Eastern Michigan University

DigitalCommons@EMU
Graduate Research Fair Presentations

Department of Accounting & Finance

3-18-2013

Accounting for Foreign Currency Transactions

with Hedging Derivatives: A Teaching Aid
Andrew L. Walla
Eastern Michigan University, awalla@emich.edu

Follow this and additional works at: http://commons.emich.edu/accfin_grf

Part of the Accounting Commons
Recommended Citation
Walla, Andrew L., "Accounting for Foreign Currency Transactions with Hedging Derivatives: A Teaching Aid" (2013). Graduate
Research Fair Presentations. Paper 1.
http://commons.emich.edu/accfin_grf/1

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Accounting for Foreign Currency Transactions with Hedging Derivatives:

A Teaching Aid
Andrew WallaDepartment of Accounting and Finance
Supporting Faculty: Dr. Hwang
Two Accounting Methods

Why are foreign currency transactions

difficult to account for?

Fair Value Hedge

Cash Flow Hedge

Foreign transactions involve foreign currencies, which require

translation to the home currency. In effect, one currency is
used to purchase another at the current exchange rate, referred to as the spot rate.
This translation is further complicated when payment is due at
a future date, because the spot rate constantly changes. This
creates uncertainty in the effective future price, adding risk.
The timeline below illustrates this phenomenon.

A fair value hedge accounts for the transaction and the derivative
separately, as follows:
Transaction: The future payment due is translated periodically
using the fair value (spot rate). Any increase or decrease in the
value between periods is reflected in income.
Derivative: The value is adjusted periodically to its fair value
(market price). Any increase or decrease in the value between
periods is reflected in income.

The cash flow hedge accounts for the transaction and derivative
separately, as follows:
Transaction: Identical to Fair Value Hedge.
Derivative: The derivatives fair value is split into its effective
and ineffective portions.
The ineffective portion is reflected in income.
The effective portion is ignored and not reported until the
final period.

The Teaching Aid

What is a hedging derivative?
A hedging derivative is a special contract that locks in the spot
rate for a future date, thereby eliminating risk. This price in
the future is known as the forward rate.
This teaching aid focuses on two types of derivatives:
1. Forward Contract: Sets the forward rate to a
fixed amount. It is free to enter, but the user
cannot benefit from any favorable exchange
rate changes.
2. Option: Sets the forward rate to a fixed
amount, but becomes optional to use. The user
must purchase the option for a fee, but the user
is not obligated to exercise the option if the exchange rate becomes more favorable.

Accounting for derivative instruments is interdisciplinary, as it requires a moderate understanding of both Finance and Accounting.
Finance: The first section of the paper introduces the concepts
necessary to understand the topic. The left side of this poster
provides a summary of these concepts.
Accounting: The remainder of the paper explains the applicable accounting methods, also on the right side of this poster.
A spreadsheet tool summarizes this information by calculating the
journal entries and financial statements, displayed on the right.
To aid in comprehension through comparison, the teaching aid
utilizes 5 cases, all with the same underlying transaction:
1. No hedge
2. Forward Contract as a Fair Value Hedge
3. Forward Contract as a Cash Flow Hedge
4. Option as a Fair Value Hedge
5. Option as a Cash Flow Hedge

Additional Information:
If you are interested in studying this topic further, please reference the following link:
https://www.dropbox.com/sh/bqi63r5taytijkv/0tik2vHKuz/Hedge%20Accounting%20Project%
20-%20Andrew%20Walla
The complete research paper, the spreadsheet tool, and a copy of this poster are included.

References:
Bodnar, G. M., Hayt, G. S. & Marston, R. C. (1998). 1998 Wharton survey of financial risk management by US non-financial firms. Financial Management, 27, 70-91.

Hull, J. C. (2012). Options, Futures, and Other Derivatives (8th ed.). New Jersey: Prentice-Hall.

Doupnik, T. & Perera, H. (2009). International Accounting (2nd ed.). New York: McGraw-Hill.

Hwang, A. L.J. & Patouhas, J. S. (2001). Practical issues in implementing FASB Statement 133. Journal of Accountancy, 191, March, 26-34.

Financial Accounting Standards Board (FASB). (1998). Statement of Financial Accounting Standards No. 133 Accounting for Derivative Instruments and Hedging Activities. Norwalk, CT:
FASB.

International Accounting Standards Board (IASB). (1998). International Accounting Standard 39 Financial Instruments: Recognition and Measurement. London: IASB.

FINCAD. (2012). Corporate Survey 2012. Surrey, Canada: FINCAD. http://www.fincad.com/derivatives-resources/survey/corporate-2012.aspx.

PricewaterhouseCoopers. (2000). Tackling FAS 133- implications for corporate America, survey of the Fortune 1000. New York: Solution133.com, LLC, a joint venture of PricewaterhouseCoopers LLP and Gifford Fong Associates. http://www.solution133.com.

Howton, S. D. & Perfect, S. B. (1998). Currency and interest-rate derivatives use in US firms. Financial Management, 27, 111-121.

Ramirez, J. (2007). Accounting for derivatives. Chichester, England: John Wiley & Sons.