Comparative Analysis of Accounting for Foreign Currency Transactions Using Derivatives: Forward Contract versus Option

• In Event: International Accounting

Abstract

This paper provides educators with a classroom example or a self-study tutorial to teach accounting for derivative instruments and hedging activities for foreign currency transactions. The example can be used in courses such as intermediate, advanced, or international accounting that discuss derivative instruments or investment topics, or in a company training program. It can also help develop critical thinking skills in analyzing the impact of different hedging strategies on a firm’s financial statements. The included scenario demonstrates how an importer uses a foreign currency derivative to hedge exchange rate fluctuations of a liability (accounts payable). This situation is applied across five cases to show the impact of derivative designation on the accounting treatment and to provide a comparative analysis of the reporting results from using different accounting treatments for the derivative. Case 0 demonstrates the impact of not using a derivative to mitigate market risk. Cases 1 and 2 demonstrate accounting for hedging activities by using a forward contract as a fair value hedge and a cash flow hedge, respectively. Cases 3 and 4 illustrate the use of an option. A downloadable spreadsheet on the author’s website can be customized for use in the classroom.

Authors

• Lijyun Angela Hwang, Eastern Michigan University

• Andrew Walla, Eastern Michigan University