August 1999



By Tina Steward Quinn and
Keith W. Smith

With the arrival of the euro on January 1, foreign exchange transactions and translation of foreign financial statements between the legacy currencies (local currencies of the 11 euro-zone countries) and the U.S. dollar have been altered substantially. The conversion rates of the legacy currencies are fixed in terms of the euro and no longer float against the dollar. Only the euro floats against other currencies with a published exchange rate. For example, a German mark can no longer be translated directly into a U.S. dollar, or vice versa. Any translation must be "triangulated," that is, converted through the euro.

The euro made its official debut into the business world in a noncash form: Euro notes and coins do not yet physically exist. The euro will be phased in during a transitional period from January 1, 1999, to December 31, 2001.

During this three-year period, parties are free to use the euro if they wish but are not required to do so. The legacy currencies will coexist with the euro during this period, then the local currencies will be phased out as the euro is physically introduced into circulation. By July 1, 2002, the changeover will be complete: The euro will be the only legal tender in euro-zone countries.

Issues for U.S. Companies

In foreign exchange transactions with companies in the euro-zone, accounts can be settled in dollars, euros, or the legacy currency. For transactions settled in dollars, no problems arise. However, transactions settled in euros will require translation into dollars at the appropriate dates and exchange rates, which may result in foreign exchange gains or losses.

Transactions settled in a legacy currency are slightly more complicated. These currencies no longer have published exchange rates with the dollar and must be triangulated through a third currency, the euro.

The European Monetary Union is quite specific on triangulation rules. The fixed conversion rates for a legacy currency must be specified against one euro using six significant digits. Reciprocal rates may not be used. The result of the conversion must be rounded to three decimal places and then translated into dollars at the appropriate exchange rate between euros and dollars.

For example, if Company U.S. purchases goods totaling 100,000 francs from Company France, how would Company U.S. record the transaction? Company U.S. would record purchases and accounts payable for $17,214.54, computed as shown in the sidebar.

Published exchange rates between francs and dollars no longer exist. The franc must be converted to euros at the fixed conversion rate of 1 e = 6.55957 FRF. The resulting euros are then translated into dollars at the current exchange rate (assumed at 1 e = $1.1292). This process would be repeated at the balance sheet date and settlement dates with any resulting gain or loss recognized.

Translation of Foreign Financial Statements

While accounting for foreign currency transactions requires minor adjustments, the issues arising with the translation of a foreign subsidiary's financial statements pose formidable challenges for a U.S. parent company. Major issues include the following:

* Is conversion to the euro a change in functional currency?

* What are the tax and accounting implications of conversion?

* Should the costs of conversion be expensed or capitalized?

Statement of Financial Standards No. 52 (SFAS 52) is the primary source of GAAP for translation of foreign currency financial statements. SFAS 52 introduced the concept of functional currency, defined as "the currency of the primary economic environment in which the entity operates; normally, that is, the currency of the environment in which an entity primarily generates and expends cash." For a foreign subsidiary of a U.S. company, the functional currency may be the local currency of the subsidiary or the reporting currency of the parent company (i.e., the dollar). The method used to translate the foreign subsidiary's financial statements hinges upon determination of the functional currency. When the functional currency is the foreign currency, the current rate method is the approach mandated by SFAS 52. If the functional currency is the dollar, then the temporal method is used to "remeasure" the foreign financial statements (See Exhibit 1).

Adoption of the euro raises a question regarding U.S. GAAP. If the local currency of a foreign subsidiary has been designated as the functional currency and the company converts its books and records to the euro, how does this affect translation of foreign financial statements for the U.S. parent? If the foreign subsidiary does not keep its books and records in the functional currency, the books must be remeasured into the functional currency before translation into the reporting currency of the parent. Any gains or losses from this remeasurement would normally be recognized in income, but since the legacy currencies are fixed in terms of the euro, no gain or loss would result.

SFAS 52 also states that once the functional currency is determined it shall be consistently used unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. A change in functional currency would be a change in accounting principle. The standard refers to a change in functional currency as change from a foreign currency to the reporting currency or vice versa. SFAS 52 does not address a change from the foreign currency to a new foreign currency. Is change from a legacy currency to the euro considered a change in functional currency?

Through its Emerging Issues Task Force (EITF), FASB has considered some of the accounting issues related to the introduction of the euro. EITF Topic D-71 considers the changeover to the euro a change in functional currency but says that the cumulative translation adjustment account should not be changed until there is a disposition of the investment. Conversion to the euro does not cause the unrealized translation adjustments to become realized. The FASB staff also suggests that not all of the costs of conversion would necessarily be expensed. Such costs should be accounted for in accordance with a company's existing policies for similar costs, which may allow capitalization.

