7.3 Cash flow hedges

Cash flow hedges are a crucial risk management tool in financial accounting. They protect against variability in future cash flows from specific risks, like changes in interest rates or foreign exchange rates. This topic explores how companies use these hedges to stabilize financial planning and reduce uncertainty.

The notes cover the definition, purpose, and accounting treatment of cash flow hedges. They delve into qualifying criteria, types of hedged items and instruments, and the mechanics of different hedging strategies. The content also addresses documentation requirements, discontinuation scenarios, and disclosure obligations for financial statements.

Definition of cash flow hedges

• Cash flow hedges protect against variability in future cash flows arising from specific risks associated with recognized assets, liabilities, or forecasted transactions
• Designed to mitigate the impact of changes in interest rates, foreign exchange rates, or commodity prices on future cash flows
• Integral component of risk management strategies in Intermediate Financial Accounting 2, helping companies manage financial exposures

Purpose and objectives

• Minimize cash flow volatility by offsetting changes in expected future cash flows with changes in the value of hedging instruments
• Provide stability to financial planning and budgeting processes by reducing uncertainty in future cash flows
• Allow companies to lock in favorable rates or prices for future transactions, enhancing predictability of financial outcomes

Qualifying criteria

• Formal designation and documentation of the hedging relationship at inception
• High probability of occurrence for the hedged forecasted transaction
• Demonstration of hedge effectiveness through quantitative or qualitative methods
• Clear economic relationship between the hedged item and the hedging instrument

Types of hedged items

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• Forecasted purchases or sales denominated in foreign currencies
• Variable-rate debt obligations subject to interest rate fluctuations
• Anticipated commodity purchases or sales exposed to price volatility
• Highly probable forecasted transactions impacting future cash flows

Types of hedging instruments

• Forward contracts used to lock in future exchange rates or commodity prices
• Options providing the right but not the obligation to buy or sell at a predetermined price
• Interest rate swaps exchanging variable for fixed interest payments
• Cross-currency swaps hedging both interest rate and foreign exchange risks

Accounting treatment

• Reflects the principle of matching gains or losses on the hedging instrument with the hedged item
• Aims to minimize income statement volatility by deferring certain gains or losses in other comprehensive income
• Requires ongoing assessment and measurement to ensure hedge effectiveness and proper accounting treatment

Initial recognition

• Record the hedging instrument at fair value on the balance sheet
• No entry required for the hedged item if it relates to a forecasted transaction
• Designate the hedging relationship in formal documentation, specifying risk management objective and strategy

Subsequent measurement

• Measure the hedging instrument at fair value at each reporting date
• Record changes in fair value of the effective portion of the hedge in other comprehensive income
• Recognize any ineffective portion of the hedge immediately in profit or loss

Hedge effectiveness assessment

• Perform at inception and on an ongoing basis throughout the hedging relationship
• Utilize qualitative or quantitative methods to demonstrate that an economic relationship exists
• Assess sources of ineffectiveness, such as counterparty credit risk or currency basis spreads

Cash flow hedge mechanics

Forward contracts

• Lock in a future price or rate for the hedged item
• Initial fair value typically zero, with subsequent changes recorded in other comprehensive income
• Reclassify accumulated other comprehensive income to profit or loss when hedged transaction affects earnings

Options

• Provide downside protection while allowing upside potential
• Premium paid recorded as an asset and amortized over the life of the hedge
• Changes in time value may be excluded from the hedging relationship and recorded in profit or loss

Interest rate swaps

• Exchange variable interest rate payments for fixed rate payments
• Record the fair value of the swap on the balance sheet as an asset or liability
• Offset the variability in cash flows of the hedged debt instrument

Hedge documentation requirements

• Formal designation of the hedging relationship at inception
• Risk management objective and strategy for undertaking the hedge
• Identification of the hedging instrument, hedged item, and nature of the risk being hedged
• Method for assessing hedge effectiveness and measuring ineffectiveness
• Description of how the entity will determine the hedged portion of the hedging instrument

