Cash Flow Hedges
In short – A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.
Without hedge accounting, there is a mismatch in the timing of when the gains or losses arising from the change in cash flows of the hedging instrument and hedged item are reflected in profit or loss. The change in the cash flows of the hedging instrument is recognized prior to that for the hedged item. With hedge accounting, the gains or losses arising from the change in cash flows of the hedging instrument are accumulated and held in a separate component of equity until the hedged item is recognized. Therefore, a cash flow hedge delays the recognition of the change in cash flows related to the hedging instrument.
Example of a Cash Flow Hedge |
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ABC Credit Union provides member loans bearing interest at variable rates. The variable-rate member loans are Assessment: In effect, the Credit Union has converted the variable rate loan assets into fixed rate loan assets and hedged their exposure to changes in market interest rates. If hedge accounting is not applied, a decrease in market interest rates would result in a gain on the swap which is recognized in profit or loss because the swap is a derivative. Since the member loans are measured at amortized cost there would be no change in their stated value. Accordingly, an earnings mismatch results. It is this mismatch that cash flow hedge accounting aims to address by recognizing the effective portion of the change in the swap in a separate cash flow hedge reserve in equity until the actual cash flows of the loan assets affects profit or loss. |
When cash flow hedge accounting is applied, the effective portion of the gains or losses on the hedging instrument is recognized in Other comprehensive income (‘OCI’). These gains or losses are accumulated in a separate component of equity known as the cash flow hedge reserve. The ineffective portion of the gains or losses on the hedging instrument is recognized in profit or loss.
At each reporting date, the cash flow hedge reserve is adjusted to the lower of the following (in absolute amounts):
- The cumulative gain or loss on the hedging instrument from inception of the hedge.
- The cumulative change in fair value (i.e., present value) of the hedged item from inception of the hedge.
Any adjustment required to balance the cash flow reserve as calculated above is recognized in profit or loss. This adjustment reflects the ineffectiveness of the cash flow hedge.
Case – Accounting for a Cash Flow Hedge (Setting up the Cash flow hedge reserve) |
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Company A entered into a $5 million fixed-for-variable swap to hedge its $5 million variable rate borrowings. During the reporting period, an increase in the benchmark interest rate affected both the hedging instrument and the hedged item. At the reporting date, the change in the fair value of the hedged item (i.e., the variable rate debt) was a $250,000 Assessment: The cash flow hedge reserve, presented as a separate component of equity, is adjusted to $250,000, this being the lesser of the gain on the hedging instrument ($300,000) and the change in fair value of the hedged item ($250,000). The effective portion of the gain on the hedging instrument ($250,000) is recognized in OCI and the remaining $50,000 (i.e., the ineffective portion of the gain on the hedging instrument) is recognized in profit or loss as per the following journal entry: To recognize the change in the cash flows of the hedging instrument.
Conversely, if the change in fair value of the hedged item was a $300,000 loss and the gain on the hedging instrument was $250,000, the entirety of the $250,000 gain on the hedging instrument would be recorded to OCI as the change in value of the hedging instrument is less than the change in value of the hedged item. No amount would be recorded in profit or loss because the cash flow hedge reserve is adjusted only for the lower of the changes in the hedging instrument and the hedged item, which means that only hedge ineffectiveness where the change in fair value of the hedging instrument exceeds the change in value of the hedged item requires hedge ineffectiveness to be reported in profit or loss. |
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Hedging relationship Component |
Accounting Treatment at End of Each Reporting Period |
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The effective portion of changes in value are recognized as a cash flow hedge reserve in equity. |
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No changes in value are recognized. |
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Hedge Ineffectiveness: Change in Hedging Instrument is Greater Than Change in Hedged Item |
Recognized immediately in profit or loss. |
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Hedge Ineffectiveness: Change in Hedged Item is Greater Than Change in Hedging Instrument |
Not recognized. This ineffectiveness will be recognized in profit or loss when the affected cash flows occur. |
Eventually, cash flows relating to the hedged item will be recognized in profit or loss, either directly or through the recognition of an asset or liability that will affect profit or loss in future periods. As can be seen in the following table, the subsequent accounting for the cash flow hedge reserve depends on the item being hedged.
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Subsequent Accounting for the Reserve |
Example |
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Hedged forecast transaction resulting in recognition of a non-financial asset or non-financial liability* *This accounting treatment also applies where a hedged forecast transaction for a non-financial asset or liability becomes a firm commitment for which fair value hedge accounting is applied (see IFRS 9.6.5.11(d)(i)). |
Remove and include in the initial cost or carrying amount of the asset and liability. Consequently, there is no impact on profit or loss until the financial asset or liability is amortized, sold or settled. |
An entity hedged a highly probable forecast transaction for a purchase of steel for use in its manufacturing process. Once the steel was purchased and recognized as inventory, the cash flow hedge reserve was transferred out of equity and included in the cost of that inventory. In effect, cost of sales (profit or loss) is affected as the sale of the inventory takes place. |
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All other hedged items |
Reclassified to profit or loss in the same period(s) during which the hedged item’s cash flows affect profit or loss. This is referred to as a “reclassification adjustment” under IFRS. |
The cash flow hedge reserve, arising from the change in the value of an interest rate swap used to hedge coupon payments of a bond that are tied to an interest rate benchmark, is recognized in profit or loss as those coupon payments are made. |
Example of the Accounting for a Cash Flow Hedge of a Forecast Transaction Resulting in the Recognition of a Non-financial Asset |
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On September 30, 20×1, Company A entered into a futures contracts to purchase 20,000 tons of iron ore on January 15, 20×2 for $80/ton. Company A designated this contract as a hedging instrument to hedge its exposure to price risk in relation to its highly probable forecast purchase of 20,000 tons of iron ore on January 15, 20×2. At December 31, 20×1, a futures contract for the January 15, 20×2 delivery of iron ore is priced at $85/ton, resulting in a gain of $100,000 (20,000 tons x [$85 – $80]). Because the critical terms of the arrangement match (i.e., the underlying, delivery date and nominal amounts are all identical), there is no hedge ineffectiveness. Assessment: The following journal entries should be recognized: December 31, 20×1 – To recognize changes in the fair value of the futures contract hedging instrument.
