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What is a cash flow hedge?
Cash flow hedge is an investment method used to control and mitigate any sudden change in either cash inflow or cash outflow of an asset/liability/forecasted transaction. Sudden change is due to various reasons like change in interest rate, change in prices, fluctuations in foreign exchange rates. Transaction with another party on a future date is called a forecasted transaction.
Accounting for cash flow hedge
- Hedging item (effective portion of loss or gain recognized in other comprehensive income and ineffective portion of loss or gain is recognized in earnings).
- Hedged item (effective portion of loss or gain is recognized in other comprehensive income initially, reclassify these loss or gain in earnings when forecasted).
Discontinuation of cash flow hedge accounting
- Account for accumulated amount in case of discontinuation of hedge accounting.
- Amount remains in cash flow hedge reserve and the same is accounted for (in case cash flow is still expected from hedged future cash flow).
- Amount is reclassified from cash flow hedge reserve to profit or loss as reclassification adjustment (in case of cash flow is no longer accepted).
Advantages
- Minimise the risk of hedged items.
- Accounting treatment for cash flow and hedging instruments.
Disadvantages
- If the hedging and hedging instrument is not offset then, hedge is ineffective.
- Profit and loss in earnings is recognised in cash; hedge transaction is related to forecasted transaction.
Cash flow hedge should terminate, when
- Hedging arrangement is not effective.
- Hedging instrument expires/terminated.
- When an organisation withdraws the hedging designation.
Understanding cash flow hedge by example
Let’s say a buyer wants to buy 150 tonnes of steel at $1500 per tonne as per current market from a company S.
Now the buyer spent $225000 as per current market rate. But the market conditions are saying that steel prices may go up to $2000 per tonne. As per the future market rate $300000 and this is $75000 more.
To avoid additional expenses, buyers may forward contracts with company S. Even though there is a raise in future, net payment will be the same.
Conclusion
It is the exposure to variability in cash flow of specific forecasted transactions which is attributed to particular risk or in other word this method deflect sudden changes that occurs in either cash outflow or inflow.
This method is more useful for manufacturing or services firms who buy their material regularly. Cash flow hedge is more important where there is a sudden change that impacts cash inflows or cash outflows.
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