What is a Cash flow hedge?
A cash flow hedge is a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a component thereof. It covers future interest payments on variable-rate debt. It also covers a highly probable forecast transaction. The requirement is that such cash flows should affect the profit and loss account.
A cash flow hedge is accounted for the following:
a) The separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following (in absolute amounts):
(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and
(ii) the cumulative change in fair value (present value) of the hedged item (ie, the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.
b) The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie, the portion that is offset by the change in the cash flow hedge reserve is recognised in other comprehensive income.
- Any remaining gain or loss on the hedging instrument or any gain or loss required to balance the change in the cash flow hedge reserve is hedge ineffectiveness that is recognised in profit or loss.
- The amount that has been accumulated in the cash flow hedge reserve is accounted for the following:
(i) If a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, or a hedged forecast transaction for a non-financial asset or a non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, the entity should remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or the liability. This is known as the basis adjustment entry and not a reclassification adjustment and hence it does not affect other comprehensive income.
(ii) For cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, in the periods that interest income or interest expense is recognised or when a forecast sale occurs).
(iii) If that amount is a loss and an entity expects that all or a portion of that loss will not be recovered in one or more future periods, the amount that is not expected to be recovered should be immediately reclassified into profit or loss as a reclassification adjustment.
When an entity discontinues hedge accounting for a cash flow hedge the amount that has been accumulated in the cash flow hedge reserve is accounted for as follows:
- If the hedged future cash flows are still expected to occur, that amount shall remain in the cash flow hedge reserve until the future cash flows occur.
- If the hedged future cash flows are no longer expected to occur, that amount shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment. A hedged future cash flow that is no longer highly probable to occur may still be expected to occur.
