Definition of Cash Flow Hedge
Cash flow hedge is a hedging process in which the risk associated with the future probable cash flows are managed. In a cash flow hedge, the risk associated with recognized asset and liability can be hedged. The cash flow hedge is done mainly in the case of foreign currency transactions because in that case the risk of dollar price going up or coming down will affect the profit/loss of the investor. The entity also makes effort to enter into the cash flow hedging transaction to safeguard them form any expected loss in the future.
Cash flow hedge is one of the types of hedge accounting. If we want to manage the risk of our asset, liability, debtors, creditors, stocks, shares, etc then 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 to enter into such contracts in the future. 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 given more preference than the cash flow hedging method and thus if the amount is adjusted in the fair value hedged account then it becomes the responsibility of the entity 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 their cash flow from the foreign fluctuations which might hamper their 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 of Cash Flow Hedge
- Suppose I plan for a trip to London today and the trip will be after 3 months and 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 future i.e. after 3 months I will be able to 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 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 then 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 to remove 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 in the hedged transaction the loss is not recovered then it is prudent to reclassify the amount into a profit loss account as a reclassification adjustment.
Some of the advantages are given below::
- A cash flow hedge 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.
- A cash flow hedge can help in the proper budgetary planning.
- A cash flow hedge also helps the investors to maintain their financial investment accordingly.
Some of the disadvantages are given below::
- The double effect of the cash flow hedge 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 the time when the gains or losses are being recognized therefore it can be a problem because the cash flow hedging is done for the future date.
- The investors may have to bear the consequences of the loss because in spite of having a hedged contract the prices may vary such that the investor will have to suffer the losses.
- Sometimes it has been seen that the losses are recovered but in most of the cases the losses are not recovered and 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 required because some adjustments are difficult for the regular accountant to pass.
- The cash flow hedge account entries are quite complicated if the equity and debt components are mixed. Therefore it is advised to bifurcate the components first to avoid any sort of confusion.
Cash flow hedging can help the investors to mitigate the risk associated with the expected probable forecast. The cash flows can be managed by the investors 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. A cash flow hedge is a smart investment method used by most of investors nowadays. All sort of foreign fluctuations is easily managed by the cash flow hedge investment methods. While doing the accounting of the cash flow hedge the accountant should have good knowledge about the entries so that the accounting mistakes can be avoided.
This is a guide to Cash Flow Hedge. Here we also discuss the definition and how does a cash flow hedge work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –
- Statement of Cash Flows
- Direct Method of Cash Flow Statement
- Mistakes in Discounted Cash Flow
- Cash Investment