The issue of change in functional currency has also been addressed by the Treasury Department in Temporary Regulations section 1.1001-5t. For companies affected by the euro conversion, two key points are covered by the temporary regulations. First, conversion to the euro from the legacy currencies is considered a change in functional currency. Second, the functional currency conversion is "not the exchange of property for other property differing materially in kind or extent." This effectively means that the mandatory like-kind exchange rules apply and no gain or loss is recognized. Temporary Regulations section 1.1985-8t further emphasizes this by indicating that currency gains and losses from foreign currency transactions between the legacy currencies of euro-zone companies would be recognized through December 31, 1998, but not after.

There are problems with both the current method and the temporal method of translation of foreign financial statements. During the transitional period, those accounts that must be translated at the current rate must be triangulated. After the transitional period, when the euro is the only currency, there will be problems translating those accounts that must be translated at historical rates since none exist for the euro prior to January 1, 1999. Until these issues have been addressed, the authors propose a possible solution to the mechanical problems involved in translating foreign statements during the transitional period and thereafter.

Consider the following example. U.S. Company has a wholly owned subsidiary in Germany. The dollar has been designated as the functional currency, therefore the temporal method is used to remeasure the financial statements into dollars. The temporal method is illustrated here because more account balances are remeasured using the historical rate, thus highlighting the problem. Any remeasurement gain or loss is reported in income. The financial records of the subsidiary have been kept in German marks. Only the balance sheet information is given since it is sufficient to illustrate the problems that arise during remeasurement. Exhibit 2 presents the balance sheet in German marks at December 31, 1998. Worksheets follow for the pre-euro period, the transitional period, and the euro period. For comparison, account balances (in marks) are assumed identical at each balance sheet date.

The Pre-Euro Period

Exhibit 3 is a worksheet used to remeasure the foreign financial statements prior to the introduction of the euro when the financial records are kept in German marks. With the temporal method, monetary assets and liabilities are remeasured using the current rate, while nonmonetary assets and liabilities are remeasured at the historical rate. Retained earnings is a composite figure.

The Transitional Period

Exhibit 4remeasures foreign financial statements during the transitional period. The assumption is made that the financial records are still kept in German marks as the subsidiary has yet to convert to the euro. Translation of the balance sheet during the transitional period would involve using triangulation where the current rates apply and using the old exchange rates between the mark and the dollar where the historical rates apply.

The Euro Period

Exhibit 5 illustrates the remeasurement of financial statements after the subsidiary has converted all financial records from the mark to the euro. Accounts that are remeasured at the current rate pose no problem, but accounts that are to be remeasured at the historical rate create a dilemma. Fixed assets, for example, may have been acquired years before the euro was introduced. The historical rate is for the mark, but the accounts are now in euros. There are no historical rates for the euro prior to January 1, 1999. How do we remeasure these accounts into dollars? One possible solution is to simply carry forward the dollar amounts from prior years. Most accounts will eventually evolve into euros, that is, equipment will be replaced and the cost will be in euros and the problem will be resolved. However, stockholders' equity may never evolve into euros. These account balances in dollars may have to be carried over indefinitely.

Exhibit 5 suggests remeasuring the balances translated at historical rates by using the historic exchange rate between the euro and the dollar as of January 1, 1999. The exchange differences would be directly recorded in equity as a translation adjustment because the differences arise from translations, not from operations. Some support for this approach can be found in the SEC's position on presentation of prior period financial statements for periods before the introduction of the euro. Such statements can be restated into euros, then translated in dollars at the January 1, 1999, exchange rate.

For companies using the temporal method, the functional currency is the dollar. This means that conversion of the legacy currency to the euro is not a change in functional currency and therefore not a change in accounting principle. For companies using the current method, conversion of the legacy currency (the functional currency) to the euro is a change in accounting principle. But both FASB and the IRS have indicated that such a change would not be a recognition event. This change in accounting principle could be treated similar to a change to the LIFO inventory method. A change to LIFO is accounted for retroactively, with the opening inventory balance under the old inventory method simply becoming the base-year inventory under LIFO. To account for the change in functional currency under the current method or to account for conversion to the euro under the temporal method, prior periods could be restated and the January 1, 1999, exchange rate for the euro would become the historical rate for those accounts translated at the historical rate. *

Tina Steward Quinn, PhD, CPA, is an assistant professor of accountancy and Keith W. Smith, PhD, CPA, is an associate professor of accountancy at Arkansas State University, Jonesboro.

Douglas R. Carmichael, PhD, CFE, CPA
Stan Ross Department of Accountancy,
Zicklin School of Business,
Baruch College

John F. Burke, CPA

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