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1. LEGAL FRAMEWORK FOR THE INTRODUCTION OF THE EURO
1.1 The Treaty Of Maastricht
Under the Treaty of Maastricht, a single European currency, the EURO, will be introduced on 1 January 1999 in all Member States of the European Union which chose to participate, provided they meet certain economic convergence criteria (including budget deficit and inflation limits). In addition to the provisions of the Treaty of Maastricht itself, the Commission of the European Community has so far issued two draft proposals for Council Regulations regarding the legal framework for the introduction of the EURO.
1.2 Draft Council Regulation Under Article 235 Of The EEC Treaty
The major provisions of this draft Regulation are as follows:
- Effective 1 January 1999, references in contracts and other legal instruments to the ECU (European Currency Unit) are to be understood as references to the EURO at a rate of one EURO for one ECU.
- Contracts denominated in the national currencies of Member States or in ECU and which extend beyond 1 January 1999 shall continue in force (continued validity of contracts).
- The degree of precision is defined with which conversion rates will be irrevocably fixed on 1 January 1999.
- Rounding rules are established.
1.3 Draft Council Regulation Under Article 109 I (4) Third Sentence Of The EEC Treaty
The principal matters dealt with in this draft Regulation are as follows:
- Introduction of the EURO as the currency of the participating Member States of the EU effective 1 January 1999.
- During a transitional period from 1 January 1999 through 31 December 2001, the new single currency may be denominated either in EURO or in the units of the former national currencies, which to this extent become expressions (subdivisions) of the EURO. After the end of the transitional period, the national currency units cease to exist.
- National banknotes and coins remain legal tender in the transitional period. Their status as legal tender ends at the latest on 30 June 2002, i.e. six months after the end of the transitional period. As of 1 July 2002, EURO banknotes and EURO coins become the sole legal tender in all participating Member States.
1.4 Three Phases
The Transition To A Single Currency Will Take Place In Three Phases, For Which Definite Dates Have Been Set.
- PHASE A: Launch of economic and monetary union. In early 1998, as soon as the participating members of the European Monetary Union (EMU) have been determined, the European Central Bank will be set in place. Preparation in the participating countries will be stepped-up throughout this phase, particularly in administration, banks, and financial institutions.
- PHASE B: Effective start of economic and monetary union. This phase begins on 1 January 1999, as of which date the conversion rates between the EURO and the participating national currencies will be irrevocably fixed and the EURO will become a currency in its own right. The currencies of the participating Member States will continue to exist during Phase B, but only as subdivisions of the EURO. Firms may also opt to convert all or part of their accounting operations into EURO. Phase B ends on 31 December 2001.
- PHASE C: Definitive changeover to the EURO. On 31 December 2001, the national currencies of the participating Member States cease to have legal value. Amounts expressed in these currencies are henceforth deemed to be in EURO converted at the irrevocable January 1999 rates. During the period from 1 January to 30 June 2002, the old national currencies must be completely withdrawn from circulation and replaced by new EURO banknotes and coins.
2. COMMERCIAL AND TAX ACCOUNTING ISSUES AS A RESULT OF THE INTRODUCTION OF THE EURO
On 4 November 1996, the European Commission (Directorate General XV) issued a paper on "Accounting for the Introduction of the EURO" dealing with various accounting issues as a result of the introduction of the EURO (EU Accounting Paper).
A number of Accounting Directives have been adopted by the EU under the company law harmonisation program. These directives bind the Member States as to the result to be achieved, but leave the choice of form and methods up to the national authorities. The following directives provide general and specific guidance on accounting issues and reporting formats:
- Fourth Directive (1978) regarding the annual financial statements
- Seventh Directive (1983) regarding consolidated financial statements
Germany has enacted legislation transforming the above directives into German law.
For certain industries, the EU has adopted specific directives supplementing those mentioned above, e.g:
- Directive regarding the accounts of lending institutions (1986 Bank Directive); and
- Directive regarding the accounts of insurance companies (1991 Insurance Directive).
