CASH FLOW
HEDGE
A fair value hedge primarily relates to the hedging of fixed-
interest balance sheet items, while cash flow hedges mean
hedges against the risk associated with future interest
payments from a variable-interest balance sheet transaction.
For mitigation of risk associated with variable interest
payments, the appropriate type of accounting is the cash flow
hedge
Cash
Flow
Hedge
Derivatives represent rights and obligations
must be reported as assets and liabilities at their fair value.
A gain or loss on a derivative that is not designated as a
hedge must be recognized in earnings.
If a derivative is designated as a hedge, then the accounting
for it varies, depending on whether it is an *effective
hedge or an *ineffective hedge.
*A hedge is considered effective if the changes in the cash flow of the hedged item and the hedging
instrument offset each other. Conversely, if the cash flow of the two items do not offset each other, the hedge is
considered ineffective.
Cash flow hedges
A cash flow hedge is used to manage variability in cash
flows of a future transaction and can be related to either a
financial or nonfinancial item.
This exposure could be the result of a recognized asset or
liability (e.g., variable-rate debt) or a forecasted
transaction (e.g., planned purchase of a commodity or
forecasted interest payment).
A cash flow hedge involves the use of a hedging
instrument (a derivative) that essentially locks in the
amount of a future cash inflow or outflow that would
otherwise be impacted by movements in the market.
The primary purpose of cash flow hedge accounting is to link
the income statement recognition of a hedging instrument and a
hedged transaction whose changes in cash flows are expected
to offset each other.
For a reporting entity to achieve this offsetting or “matching” of
cash flows, the change in the fair value of the derivative (or in
some cases, a portion of the change in fair value) designated as
a cash flow hedge is initially reported as a component of other
comprehensive income (OCI) and later reclassified into earnings
in the same period(s) when the hedged transaction affects
earnings (e.g. when a forecasted sale occurs). This
reclassification is reported in the same income statement line
item in which the hedged transaction is reported.
Example DH 5-1 illustrates a cash flow hedge used to
offset the volatility in future interest payments.
EXAMPLE DH 5-1
Cash flow hedge of floating interest payments
DH Corp issues debt with a term of 10 years. The debt
requires DH Corp to make monthly interest payments
based on LIBOR. DH Corp manages the uncertainty
associated with changes in LIBOR with a swap in which
it pays a fixed rate and receives the LIBOR rate.
The LIBOR payments DH Corp receives from the swap
counterparty (C) will offset the payments it needs to make on its
debt (A), and as a result, the net of payments and receipts on the
swap and the debt will be fixed (B).
.
How should DH Corp recognize the swap?
Analysis
If the swap qualifies as a cash flow hedge of the variability
in the contractually specified interest rate, DH Corp would
reflect the change in fair value of the swap in OCI and
reclassify a portion to earnings when each applicable
interest payment is made
The net result would reflect interest expense after consideration
of the hedging transaction. In other words, “net” interest
expense would reflect the fixed rate.
If the hedging relationship does not qualify for hedge
accounting, DH Corp would reflect changes in the fair value of
the swap in earnings each reporting period.
This amount would include the changes in fair value of the
swap stemming from estimated cash flows over the full 10-year
term.
[Link]
sh_flow_hedges_US.html