Accounting/The Euro term paper 17918

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To the extent that Europe grows faster, becomes a more effective economy, they become an important trading partner of the United States...It is conceivable that the euro will rise as a significant currency in the world. And that's good, not bad. --Alan Greenspan Introduction On January 1, 1999, eleven European nations began to use a common currency, the euro. These nations are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. The use of the euro will have an impact on businesses operating or investing in Euroland, a term commonly used for the 11 European nations that have agreed to share the euro as their principal currency (Kelly, 1999). This paper will give an overview of the European unified monetary system, some pros and cons of the euro, and the effects of the euro on accounting, contracts, industry and international investors. The general focus of this paper is on international member nation companies and international U.S. companies doing business in Euroland.European Monetary Unification System European countries have been working towards the integration of the economic and monetary systems of all European nations and the use of a single European currency. On April 13, 1979, the European Commission (EC) established the European Monetary System (EMS) to stabilize European exchange rates by empowering the EC to coordinate the national financial policies of its members. The System Exchange Rate Mechanism (SERM) established fluctuation limits of 2.25 percent, except 6 percent for Italy until 1990, for the inflation rates of EMS members. When a member nation s fluctuation rate exceeded 75 percent of the SERM limit, the country was required to take measures to correct the rates (Watson, 1997:20-42). In 1983, France made a significant choice to limit their inflation rate, rather than spend money to make domestic expansions. This action greatly increased the credibility of and excitement for the EMS. Over the next two years, EMS members made only one inflation rate adjustment. The EMS was viewed as an intermediate step towards European Monetary Unification (EMU). On July 1, 1987, the Single European Act (SEA) was enacted by majority vote and signed by 12 nations. The SEA amended the European Economic Community (EEC) Treaty as follows: the Community shall adopt measures with the aim of establishing . . . free movement of goods, persons, services and capital. In 1988, as a result of the positive reaction to the SEA, European government heads directed the EEC towards monetary unification and developed a plan to remove all economic barriers between European nations by July 1990. Member nations believed that the full benefits of the SEA would not be realized until currency exchange rates were fixed and all European countries used a single currency (Watson, 1997:44-50). The Maastricht Treaty, signed on February 7, 1992, established three stages for European Monetary Unification. The first stage of capital liberation was already in process when the treaty was signed. The second stage, which began on January 1, 1994, involved the secure convergence of members economic policies in accordance with EC set guidelines, price stabilization and reviewing EC members for readiness for EMU. The main convergence criteria laid down by the Maastricht Treaty are as follows: an inflation rate not more than 1.5 percent above the average rate of the three member nations with the lowest inflation; a public budget deficit not exceeding 3 percent of gross domestic product; public debt of not more than 60 percent; a long-term interest rate no more than 2 percentage points higher than the average rate of the three member nations with the lowest inflation; and no serious currency devaluations. The final stage, which began on January 1, 1999, launches the euro and transfers all responsibility for member monetary policy to the European Central Bank Watson, 1997:53-60).The euro is being introduced in three phases. Phase A creates the economic and monetary union of the member nations and establishes the European Central Bank. Phase B began January 1, 1999 and ends December 31, 2001. This stage launches the euro and transfers all responsibility for member monetary policy to the European Central Bank (European Commission, 1997a). On January 1, 1999, fixed exchange rates (Table 1) were released and use of the euro began for electronic transactions. However, euro notes and coins will not be released to the public until January 2002 (Kelly, 1999). Phase C begins January 1, 2002 and during this time all national currencies must be converted to the euro and euro bank notes and coins will be put into circulation (European Commission, 1997a). Pros and Cons of the EuroOne of the biggest advantages for member nations is the elimination of exchange rate risk. Businesses today face these risks whenever they become involved in transactions using a foreign currency whether exporting, importing or investing overseas. Though hedging techniques have been used to reduce this risk, it is estimated that the cost to small firms may be as high as two percent of their sales and purchases. Businesses in euro countries will no longer face conversion charges when conducting business in other euro countries. This, coupled with the removal of exchange rate risk, may give such firms a competitive advantage. The conversion to the euro is also expected to improve social stability, increase foreign investment because of a stronger international recognition, create price transparency and make exporting among member nations easier.Some of the member nations have been concerned, though, about losing their autonomy and the additional costs during the transition period. Smaller companies may not be able to make the decision of when to convert to the euro as the larger companies they do business with will probably dominate (Y2K, 1998).Effects of the Euro During phase B, there will be a no compulsion / no prohibition rule that is the euro may be adopted voluntarily during this time, but it is not mandatory to do so. However, by July 1, 2002 all transactions will be exclusively in euros. Determining when to change over during the transition period will depend on the filing requirements of each member nation. Currently, three groupings can be identified: In the total euro option, companies will use the euro for in-house accounts and financial reporting. In the partial euro option, companies in-house accounts will remain in their national currency and their financial reporting will be in the euro.  