Sections 340 through 340o of the German Commercial Code (HGB) reflect the Bank Directive, whereas sec. 341 - 341o HGB have transformed the Insurance Directive into German law.
The EU Accounting Paper has been drafted on the basis of the above directives.
No guidelines have as yet been issued by the German legislature or government. It is generally believed that the issues connected with the introduction of the EURO can be solved within the existing legal framework.
2.2 Costs Associated With The Changeover
2.2.1 Statutory treatment
Companies will have a variety of costs as a result of the introduction of the EURO:
- Administrative planning and changes in software
- Staff training
- Providing information to customers
- Adaptation of vending machines
- Adaptation of automatic cash dispensers (banks)
For statutory accounting purposes, three different categories of costs can be identified:
- 1ST CATEGORY: Costs not incurred for the production of tangible assets and which can also not be treated as prepaid expenses (sec. 250 par. 1 HGB). These costs include costs connected with information provided to customers, suppliers and employees, including analysis of the payment transactions. These costs cannot be capitalised and will be expensed in the year in which they are incurred.
- 2ND CATEGORY: Intangible assets not acquired for consideration, e.g. development of software by a company's own staff or adaptation of existing software by one's own staff to the new situation. The costs incurred for such tasks cannot be capitalised but must be expensed when incurred.
- 3RD CATEGORY: Tangible and intangible assets acquired in return for consideration. They must be capitalised at cost and written off over their useful economic life. Costs associated with the update of capitalised assets, e.g. updates of standard software, can only be capitalised and included in the cost of the underlying asset if they result in an extension or improvement of the underlying asset significantly beyond its original state (sec. 255 par. 2 sentence 1 HGB).
Accruals for such changeover costs may be justified under one of the following two legal grounds:
- Contingent liabilities
- Repair and maintenance expense incurred during the first three months of the year following the fiscal year just elapsed.
2.2.2 Tax accounts
Taxable income is determined on the basis of the results as shown by the commercial accounts unless an adjustment is specifically required under tax law (linkage of the tax accounts to the commercial accounts - Massgeblichkeitsprinzip). Since here no exception applies, accruals established for one of the above reasons will be respected for tax purposes as well.
The above mentioned principles therefore also apply for tax accounting.
2.3 German Based Assets/Liabilities
Starting 1 January 1999, the EURO will become a currency in its own right. The various national currencies will continue to exist only as subdivisions of the EURO.
Upon introduction of the EURO, companies have the option of converting their accounts into EURO. Such conversion is compulsory upon the commencement of Phase C (1 January 2002).
Translation does not entail revaluation of a company's assets and liabilities. Rather, the existing values of these assets and liabilities are simply expressed in a new currency. The conversion procedure is relatively simple and merely requires restatement of all assets, liabilities, and equity in EURO using a specified conversion rate.
Currency conversion will not result in any exchange differences with respect to domestic based assets/liabilities.
ACCOUNTS IN DM Real Estate 30 Equity 42 Inventory 70 Liabilities 58 100 100
Irrevocable conversion rate of 2 DM = 1 EURO
ACCOUNTS IN EURO Real Estate 15 Equity 21 Inventory 35 Liabilities 29 50 50
The above considerations are also valid for the tax accounts.
2.4 Assets/Liabilities Based In Another Participating Member State
Currency translation can result in conversion differences for assets and liabilities based in other participating member states.
2.4.1 Conversion differences for non-monetary items
German company A owns real estate in France acquired for FF 300. The DM equivalent as shown in the accounts is DM 100 based on the historic exchange rate of 3:1 prevailing at the time of acquisition.
The irrevocable conversion rate as at 1 January 1999 is:
7 FF = 2 DM = 1 EURO
The conversion rate results in the following values for the real estate:
DM 85.72 (= FF 300 x 2/7)
EURO 42.86 (= FF 300 x 1/7)
Under the principle of conservative accounting (requiring provision for all foreseeable risks - sec. 252 par. 1 no. 4 HGB), the lower value must be allocated to the real estate, resulting in a loss of DM 14.28 (= EURO 7.14).
The above considerations are also valid for the tax accounts.
