Cash Flow Hedge

Cash flow hedge is an arrangement to manage risk of changes in cash flows associated with a recognized asset or liability or a probable forecast transaction. It is one of the three hedging arrangements recognized by accounting standards, the others being fair value hedge and net investment hedge.

Most of assets and liabilities have associated periodic cash flows, for example an investment in foreign bonds may have cash inflows in the form of interest receipts denominated in foreign currency. Similarly, a floating-rate loan may have cash outflows in the form of interest payments which vary according to some benchmark interest rate, say LIBOR. Since cash flows for both the instruments are uncertain because they depend on external variables i.e. foreign exchange rate and the interest rate prevalent in the market, companies may elect to remove this risk of variability of cash flows by entering into hedging transactions. For example, the risk of variability of cash inflows from the foreign-currency bond can be managed by entering into a currency swap involving payment of the foreign currency and receipt of domestic currency. Similarly, the risk in cash flows of floating-rate bond may be mitigated by entering into an interest rate swap involving receipts on a floating rate and payments on a fixed rate. In hedging arrangement, the instrument used to mitigate any particular risk is called hedging instrument and the asset or liability whose risk is being mitigated is called hedged instrument.

Hedge accounting is optional, which means a company may elect to not adopt the specific accounting rules and instead account for hedged instrument and the hedging instrument separately. If hedge accounting is not adopted, the hedging instrument is recognized at fair value through profit and loss. However, if a company choses to account for the hedge as a whole, it has to meet certain requirements: i.e. at the start of the hedge, the hedging arrangement should be documented, it should be highly effective and stay effective over the term of the hedge and the hedging instrument, and the hedged instrument should be identified.

If a hedge meets the recognition criteria and it is identified to be a cash flow hedge, the changes in value of hedging instrument should be broken down into two components: the first component exactly matching the change in value of the hedged instrument, should be recorded in other comprehensive income; and any excess change in value should be recognized in profit or loss. The amount recognized in other comprehensive income is reclassified to profit or loss at the time of settlement or termination of hedge relationship.

Example & Journal Entries

On 1 December 2015, Platform, Inc. entered into a 1-year contract with a multinational financial services giant to provide air transport to its executives. Under the contract, Platform will be paid EUR 1,000 per kilometer for 12,000 minimum guaranteed kilometers per annum. Payment shall be made at the end of each quarter. Platform obtained an aircraft on a wet lease (i.e. a lease of aircraft together with crew and maintenance, etc.). Since almost all of Platform’s costs are denominated in USD, it enters into a 3-month forward contract to sell EUR 3,000,000 forward at USD1.5/EUR.

At its financial year end, i.e. 31 December 2015, USD had appreciated to 1.45/EUR and the company had operated a total of 1,000 kilometers over the one-month period.

By end of February 2016, i.e. at the end of first quarter, the company had provided services for 3,100 kilometers. Exchange rate at the quarter end was USD1.44/EUR.

Solution

This is a cash flow hedge because Platform is looking to hedge the risk of variability of its cash flows i.e. revenue. The hedging instrument is the forward contract while the hedged instrument is the cash flows from services contract.

Based on 1,000 kilometers operated in the first month i.e. December 2015, Platform expects to operates 3,000 kilometers in the first quarter and earn EUR 3,000,000 (3,000 * EU1,000). USD value of the expected kilometers @ the year-end exchange rate of USD1.45/EUR amounts to $4,350,000 against initial forecast of $4,500,000 (EUR 3,000,00*1.5). The adverse movement in the cash flows due to currency fluctuation amounts to USD $150,000 ($4,500,000 - $4,350,000). This loss in future cash flows from foreign exchange movement is offset by the gain on hedging instrument. The hedging instrument entitles Platform to convert EUR 3,000,000 at USD1.5/EUR even though EUR depreciated over the one month. The gain on forward contract is $150,000 (EUR3,000,000 * (1.5 – 1.45)). The hedging instrument exactly offsets the movement of the cash flows expectation and is totally effective, hence, it should be recognized in other comprehensive income.

Platform shall make the following journal entry as at 31 December 2015:

Derivative position (asset)$150,000
Other comprehensive income$150,000

At the end of the first quarter, since the actual kilometers for the quarter were 3,100, the cash flows exposure which required hedging increased to EUR 3,100,000 (=3,100*1,000). The value of forward contract at the end of February would be $180,000 (EUR 3,000,000 * (1.5 – 1.44)). This represents a gain of $30,000 ($180,000 minus $150,000) over the last reporting period.

Actual adverse foreign exchange movement in the revenue transaction was $186,000 (EUR 3,100,000 *(1.5 – 1.44)) which is higher than the favorable movement of $180,000 in the associated hedging instrument. This means the hedging arrangement has been ineffective to the extent of $6,000 (=$186,000 - $180,000).

Accounting standards require recognition of the lower of cumulative gain or loss in the hedging instrument or in the fair value of the hedged item separately in the other comprehensive income as reserve. The $30,000 favorable movement in the hedging instrument shall be recognized as follows:

Derivative$30,000
Other comprehensive income$30,000

At settlement, the whole arrangement is wrapped up as follows:

Other comprehensive income$180,000
Cash (3,000,000 * 1.5 + 100,000 * 1.44)$4,640,000
Revenue$4,644,000
Derivative (asset)$180,000

Please note that the $6,000 ineffective part of the hedge is reflected in profit and loss through a reduction in revenue, i.e. revenue is calculated by applying the 1.5USD/EUR hedged relationship to only first EUR 3,000,000 chunk and the additional EUR 100,000 are exchanged at USD 1.44/EUR i.e. the prevailing exchange rate.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork