade magazines. The company’s headquarters are in the United States, and it has small magazine and advertising sales offices in France and the United Kingdom. These offices are organized as branches—which could influence Ace’s international business strategy. Its European customers receive invoices in dollars from Ace’s U.S. operations center and tender payment via wire transfer to Ace’s U.S. bank account.

Since the euro first appeared, Ace’s French customers have requested billing in euros to partially relieve them of foreign exchange costs and risks. However, in the United Kingdom, which isn’t adopting the new currency, Ace customers haven’t expressed any dissatisfaction with being billed in dollars.

Ace faces considerable challenges in its quest for market share. Its largest competitor, also a U.S. company, bills EU companies—and collects payment from them—in euros. Given the euro’s steep decline in value relative to the dollar (see Exhibit 1 ), Ace had to offer deep discounts to its French customers in the fiscal year ended June 30, 2000. That led Ace’s management to ask its CPA firm to evaluate the advisability of conducting the company’s European business in euros. By requesting this analysis, management aimed to

Calculate what the impact on the company’s financial statements would have been if it had issued euro invoices to its French customers in the fiscal year ended June 30, 2000.

Determine the accounting entries and the proper recognition of gains and losses from foreign currency transactions.

Assess the feasibility, cost and benefit of upgrading the company’s information technology systems to issue euro-denominated invoices.

Consider the tax implications related to foreign currency transactions.

ACE’S FINANCIAL STATEMENTS GET A EURO MAKEOVER

CPAs can use the following example to help their clients understand how doing business in euros can influence their financial reporting. To calculate the impact on the company’s financial statements had it issued euro-based invoices to its French customers, Ace’s CPA firm looked at the company’s historical monthly sales totals, which it converted from dollars to euros. The CPA firm also used the following information in its analysis:

From its U.S. offices, Ace issues euro invoices to French customers and receives payment in euros by wire transfer to its U.S. bank account. When the company issues a euro invoice to one of its French customers, it records the receivable in dollars, the amount of which it calculates at the current euro-dollar exchange rate.

Each month, Ace issues approximately 280 invoices to French customers. Its U.S. bank charges $1.25 per foreign currency transaction, resulting in annual charges of approximately $4,200.

On average, Ace collects receivables within 60 days of invoicing. Thus, for financial reporting purposes, the company faces the risk that the number of euros it billed for may decline in dollar-equivalency by the time the cash arrives, two months later. Although the reverse also is possible, during the period analyzed here the euro has declined in value relative to the dollar. Further, Ace has annual contracts for some of its advertising, with prices fixed in euros for the coming year. But foreign currency transactions are not recorded, because they’re not recognized in the accounting records until the service they represent is rendered. Nevertheless, due to fluctuations in the euro’s value during the contract year, the dollar amount reported as revenue may differ significantly from that stated in the contract, making it difficult for the company to budget its cash flow.

In France, Ace has about $1 million in annual expenses, which it pays in euros through a U.S. bank. If the company receives euros from sales in France, the foreign currency cash outflows will partially offset the currency exposure related to cash inflows from sales.

Based on these facts, the accountants calculated that the foreign exchange loss to the company during the year ended June 30, 2000, would have been $98,574 if it had billed in euros during this time period (see Exhibit 2 ). Such transaction losses would largely be due to the euro’s relative weakness vs. the dollar during the fiscal year. If the euro strengthens in future years, it’s possible Ace will recognize transaction gains, which, with transaction losses, it will record on its income statement and recognize for U.S. tax purposes.

Partially offsetting the transaction loss, the company incurred a translation gain of $17,991 from the conversion of its euro-denominated accounts receivable to U.S. dollars, using the exchange rate on June 30, 2000. Although translation gains and losses are recorded on the income statement, they aren’t recognized for tax purposes unless certain hedging rules—beyond the scope of this article—apply.

Exhibit 3 contains the journal entries required to record these transactions; exhibit 4 summarizes their effect on the June 30, 2000, financial statements.

ADDING IT UP—THE IMPACT ON CURRENT OPERATIONS

If the company decided to issue invoices in euros, it would have to be able to record euro-denominated orders in its accounting system, print the euro symbol on invoices for the orders and record the related income as dollars in its accounting system. The following issues also require consideration:

Ace would have to enhance its accounting system to track—in euros and dollars—each account, ensuring that full and partial payments received in euros were properly applied and gains and losses were recorded. The company also would have to be able to respond to customer inquiries about open balances in euros and track invoice adjustments (such as debit or credit memos) in both currencies.n It would be necessary to set up a reporting system that linked Ace and its bank, reporting euro payments that customers wired to the bank, dollars that the bank sent the company after converting the euros and the amount that the bank deducted for transaction processing. Also, to convert and record the foreign currency transactions accurately, Ace should obtain dollar-euro exchange rates from the bank daily.