In the national currency option, companies will maintain their in-house accounts and financial reporting in the national currency up until the introduction of euro notes and coins (European Commission, 1997a). Accounting Systems During the transition period, phase B, companies will have to decide whether they plan to convert immediately to the euro or continue operating in their national currency and run a dual system for conversions (KPMG, 1997b). Government studies have indicated that European businesses are expected to transfer accounting records to euros as soon as they are financially and technically able. Many businesses have said that they will make all accounting changes related to the euro at the beginning of 1999 because it will result in greater price transparency to clients and investors. They will also be able to avoid dealing with conversion to euro systems and expected computer problems at the start of the new millennium simultaneously. Other business owners claimed that they saw an advantage to dealing with conversion to euro systems immediately, but they were still in the process of finding funds to finance the large computer system changes that were considered to be necessary (OECD, 1998).Triangulation. To continue operations in their national currency during this transition period, a more complicated conversion process, known as triangulation, must be used when conducting business in a foreign currency. The triangulation process involves two conversion computations, rather than one. The first step is to convert the currency being used into euros. The second step is to convert the euros into the desired currency. For example, if a business wanted to convert a sale of 100 German marks into French francs, the marks must first be converted to 51.129 euros. Then the euros must be converted to 335.386 francs. Rounding must always be accurate to at least three decimal places and performed to the nearest subunit of currency (Chabot, 1999:149-151). The cost for companies to implement processes for triangulation is predicted to be $86 billion (Vincent). System Upgrades. Most companies operate with standard software packages that will require upgrades in order to cope with the euro. However, companies that still rely on old in-house systems, often written in outdated programming languages; should be particularly cautious. In many cases, these applications are badly documented, and the programmers have left the company. The changeover to the euro could provide the opportunity to switch to more efficient software packages (Euro, 1998).Investing in software that can handle sales and purchases with EMU nations and new triangulation conversion methods is the most efficient way for companies to handle phase B transactions that might involve as many as three currencies and more complicated monetary conversion methods. However, the purchase of new software is only one of the many costly adjustments. The following company documents and equipment must be reviewed for accuracy and the ability to handle the euro: invoices, price lists, packing slips, web sites, bank accounts, cash registers, computer keyboards and external and internal reports (Chabot, 1999:138-142).It is important for companies to check with their usual providers about preparing standard solutions for systems upgrades and at a reasonable cost. The euro coincides with the millennium issue and both projects will be extremely time consuming for programmers and analysts. It is likely that there will be a shortage of specialized Information Technology experts in the months just prior to 1999 (Euro, 1998).Conversion Costs The treatment of conversion costs incurred as a result of the euro is regulated by the accounting authorities of individual countries. The European Commission guidelines recommend expensing these costs as they are incurred unless they result in future benefits. Costs that result in identifiable benefits during phase B can be capitalized and amortized (European Commission, 1997a). In the United States, the Financial Accounting Standards Board (FASB) has stated that not all software upgrades and hardware purchases that are made in response to the release of the euro should be expensed when incurred. Rather, the Board released an opinion on May 21, 1998 that ordered American companies to record these purchases in accordance with the existing accounting policies of the company and in the same manner as similar purchases made previously. The FASB is expected to release additional opinions related to the treatment of the euro in the near future (Chabot, 1999:142).Financial Reporting By the end of phase B, all financial statements that report national currencies, such as marks and lira, must be converted to euros. This currency change will affect numerous business reports, such as prospectuses, security filings, annual financial reports, tax returns and press releases. Businesses should convert all reports at one time to avoid confusing report users with conflicting data (Chabot, 1999:142-143). For example, if the annual financial report shows annual sales of 400,000 marks and the shareholder letter discusses annual sales of 204,517 euros, this discrepancy will probably cause much confusion among financial statement users. Translation. Member nation companies that do not have dealings in foreign currencies have never performed a currency translation. These companies will need to translate their financial reports into euro units. The translation procedure will not result in any gains or losses, as the currency translation will be performed with the fixed conversion rates (European Commission, 1997a). In the U.S., generally accepted accounting principles (GAAP) require U.S. companies that have foreign operations to translate foreign currency financial statements to the U.S. dollar for consolidated financial statements. If the foreign operation s financial statements are not denominated in its functional currency; they must be remeasured into the functional currency prior to translation (KPMG, 1999). For U.S.-owned foreign operations, a change to the euro as their functional currency is considered a change in accounting method. The Internal Revenue Service has issued proposed and temporary regulations stating that these operations will be considered to have automatically adopted the euro as their functional currency to be effective when the operations begin using the euro for reporting (KPMG, 1997a).

