Updated July 17, 2023
Definition of Cash Flow Hedge
A cash flow hedge is a hedging process in which the risk associated with the future probable cash flows is managed. The risk associated with recognized asset and liabilities can be hedged in this.
It is done mainly in the case of foreign currency transactions because the risk of the dollar price going up or coming down will affect the profit/loss of the investor. The entity also makes an effort to enter into the cash flow hedging transaction to safeguard them from any expected loss in the future.
Explanation
This is one of the types of hedge accounting. If we want to manage the risk of our assets, liability, debtors, creditors, stocks, shares, etc., we have to enter into a hedging contract. In this case, all my components will be saved in case of any foreign currency fluctuation. This is also a process to safeguard the interest of the investors from price fluctuation. Therefore, the investors will be encouraged to invest in foreign currency or enter into such contracts. A separate Cash Flow hedge reserve account is created to adjust all the hedging transactions. It has also been seen that the fair value hedging method is more preferred than the cash flow hedging method. Thus if the amount is adjusted in the fair value hedged account, it becomes the entity’s responsibility to remove it from the cash flow hedge account. Otherwise, double entry will be there.
How Does a Cash Flow Hedge Work?
An entity makes a plan to hedge its cash flow from foreign fluctuations, which might hamper its cash flows. The entity makes a cash flow reserve account, and all the hedging is done through that account only. The risk is mitigated, and the forecasted probable cash flows are managed properly.
Example
- Suppose I plan a trip to London today, which will be after 3 months. I came to know that the prevailing pound rate is INR 99.54, and therefore I estimated all my expenses, and it came to INR 5 00,000. i.e., 5024 Pound approx.
So, now I have budgeted for INR 5 00,000. But I am now afraid of the pound rate increasing or the INR rate decreasing. Therefore I entered into a contract of cash flow hedge today. So that in the future, i.e., after 3 months, I can go on my trip.
- A businessman is afraid of a market scenario, and he wants to enter a hedging contract so that he can be free at the time of a price rise or price falls. Therefore he has to enter into a cash flow hedge contract today so that his cash flows are hedged.
How to Account for a Cash Flow Hedge?
- A separate cash flow hedge reserve account is created.
- The equity component of the entire hedged transaction is adjusted to the cumulative profit or loss and if there is any sort of changes in the fair value of the hedged transactions.
- A portion of profit or loss from the entire hedged transaction is then recognized as Comprehensive Income.
- Other than that, any remaining profit or loss component is adjusted with the profit and loss account for that period.
- If in any hedged transaction, there is a firm commitment and the fair value hedged account treatment has already been applied, then in that case, the entity is responsible for removing the same amount from the cash flow hedge reserve account to avoid the double treatment.
- Other than this, the amount is recognized from the Cash flow hedge reserve account to the Profit and Loss Account.
- In case of loss, if the loss is not recovered in the hedged transaction, then it is prudent to reclassify the amount into a profit loss account as a reclassification adjustment.
Advantages
Some of the advantages are given below::
- It can help the entity or any individual from the cash flow fluctuation which can happen in the future.
- The risk is mitigated to a greater extent.
- This can help in proper budgetary planning.
- It also helps investors to maintain their financial investments accordingly.
Disadvantages
Some of the disadvantages are given below::
- The double effect of this reserve and the fair value hedging method can create confusion if the entity does not remove the adjustment of the cash flow hedge reserve account on time.
- The entire hedging depends upon when the gains or losses are recognized; therefore, it can be problematic because the cash flow hedging is done for the future.
- The investors may have to bear the consequences of the loss because, despite having a hedged contract, the prices may vary, so the investor will suffer the losses.
- Sometimes it has been seen that the losses are recovered, but in most cases, the losses are not recovered; hence, they are adjusted in the Profit/Loss account for the entire period in one period.
- The entity should hire experts to make all the necessary accounting adjustments because some adjustments are difficult for the regular accountant to pass.
- These accounts entries are complicated if the equity and debt components are mixed. Therefore it is advised to bifurcate the components first to avoid confusion.
Conclusion
Cash flow hedging can help investors to mitigate the risk associated with the expected probable forecast. The investors can manage the cash flows very well by entering into the cash flow hedge. A separate cash flow hedge reserve account is created, and all the adjustments are passed through this account. It is a smart investment method most investors use nowadays. These investment methods easily manage all sorts of foreign fluctuations. While accounting for the cash flow hedge, the accountant should know the entries well to avoid accounting mistakes.
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