2.4.2 Conversion differences for monetary items
22.214.171.124 Conventional instruments
The fixing of the conversion rates between participating currencies and the EURO can result in the realisation of exchange differences. The choice of reporting currency, EURO or national currency unit, cannot alter the fact that exchange risks with respect to the currencies of participating Member States will cease to exist. Exchange differences will be realised wherever the irrevocable conversion rate fixed as at 1 January 1999 differs from the exchange rate prevailing at the inception of debts and debt claims denominated in other participating currencies.
In 1995, Company A in Germany takes out a 5 year loan of FF 1,000,000. The exchange rate at the time of issuance of the loan in 1995 was 3 FF = 1 DM. The repayment obligation is thus accounted for by Company A at DM 333,333.
The irrevocable conversion rate as of 1 January 1999 is 7 FF = 2 DM = 1 EURO
Under German accounting rules, the positive exchange difference would normally not result in a gain. The loan is shown on the books at the historic exchange rate with the result that the positive exchange difference is not recognised until the loan is repaid.
However, due to the irrevocable fixing of the conversion rates as of 1 January 1999, the positive exchange difference must be realised.
The realised gain is (DM):
DM credit at historical cost 333,333 EURO credit as per conversion date (expressed in DM as subdivision) 285,714 Locked in profit 47,619
A German working group for accounting matters (Schmalenbach-Gesellschaft - Arbeitskreis Externe Rechnungslegung) is of the opinion that the positive exchange rate differences cannot be realised. They contend that the liability "loan payable" retains its identity so that a valuation in excess of cost would violate the German principle of conservative accounting. Even if the identity of the liability were to be destroyed, they argue that an option exists to carry over the value at which the liability is shown in the accounts or to realise the positive exchange difference (so-called "exchange principles" or Tauschgrundsaetze). The above argumentation can be found in Der Betrieb 1997, 237 (Die dritte Stufe der Europaeischen Waehrungsunion - Auswirkungen auf die externe Rechnungslegung).
The above considerations are also valid for the tax accounts. Depending on which approach is correct, there will be a taxable profit or not.
However, even if the view of the Schmalenbach-Gesellschaft is shared, there will only be a deferral of tax. The profit must be realised at the latest when the loan is repaid.
126.96.36.199 Derivative instruments (Forward exchange contract as example)
Company A entered into the following forward exchange contract with Bank B in September 1995: Purchase of UK £ 1 million in return for DM 2,400,000 with September 1999 as closing date.
The conversion rate as of 1 January 1999 is
0.6666 UK £ Sterling = 2 DM = 1 EURO.
Under the principle of conservative accounting, positive exchange differences cannot be reported if not yet realised.
However, as of January 1, 1999, the conversion rates will be irrevocably fixed with EURO as the surviving currency and the national currencies as subdivisions of the EURO.
The exchange gain is (DM):
Conversion amount as per January 1999 3,000,000 Agreed purchase price -2,400,000 Gain 600,000
The gain of DM 600,000 is also realised for tax purposes.
After the introduction of the EURO, exchange risks will disappear in contracts between the currencies of two participating Member States. In the absence of exchange risks, the outcome of a forward exchange contract can be calculated with certainty and the exchange difference is realised. While the legal framework for the EURO provides for the continued validity of contracts, forward exchange contracts of the type posited will no longer serve their original purpose. From the foregoing, the conclusion may be drawn that these contracts will be terminated upon introduction of the EURO with the consequence that the party benefiting from a positive exchange rate difference will receive a cash settlement.
The above considerations are also applicable if the forward exchange contract is used to hedge an exchange risk on another transaction. Let us assume that, in the above example, Company A is required under a supply contract to pay the amount of UK £ Sterling 1 million to the UK seller (i.e. creditor) in September 1999. For the purpose of exchange risk reduction, Company A buys UK Pounds Sterling 1 million per September 1999 at a rate of 2.4, i.e. in return for DM 2.4 million. Any loss resulting from the hedged transaction can be set off against the gain from the forward contract so that the effect on the profit and loss account of Company A is neutral.