Gains and Losses. Overall, for member nations exchange gains and losses will be realized December 31, 1998. Some member nation s accounting authorities are allowing them to defer realization for tax purposes, but with limitations. For U.S. companies, any gains or losses resulting from the translation process will be reflected in the current period income statement (KPMG, 1999). Comparative Financial Statements. The Securities and Exchange Commission (SEC) has issued an opinion (Topic No. D-71) that encourages American corporations that are changing their reporting currency to the euro to perform historical recasting of financial data that is released for the purposes of comparison (Chabot, 1999:142-143). Continuity of Contracts There is little substantive risk of contracts being discontinued as a result of the introduction of the euro on the grounds that they have become impossible to carry out or that their purpose has been frustrated. However, parties to contracts remain free to agree that the continuity terms of the EC legislation do not apply if they wish to do so (Euro, 1998). Contracts Between Member Nations. Article 7 of Regulation No. 974/98 forbids contracting parties from altering or terminating a contract because of the introduction of the euro. EC legislation stipulates that the euro shall be substituted for the currency of each participating member nation at the conversion rate . This statement was issued to guarantee a link between the national currencies and the euro. To guarantee the continuity of contracts in non-member nations, EC legislation is relying on the principle of the state theory of money . This principle holds that each Nation determines the legality of their currency. This principle is universally accepted, and therefore, should ensure contract continuity even in non-member nations (European, 1997b). Contracts With the U.S. In the U.S., some states have begun legislation that will permit an automatic substitution of the euro for the outgoing national currency. If euro substitution is not allowed, contracts denominated in foreign currency that will be replaced by the euro will become invalid. A contract that is legally terminated could create a gain or loss that would need to be recognized for tax purposes (KPMG, 1999). Force Majeure Clauses. When extenuating circumstances beyond the control of parties prevent performance or change the circumstances of the contract; force majeure clauses justify this non-performance. Unless a clause in a contract refers specifically to the euro, a conversion to the euro should not lead to the non-performance of a contract. EC legislation has ensured that obligations in a national currency can be settled in the euro (European, 1997b). Increased Costs. Generally, contracts have clauses that allow lenders to pass on increased loan costs to the borrower. The changeover to the euro should not cause increased costs. Although, if there are regulatory changes after the introduction of the euro, increased costs of refinancing could be passed on to the borrower (European, 1997b).Industry Outlook The four key economic benefits of European monetary unification are elimination of exchange rate rise, decreased conversion costs, price transparency and increased market size. When exchange rates are not stabilized, the risk for foreign purchases and investments is extremely high. European monetary unification stabilized exchange rates on January 1, 1999. Consequently, the financial risk associated with the fluctuation of monetary exchange rates is eliminated. European monetary unification will greatly decrease conversion costs, which absorbs a large amount of European sales dollars every year. According to the European Commission, European businesses pay $12.8 billion annually for conversion costs. When Euroland adopts a single currency, it will become much easier for the European consumer to compare prices between countries. For example, for a consumer to compare prices of a BMW car in Italy and Germany accurately, complex monetary conversions must be made between the German mark and the Italian lira. When Germany and Italy are both using the euro; prices can easily be compared to each other. The final advantage of European monetary conversion is the increased size of all European markets. Rather than serving the market of a single country, businesses will have the option to expand and serve the markets of ten other nations. This will increase competition in all European markets, and result in lower cost for Euroland citizens (Chabot, 1999:39-44). Industries That May Profit. As a result of the euro s release, several markets are expected to receive a large increase in sales. Many businesses will need to update their computer software and hardware systems that allow the incorporation of the euro. Consequently, the computer and software industry is expected to receive a large surge of sales and demand for products. The tourism industry is also likely to receive a large surge due to the elimination of monetary conversion costs. Travelers will now be able to move between member nations without losing a significant percentage of their travel funds to monetary conversion costs. Financial advisors that are familiar with large markets are also expected to benefit greatly. It is expected that large international firms that are familiar with the American and Japanese markets will receive many new clients, and financial consulting revenues are expected to skyrocket (Chabot, 1999:129-130).Industries That May Sacrifice. Industries that are most vulnerable to the potentially troublesome results of the euro have several common characteristics. The euro presents extremely high levels of risk to industries that must make large currency management and training investments or are directly involved in business activities related to currency, such as banks and investment firms. The euro also imposes high levels of risk on businesses that are vulnerable to the opening of European markets and the drastic increase in cross-border competition that will occur as a result. Business enterprises that are extremely sensitive to changes in the interest rate of Euroland are experiencing extremely high levels of risk because the euro and the European Central Bank is a new financial leader and has no previous history to review. Those companies trying to predict the decisions of the ECB with regard to interest rates will likely be playing a guessing game for the first couple of years. According to KPMG, the business