Are You Euro-Fluent?

n January, the European Union (EU) introduced a new currency named the euro . By 2002, it will be used by at least 11 EU nations, whose national currencies will pass into history. This immense change from a disparate—if distinguished—group of trading nations to a unified financial force will have big repercussions here. Some large U.S. companies, such as banks and insurance companies, began preparing for the currency transition shortly after the Treaty on European Monetary Union was ratified in 1993. But the euro will affect more than just large companies—any company that invests directly in Europe or that imports products from or exports them to Europe must tailor a euro strategy if it wants to stay competitive.

To prepare for trade under the monetary union, U.S. companies must update their information systems, their internal and external financial reporting and assess the impact of the new currency on all business functions. CPAs who operate as CFOs, COOs or controllers of such companies may be responsible for their companies’ euro conversion efforts, while CPAs in public practice must help their business clients manage the complexities of currency conversion, ensure compliance and reporting requirements are met and reassess tax strategies.

Ignoring the changes taking place in Europe could cost your company or your clients business. Know what the euro is and what you need to do to become euro-ready.

ONE EUROPE, ONE MONEY

The EU launched the euro last January in accordance with the 1993 treaty, and 11 nations that joined the European Economic and Monetary Union (EMU)—known as Euroland—fixed their national (legacy) currencies to the euro. Euroland includes Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. In January, the legacy currencies of these countries became subunits of the euro (just as cents are subunits of the dollar).

Four of the 15 member nations of the EU are not taking part in the monetary union—Britain, Denmark, Greece and Sweden. Greece failed to meet the criteria for the euro, and Britain, Denmark and Sweden chose not to convert their currencies.

Since January, familiar currencies such as the deutsche mark (DM) and the lira no longer float in the currency markets, and foreign exchange transactions that involve legacy currencies must be calculated through the euro using fixed conversion factors (see exhibit 1 below).

To help people get used to the euro, the European Commission (EC)—an executive body in charge of monitoring economic developments in the EU—allowed for a three-year transition period (January 1, 1999 to January 1, 2002) during which individuals, companies and organizations can use both the euro and national currencies. Under this concept of “no compulsion, no prohibition,” noncash transactions such as credit cards, bank drafts, wire transfers and direct deposits can be denominated in either currency; banks will record the drafts and deposits in whatever currency the customer designates for the account. The EMU will not issue euro coins and bank notes until January 1, 2002; by June 30, 2002, all legacy currencies will become obsolete.

European companies may prepare their financial statements in either the legacy currency or the euro after January 1, 1999, and most tax authorities will be able to process euro-denominated tax returns.

REVAMPING INFO TECH

Although the euro’s initial phase-in was relatively smooth (interest rates and monetary policy in Europe are controlled by the new European Central Bank in Frankfurt, Germany; securities exchanges in all Euroland countries are trading in euros; and all interbank transfers are done in the new currency), many U.S. companies fail to understand the many different ways the euro can affect them. In fact, many U.S. companies have yet to update their accounting and information systems to handle euro conversions.

What should U.S. companies do to prepare for the euro? They should develop a practical conversion strategy and implement it soon to ensure their information technology is updated to handle euro conversions and they are in compliance with European regulations. Here’s how:

Conversion. A company’s conversion strategy must identify all software and data affected by the new currency. The process of making the appropriate systems and software euro-compliant may place considerable burdens on IT personnel, especially in companies that developed their software internally or are still dealing with the added burden of the year 2000 computer problem. But even if the company purchases euro-compliant software and its vendors offer euro updates, management must ensure that euro-compliant software meets company needs and is installed on a timely basis.

Transition period. During this period, companies doing business in Euroland can enter into and settle transactions in the legacy currency or the euro or both and must be able to process and display transactions in both currencies. They can do this by using applications software or in the old-fashioned way—manual conversion. If a company uses an IT approach, it has the option of keeping books for each currency, of adding functionality to display and process transactions in two currencies or of simply converting all data to the euro. Each approach has benefits and drawbacks that must be evaluated to determine the method that best suits and is the most cost-effective for each company.

A survey of euro-compliant organizations revealed that global financial institutions, Euroland stock exchanges and multinational companies were the first to convert. Entities that updated existing systems did so by upgrading to euro-compliant releases of their third-party application software or by making modifications to their internally written applications. Application software packages from vendors such as SAP, Baan, Scala, Navision Software, Oracle and Peoplesoft allow transaction processing in both currencies.

European Commission regulations. European Commission (EC) regulations require that the conversion factors between legacy currencies and the euro have six digits, regardless of the decimal. Thus, 1 euro equals 6.55957 French francs or 1,936.27 lire. Conversion factors cannot be rounded or truncated and inverse rates may not be used. The large number of digits is intended to minimize rounding differences but does not eliminate them entirely; therefore, the relatively large number of decimals resulting from six-digit conversion factors may present a problem for some companies. Corporate information systems must be able to accumulate those differences in a separate account and leave an adequate audit trail so company managers and auditors can trace the rounding differences to their sources and determine their materiality.