Discontinuation of hedge accounting

Voluntary discontinuation

• Entity chooses to terminate the hedging relationship before its natural expiration
• Accumulated gains or losses in other comprehensive income remain until the hedged transaction occurs
• Future changes in fair value of the hedging instrument recognized directly in profit or loss

Involuntary discontinuation

• Occurs when the hedging relationship no longer meets the qualifying criteria
• May result from changes in the hedged item, hedging instrument, or risk management objectives
• Accounting treatment depends on the reason for discontinuation and future expectations of the hedged item

Disclosure requirements

Balance sheet disclosures

• Carrying amounts of hedging instruments by category of risk and type of hedge
• Accumulated amount of fair value hedge adjustments remaining for discontinued hedges
• Reconciliation of each component of equity and analysis of other comprehensive income

Income statement disclosures

• Hedge ineffectiveness recognized in profit or loss
• Line items in the income statement affected by the reclassification of hedging gains or losses
• Separate disclosure of the amount of ineffectiveness for cash flow hedges and net investment hedges

Cash flow statement disclosures

• Impact of hedging activities on the entity's future cash flows
• Description of any forecast transactions for which hedge accounting was previously used but are no longer expected to occur
• Amount reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment

Differences vs fair value hedges

• Cash flow hedges protect against variability in future cash flows, while fair value hedges protect against changes in fair value of recognized assets or liabilities
• Accounting treatment differs in the timing and location of recognizing hedging gains and losses
• Cash flow hedges defer effective portion in other comprehensive income, fair value hedges recognize all changes in profit or loss
• Hedged items in cash flow hedges often relate to forecasted transactions, while fair value hedges typically involve recognized assets or liabilities

Examples and journal entries

Foreign currency cash flow hedge

• U.S. company hedges forecasted sale denominated in euros using a forward contract
• Journal entry to record change in fair value of forward contract:

  Dr. Other Comprehensive Income   XXX

  Cr. Forward Contract (Asset/Liability)   XXX

• Reclassification entry when sale occurs:

  Dr. Cash Flow Hedge Reserve   XXX

  Cr. Sales Revenue   XXX

Interest rate cash flow hedge

• Company hedges variable interest payments on debt using an interest rate swap
• Journal entry to record interest expense and swap settlement:

  Dr. Interest Expense   XXX

  Cr. Cash   XXX

  Dr. Cash Flow Hedge Reserve   XXX

  Cr. Interest Expense   XXX

Commodity price cash flow hedge

• Manufacturer hedges future purchases of raw materials using commodity futures
• Journal entry to record change in fair value of futures contract:

  Dr. Other Comprehensive Income   XXX

  Cr. Futures Contract (Asset/Liability)   XXX

• Reclassification entry when inventory is purchased:

  Dr. Cash Flow Hedge Reserve   XXX

  Cr. Inventory   XXX

Impact on financial statements

Effects on comprehensive income

• Effective portion of the hedge recorded in other comprehensive income, reducing volatility in reported earnings
• Reclassification of gains or losses from other comprehensive income to profit or loss when hedged transaction affects earnings
• Presentation of hedging results separately within the statement of comprehensive income

Effects on equity

• Accumulated other comprehensive income includes deferred gains or losses on cash flow hedges
• Changes in the cash flow hedge reserve reported as a separate component of equity
• Impact on total equity depends on the effectiveness of the hedge and timing of the hedged transaction

Challenges and limitations

• Complexity in measuring hedge effectiveness and calculating ineffectiveness
• Difficulty in forecasting timing and amount of hedged cash flows for long-term hedges
• Potential for hedge accounting to be discontinued if qualifying criteria are no longer met
• Operational challenges in maintaining proper documentation and performing ongoing assessments

Regulatory considerations

IFRS vs US GAAP

• IFRS 9 and ASC 815 provide guidance on hedge accounting under their respective frameworks
• Differences in eligible hedged items, effectiveness testing requirements, and presentation of hedging results
• IFRS allows more flexibility in hedging strategies and effectiveness assessment methods
• US GAAP has more prescriptive rules for qualifying criteria and effectiveness testing