On January 15, 20×2, the Company settles the futures contract net when the spot price for iron ore is $84.50/ton, receiving cash of $90,000 (20,000 tons x [$84.50 – $80]) and recording an adjustment to the cash flow hedge reserve of $10,000 (20,000 tons x [$85 – $84.50]). January 15, 20×2 – To recognize the settlement of the futures contract hedging instrument.
On January 15, 20×2, Company A also completes its purchase of iron ore for $1.69 million (20,000 tons x $84.50). The Company also records the adjustment of the cash flow hedge reserve to the carrying value of the inventory on initial recognition. To recognize the inventory purchase together with the adjustment to the cash flow hedge reserve.
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Example of the Accounting for a Cash Flow Hedge When no Non-financial Asset or Liability is Recognized |
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Part I: On September 30, 20×1, Company A entered into a futures contract to sell 20,000 tonnes of canola on January 15, 20×2 at a price of $480/tonne. The Company designated this contract as a hedging instrument to hedge its exposure to commodity price risk in relation to the first 20,000 tonnes of its highly probable forecasted sales of canola between January 15, 20×2 and April 15, 20×2. At December 31, 20×1, a futures contract for the January 15, 20×2 delivery of canola is priced at $485/tonne, resulting in a loss of $100,000 (i.e., 20,000 tonnes x [$485/tonne – $480/tonne]). Using historical sales figures, estimated future prices and present value discounting, the Company determines that the gain on the hedged forecasted sales is $95,000, resulting in $5,000 of hedge ineffectiveness. Assessment: The following journal entries should be recognized: December 31, 20×1 – To recognize changes in the fair value of the futures contract hedging instrument.
Part II: On January 15, 20×2, the Company settles the futures contract net when the spot price for canola is $484.50/tonne, paying cash of $90,000 (20,000 tonnes x [$484.50 – $480.00]). The change in the price of the futures contract since year-end results in a gain of $10,000 (20,000 tonnes x [$485.00 – $484.50]). The Company calculated that $3,000 was hedge ineffectiveness as follows:
Assessment: An entry to OCI is made to reduce the cash flow reserve by $7,000 (i.e., $95,000 – $88,000). The total change in the price of the futures contract since year-end is $10,000. Therefore, $3,000 hedge ineffectiveness. January 15, 20×2 – To recognize the settlement of the futures contract hedging instrument.
This leaves $88,000 in the cash flow hedge reserve to be recognized in profit or loss as the hedge item’s cash flows affect profit or loss. Part III: Company A makes sales of canola as follows:
Assessment: At each date, Company A would record its sales net of the following adjustments for the cash flow hedge reserve:
* Note that only 2,800 tonnes are used in this calculation as this is the remaining amount of the original 20,000 tonnes of canola sales that were hedged. It is important for the purposes of calculating the cash flow hedge reserve adjustments to maintain records of the nominal amounts involved. |
Note! In the previous examples, depending on the date at which an adjustment was being recorded, the entity used either the forward price for delivery or the spot price for the purposes of calculating the adjustment. The price for forward delivery is used until calculating the final adjustment. It is important that the price used reflects the circumstances of the hedging relationship; calculations made for dates in the future should use information that reflects the market’s best estimate of prices that will exist at that date.
When the cash flow hedge reserve is in a loss (i.e., debit) position and an entity expects that all or a portion of that loss will not be recovered in the future, the amount which is not regarded as recoverable is immediately reclassified to profit or loss as a reclassification adjustment.
Example of Reclassification of Loss in OCI if not Recoverable in the Future |
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Company A has a loss in its cash flow hedge reserve account. This loss represents the cumulative loss from the hedge of the Company’s highly probable future purchase of inventory. This reserve will cause the amount of the inventory, when recognized, to exceed its net realizable value. Assessment: As the Company doesn’t anticipate recovering the full cumulative loss in the cash flow hedge reserve account, any excess should immediately be reclassified to profit or loss. |
Accounting for the Cash Flow Hedge Reserve on Discontinuation of the Hedging Relationship
When a cash flow hedge is discontinued, any accumulated cash flow hedge reserve is accounted for, as follows:
- If the hedged future cash flows are still expected to occur, the cash flow hedge reserve is maintained and only recognized in accordance with the accounting treatment previously discussed in this section (i.e., adjusted against the non-financial asset recognized, recognized into profit or loss when the cash flows of the original hedged item also impact profit or loss, etc.); or
- If the hedged future cash flows are no longer expected to occur, the cash flow hedge reserve is immediately reclassified to profit or loss as a reclassification adjustment.
A hedged future cash flow which is no longer considered highly probable to occur may still be expected to occur. However, it is no longer eligible to be designated as a hedged item in a hedging relationship.
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