The extent to which Ace’s current accounting software could be made euro-ready is an issue its management must discuss with its technology staff and software vendor. Under present circumstances, the company would have to issue many euro-denominated invoices. But if the United Kingdom joins the EMU, the number of Ace’s euro invoices would rise sharply. The company therefore should obtain practical, cost-effective software to meet its needs in the years to come.

Accounts-receivable staff would have to receive adequate training to ensure they properly recorded foreign currency transactions. As the system developed, management would have to ensure adequate internal controls were an integral part of the foreign exchange receivables system and that it regularly monitored gain and loss accounts.

If the company chose to hedge its foreign currency exposure, the accounting system would have to provide timely and adequate information to support decision making about hedging.

ALTERNATIVE STRATEGIES FOR INTERNATIONAL BUSINESS

If Ace chose to invoice some customers in euros, it would face several challenges, especially in relation to its accounting software. Because it would be expensive to process foreign currency transactions, the company would have to manage its international business in the most cost-effective way possible and limit its exposure to foreign-exchange-related losses. To do that, it would have to consider these alternatives:

Instead of having customers wire payments to its U.S. bank, Ace could avoid the $4,200 in annual bank charges by having French customers send their payments to a euro-denominated bank account in Europe or in the United States. It could use that account to pay its euro-denominated expenses and ask the bank to transfer any excess funds to its dollar-based account monthly. While the cost of such services would be significant, it probably would be much less than the charges Ace would incur by receiving individual customer payments in its U.S. account. Note that if the company were to set up a foreign bank account, it might have to file a disclosure form with the U.S. Treasury Department.

Ace already mitigates some of its currency risk by incurring expenses payable in euros (see Exhibit 2 ). But if it could use euros to satisfy other obligations currently paid in dollars, Ace would equalize its euro inflows and outflows and eliminate its exposure to exchange-rate volatility. The company could achieve this by moving certain administrative duties—such as generating and mailing invoices, maintaining accounts-receivable ledgers and collection duties—from the United States to France. It may even be feasible to move to a European location all administrative functions related to Ace’s French and U.K. business and pay for them with euros instead of dollars. Any relocated functions could be performed by Ace employees or outsourced. But before implementing any changes, the company should analyze such modifications’ income tax consequences.

Moving the invoicing and accounts-receivable functions to Europe may also be the most cost-effective solution to the information technology challenges the company faces from foreign currency transactions. Although Ace’s accounting software uses the dollar as its functional currency and does not support euro-invoicing, the company could implement the same software in a French office and program it to use the euro as its functional currency. Ace could summarize—under one monthly entry in the United States—any transactions it records in Europe.

The company could purchase forward exchange contracts to hedge its currency risk. (Forward contracts provide for the purchase or sale of foreign currency at an exchange rate set when the contract is signed and arrange for payment and delivery at a specified time in the future.) Such contracts do not eliminate potential losses from adverse foreign exchange developments; they only eliminate uncertainty for a certain period. Furthermore, by hedging a foreign currency exposure, the company also forgoes the possibility of realizing foreign exchange gains.

The cost of purchasing forward contracts can be significant, and the company must be willing and able to devote considerable time and expertise to continually managing them. If Ace uses hedges, it must also address the requirements of FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities, for U.S. financial statement disclosures.

Ace also could reorganize its foreign operations from branches to wholly owned subsidiaries. In general terms, the foreign currency transactions the company’s branches generate result in gains and losses that are reported on the company’s income statement. If Ace were to conduct its foreign operations through a subsidiary, it would have to report the effect of currency fluctuations in the equity section of its balance sheet. Because investing in a subsidiary is inherently a long-term approach to foreign operations, accounting for an investment abroad differs significantly from accounting for a branch’s foreign currency transactions. Furthermore, establishing a subsidiary in France would have significant tax implications for the company, both in the United States and abroad. For these reasons Ace would have to evaluate this strategy in depth before deciding to implement it.

READING THE BOTTOM LINE

While considering the above alternatives, it became clear to management that Ace has to make strategic decisions about its international business. The introduction of the European single currency gave the company’s customers additional bargaining power in their quest for euro-denominated transactions. If Ace considers international markets important for future growth, it must restructure its foreign operations and enhance its information systems. On the other hand, if Ace ranks foreign markets as a minor factor in its future plans, its management may decide to continue billing foreign customers in dollars and serving them from its U.S. offices.

In this case study, Ace had the wisdom to include its CPA firm in its analysis and strategic planning. But some companies, under pressure from impatient customers, may choose to act swiftly, neglecting to adequately consult their CPA firms. That’s why practitioners eager to serve as advisers in such situations must clearly demonstrate their knowledge of, and sensitivity to, the foreign exchange and international operations issues discussed in this article. Armed with such knowledge, they can help their clients craft judicious and effective approaches to the euro and other emerging aspects of the economic landscape.

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