188.8.131.52 Time of realisation
For companies with a fiscal year ending on 31 December 1998, exchange differences on all monetary items will be realised in the 1998 fiscal year.
In principle, the valuation of all items must be based on exchange rates as of the closing date (31 December 1998). Since the irrevocable fixing of the conversion rate occurs as of 1 January 1999, one might argue that the exchange differences will be realised in 1999. However, the above principle may be disregarded in exceptional circumstances (sec. 252 par. 2 HGB).
For companies with fiscal years not coinciding with the calendar year, the realisation of exchange differences may occur in the last fiscal year ending before 31 December 1998 provided that the conversion rates have already been fixed at the time of preparation of the annual financial statements.
Please note that the position here taken is not shared by all experts. Some commentators believe that the exchange differences should be realised in 1999. The EU paper of 4 November 1996 on Accounting for the Introduction of the EURO raises under no. 54 the question whether, in case of significant positive exchange differences, the companies affected should have the option of spreading the resulting exchange gain over a more than one accounting period. German accounting law, however, does not provide for such spreading of accumulated exchange differences.
There is no need to prepare an opening balance sheet as of 1 January 1999.
2.5 PREPARATION OF ANNUAL FINANCIAL STATEMENTS IN EURO
From Phase C onward (post 31 December 2001), the financial statements must be prepared and published in EURO since the national currencies of the participating Member States will have ceased to have legal value. This applies to all fiscal years ending after 31 December 2001.
For fiscal years ending after 31 December 1998 but before 1 January 2002, the present wording of sec. 244 HGB would prevent German companies from preparing their statutory accounting in EURO. Under sec. 244 HGB, the financial statements must be prepared in the German language and in Deutsche Marks.
It is, however, likely that sec. 244 HGB will be changed to allow companies to prepare and publish their financial statements in EURO. German companies would then have the option during Phase B to use either EURO or Deutsche Marks. In this event, it would be expedient to change the accounting currency to EURO at the beginning of a fiscal year. If the relevant fiscal year ends on 31 October 1999, the switch to EURO could be scheduled for 1 November 1998.
Assuming that sec. 244 HGB is amended as expected, this would permit the use of EURO-based accounting for tax purposes as well (corporation tax, trade tax, value added tax etc. - sec. 140 ff. AO). However, tax returns and tax payments would probably still have to be made in DM since the German tax authorities are not expected to convert to EURO during Phase B.
The restatement of the accounts in EURO can result in rounding differences.
Example: Balance sheet in DM
Fixed assets 30 42 Equity Current assets 55 23 Accruals Prepaid expenses 15 35 Liabilities 100 100 Conversion at a rate of 1.94612 DM = 1 EURO Balance sheet in EURO Fixed assets 15.42 21.58 Equity Current assets 28.26 11.82 Accruals Prepaid expenses 7.71 17.98 Liabilities 0.1 Rounding difference 51.39 51.39
The rounding difference of 0.01 is recognised in the profit and loss account. It is not permitted to record this difference directly as an increase in equity.
3. IMPACT ON FUTURE BUSINESS STRUCTURES
The introduction of the EURO may have considerable impact on the structure of businesses operating in several EU Member Countries.
At present, the tendency is for multinational companies to form a separate subsidiary for each Member Country. Particularly in the case of non-EU multinationals, a European holding company is often set up to hold the various European subsidiaries.
After the creation of the European Monetary Union (EMU), a trend may develop towards establishment of a single operating company for the entire EMU. Instead of multiple subsidiaries, this single operating company would do business through branches established in the various Member countries ("Branch-out Solution).
4. CONCLUDING REMARKS
The above comments are written from the German perspective and need not necessarily apply in other EU Member Countries. Furthermore, they are not exhaustive. There are various additional issues posed by the introduction of the EURO, such as the handling of consolidated accounts or the restatement of share capital as a result of shares not evenly divisible by 100, 10, or 5. Please also note that the conclusions reached in this article may change as a result of amendments in German or EU law. Changes in the interpretation of existing laws are also possible.
This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance