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A cash flow hedge is a hedge of the exposure to variability in cash flows that
Loan asset 1,300
(To record the decrease in the fair value of the loan asset attributable to the hedged risk)
Cash Flow Hedge
• Is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction (A forecast transaction is an
uncommitted but anticipated future transaction).
• Could affect profit or loss.
Cash flow hedge accounting involves this accounting:
• Changes in the fair value of the hedging instrument attributable to the hedged risk are recognized in other comprehensive income to the extent that the hedge is
effective (rather than being recognized immediately in profit or loss).
• The accounting for the hedged item is not adjusted.
• If a hedge of a forecast transaction subsequently results in the recognition of a nonfinancial asset or nonfinancial liability (or becomes a firm commitment for
which fair value hedge accounting is applied), the entity has an accounting policy choice of whether to reclassify the associated gains and losses that were
recognized in other comprehensive income to profit or loss as a reclassification adjustment in the same period or periods during which the asset acquired or the
liability assumed affects profit or loss or to remove the associated gains and losses that were recognized in other comprehensive income and include them in the
initial cost or other carrying amount of the asset or liability (a so-called basis adjustment).
• If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or financial liability, the gains and losses recognized in other
comprehensive income remain there.
• When the hedged item affects profit or loss (e.g., through depreciation or amortization), any corresponding amount previously recognized in other
comprehensive income is reclassified to profit or loss (“recycled”).
To the extent the cash flow hedge is not fully effective, the ineffective portion of the change in fair value of the derivative is recognized immediately in profit or loss.
Example
Cash flow hedges include
• A hedge of the exposure to variable interest cash flows on a bond that pays floating interest payments
• A hedge of the cash flows from a forecast sale of an asset
• A hedge of the foreign currency exposure associated with a firm commitment to purchase or sell a nonfinancial item
Example
Entity A has the euro as its functional currency. It expects to purchase a machine for $10,000 on October 31, 20X6. Accordingly, it is exposed to the risk of
increases in the dollar rate. If the dollar rate increases before the purchase takes place, the entity will have to pay more euros to obtain the $10,000 that it will
have to pay for the machine. To offset the risk of increases in the dollar rate, the entity enters into a forward contract on April 30, 20X6, to purchase $10,000 in
six months for a fixed amount (€8,000). Entity A designates the forward contract as a hedging instrument in a cash flow hedge of its exposure to increases in
the dollar rate. At inception, the forward contract has a fair value of zero, so no journal entry is required.
On July 31 the dollar has appreciated, such that $10,000 for delivery on October 31, 20X6, costs €9,000 on the market. Therefore, the forward contract has
increased in fair value to €1,000 (i.e., the difference between the committed price of €8,000 and the current price of €9,000 (ignoring, for simplicity, the effect
of differences in interest rates between the two currencies). Entity A still expects to purchase the machine for $10,000, so it concludes that the hedge is 100%
effective. Because the hedge is fully effective, the entire change in the fair value of the hedging instrument is recognized in other comprehensive income. Entity
A makes this entry:
Forward asset 1,000
Other comprehensive income 1,000
On October 31, 20X6, the dollar rate has further increased, such that $10,000 cost €9,500 in the spot market. Therefore, the fair value of the forward contract
has increased to €1,500 (i.e., the difference between the committed price of €8,000 and the spot price of €9,500). It still expects to purchase the machine for
$10,000 and makes this journal entry:
The forward contract is settled and Entity A makes this entry:
Forward asset 500
Other comprehensive income 500