markets that are most sensitive to the introduction of the euro are the insurance, telecommunications, utilities and pharmaceuticals industries (Chabot, 1999:130-132). The banking industry is the enterprise that will suffer the most from European monetary unification for three reasons. First, because money is the primary product of the banking industry, banks and other financial institutions will have abnormally high transition costs. Every document produced by the banking industry involves money, and every document must be adjusted to reflect the euro. The European Banking Federation estimates that the banking industry will pay approximately $11 billion annually for transition costs. Second, as 11 national currencies unify and become one, banks will be losing a significant amount of foreign exchange revenues, estimated to be $350 billion daily (22 percent of the world s foreign exchange market). Price Waterhouse estimates that the banking industry will lose 50 percent of their foreign exchange business and 60 percent of bond arbitrage trading revenues. The Bureaux de change will lose $1.9 billion (two-thirds) of its annual revenues by 2010. The final reason that banks will suffer is simply increased competition for all types of lending and savings rates. It is expected that the European banking industry will drastically reduce in size over the next few years. The increased competition will encourage many mergers of competing banks and the elimination of noncompetitive financial firms (Chabot, 1999:130-131). Many local European businesses that do not perform services for clients internationally, such as local grocers, bakers and restaurants, will incur significant costs to incorporate the euro into their business systems, but will not receive any benefits, such as serving a larger market. For example, a local grocer in Paris is not likely to attempt to expand their business into the markets of Italy or Germany. However, the grocer must make significant changes to the business computer systems and other equipment, such as the cash registers, to incorporate the euro into their business activities (Chabot, 1999:130-131).International Investors European monetary unification has unified its members economically in many ways. However, investors must recognize that the diversity of the financial markets of EMU member nations has not been removed entirely. Like the 50 states in America s economy, the 11 EMU nations will continue to have different climates, economies and products that they produce better than any other nation. Consequently, investors will continue to benefit from investing in European companies that are operating in the EMU nations that are performing best financially (Chabot, 1999:151-152). Due to the release of a single European currency and fixed exchange rates, investors, security analysts, brokers and investment fund managers will no longer need to assess exchange rate risk when considering the purchase of European stocks and bonds. Companies can now be assessed for investment purposes simply based on their financial history and predictive forecasts. The European market will become much more similar to the American stock market because all Euroland stocks can be compared to each other without considering the exchange rates of the two member nations (Chabot, 1999:153).Because of the stabilization of European exchange rates, the magnitude and sophistication of the Euroland financial markets are expected to increase significantly over the next ten years for three reasons. First, the risk and uncertainty of European investments is reduced greatly. As discussed above, exchange rates no longer need to be considered when making Euroland investments. Second, the ability of Euroland national governments to issue bonds is restricted by the Stability Pact, signed by the EMU. Demand for low-risk government bonds is also expected to decrease because the stabilization of European exchange rates lowers the risk for other types of investments that earn interest and dividends more quickly, such as corporate stocks and bonds. Third, young investors welcome high-risk, high-return securities. These investors are expected to purchase high volumes of Euroland private equity opportunities, small-cap IPOs, high-grade corporate bonds, junk bonds and asset-backed securities. Consequently, the value of these investments is expected to experience large gains (Chabot, 1999:152). One question that all investors must consider is whether Euroland securities are a secure long-term investment. Provided the EMU stays united, Euroland corporations are expected to experience significant growth in the next decade. However, many investors are not yet certain that the members of the EMU will stay committed to joining the economies of its members. They fear that the next economic shock experienced by an EMU member will cause the downfall of the EMU and the euro altogether. In other words, will the euro be successfully incorporated into the world financial markets? If investors are confident that the euro will survive future economic shocks experienced by Euroland nations and be the primary currency of Europe in ten years, there is no better time than now to invest in the European stock markets (Chabot, 1999:153-158). Conclusion The ultimate goals of EMU are to establish a single currency for European nations, eliminate price discrepancies between European countries and enable Europe to be viewed as a continent, rather than a group of nations, in the global economy. The EMU continues to search for ways to successfully integrate the economies of the European countries without losing the individuality of each member nation. All international and member nation companies will have to convert to the euro at some point in time and will have to make changes to their accounting systems. When changing accounting systems, organizations will need to take into account the conversion and rounding procedures and the need for dual currency unit invoicing and reporting. Accounting departments must determine which accounts are affected by the euro and prepare to handle sales and purchases using the new currency. International companies and companies in member nations will need to properly record all costs related to the conversion and translation processes. It is advisable for U.S. companies with European subsidiaries to get tax planning advice from a professional concerning the specific issues related to their organization.


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