Triangulation. Many systems in use today have sophisticated multicurrency capabilities that use direct exchange rates between currencies to perform conversions. However, as of January 1, 1999, direct conversions of legacy currencies no longer are allowed. The conversion as of 1999 has to be made through the euro—for example, Dutch guilders to euros to French francs, using the fixed conversion factors for guilders and francs to the euro. This conversion method is called triangulation (see exhibit 2, page 27). As businesses work toward euro-compliance, it is important to ensure their software applies the triangulation method for currency conversions. Although it is possible to calculate a direct guilder-to-franc rate from the fixed conversion factors, doing so is not consistent with EC regulations. The triangulation method reduces rounding differences and, as a result, intermediate products (guilder divided by euro rate) may not be rounded. Only the final product (in our example, francs) can be rounded to its usual two decimals.

EURO REPORTING

Generally, euro financial reporting can begin for any year starting after December 31, 1998, but must begin sometime before January 1, 2002.

U.S. consolidations. The timing of euro reporting for Euroland subsidiaries has important consequences for a U.S. parent company. If the U.S. consolidation must be prepared on a tight schedule to satisfy the needs of shareholders or creditors, CPAs should make sure the subsidiaries adequately address any conversion problems and issues that may arise. This will ensure that subsidiaries report final numbers to the U.S. parent company in accordance with the U.S. consolidation timetable. The euro conversion should take place several months before year-end; it is best to prepare an interim consolidation to highlight and address all conversion issues.

CPAs must be certain that historical trends are not distorted as a result of the conversion. The euro did not exist in the market until 1999, and no euro/dollar exchange rates are available to convert prior-year financial data. Therefore, when converting historical data from years before 1999, a non-Euroland reporting entity, such as a U.S. parent company, must always use the exchange rate of the legacy currency to the non-Euroland currency (in this case, the U.S. dollar), even if the foreign entity reports historical data in the euro.

To illustrate this, consider a U.S. company with a subsidiary in Germany that adopts euro reporting for the year beginning January 1, 1999. On December 31, 1999, the subsidiary presents prior-year financial data by converting the previously reported DM amounts to euros at the fixed conversion factor. When the U.S. company prepares consolidated financial statements, it must convert the balances on December 31, 1999, according to the euro/dollar exchange rate. However, prior-year balances must be converted to dollars using the DM/dollar exchange rate, because euro/dollar rates did not exist before 1999.

Disclosures. Since the conversion to the euro likely will have a material effect on U.S. companies that conduct a significant amount of business in Europe, euro-related disclosures in U.S. financial statements may be required. Disclosure obligations in filings with the SEC are discussed in SEC Staff Legal Bulletin no. 6 ( www.sec. gov/rules/othern/slbcim6. htm ). Such disclosures may include trends or uncertainties expected to have a material effect on the financial statements, such as the implications of changes in the company’s competitive environment or the significant costs associated with the conversion.

COSTS, TAXATION AND CONTRACTS

CPAs also must stay on top of accounting requirements resulting from the euro. Most notable among them is accounting for conversion costs, which are expected to be significant and could amount to five times the cost of a Y2K conversion. Whether these costs are expensed or capitalized in the United States must be determined by CPAs based on EITF Abstracts , “D-71, Accounting Issues Relating to the Introduction of the European Economic and Monetary Union (EMU)”.

Generally, the FASB staff says that not all euro-related costs to make changes to software or physical assets should be expensed as incurred. Rather, the accounting for those costs should be consistent with the company’s existing accounting practice for similar costs.

European companies expense most of the euro conversion costs, except in Germany, where capitalization is indicated under certain circumstances. The differences in accounting for conversion costs may result in U.S. GAAP adjustments when foreign subsidiaries are consolidated.

The possible impairment of long-lived assets also must be addressed. If a company owns machinery, such as vending machines, computer software or hardware that cannot be made euro-compliant, the carrying amount of those assets may not be recoverable and a loss must be recognized under the provisions of FASB Statement no. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of .

U.S. taxation: The U.S. Department of the Treasury issued temporary regulation 1.985-8T in 1998, making the euro conversion generally a tax-neutral event for U.S. taxpayers. However, the Treasury did not address whether conversion costs are deductible for tax purposes. It is not clear when the Treasury will issue further guidance.

Legal implications. Many legal contracts call for payment in a legacy currency when that currency no longer exists. Contracts under the jurisdiction of the EU are covered by euro legislation that introduces the continuity-of-contracts principle. According to that concept, monetary amounts in existing agreements are to be stated at their euro equivalents at fixed conversion rates and the contracts remain enforceable. Some U.S. states, including California, Illinois, Michigan and New York, and some foreign governments also have addressed the euro issue by adopting their own contract continuity legislation. CPAs should have legal counsel review existing contracts to determine whether they continue to be enforceable.

MAKE CHANGE WORK FOR YOU

For many U.S. companies, the euro is not an operational issue but, rather, a strategic opportunity. The price transparency resulting from the single currency no longer will allow companies to price their goods differently in different European countries. The necessary repricing will result in intense competition between companies and change European markets forever.

U.S. companies that have successfully converted their systems to be euro-compliant are in a good position to respond to these challenges. They will be able to benefit from the strong U.S. economy and quickly respond to price competition and build market share in Europe. Those that are not capable of implementing a conversion strategy or that do not meet EC regulations must consider whether to start planning now to be euro-compliant. If they wait, they are likely to miss the opportunity to grow their businesses while their euro-compliant competitors and other U.S. companies take advantage of the huge European market and as e-commerce continues to break down the barriers of doing business overseas.