CFM27170 - Accounting for corporate finance: hedging: cash flow hedge: example

This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.

Cash flow hedge: example

A UK trading company prepares accounts to 31 December. In October 2005, it receives an order from a Spanish customer, which it expects to fulfil early in January 2006. The customer will be invoiced in euros, and the company expects to receive €1.5 million in late January. It wishes to hedge the foreign exchange risk consequent on this forecast transaction, which is highly probable

The company enters into a forward currency contract on 15 October to sell €1.5 million on 15 January 2006, designating the forecast cash flow as the hedged item and the currency contract as the hedging instrument. Management prepares hedge documentation and assesses the hedge prospectively as almost 100% effective (the hedge is not perfectly effective because it is not certain that the transaction will occur on the same date that the currency contract matures).

At 31 December 2005, sterling has strengthened against the euro and the currency contract has a positive fair value of £50,000. The company assesses the hedge as being 102% effective, that is to say the fair value increase of £50,000 in the hedging instrument would be matched by a £49,000 decrease in the fair value of the forecast cash flow.

The effective portion of the hedge - the ‘matched’ £49,000 increase in fair value - is credited to other comprehensive income (OCI) as the lesser of the cumulative gain on the hedging instrument and the cumulative change in the fair value of the expected future cash-flows. This will typically be taken to a cash flow hedging reserve (CFHR). The ineffective portion - £1,000 - is credited to profit or loss. The accounting entries will be:

  • Dr currency contract - £50,000
  • Cr CFHR (OCI) - £49,000
  • Cr Income Statement £1,000

On 10 January 2006 - somewhat earlier than expected - the company receives the sales proceeds of €1.5 million. It terminates the currency contract, which has a fair value of £52,000 at that date, receiving £52,000 cash on termination. As at 10 January, the hedge is tested and found to be 100% effective.

The fair value of the hedge has increased by £2,000. However, the hedge is now fully effective, so that the cumulative amount in OCI needs to reflect the entire £52,000 increase in fair value. This means the accounting is:

  • Dr currency contract - £2,000
  • Cr CFHR (OCI) - £3,000
  • Dr Income Statement £1,000

On 10 January 2006 the forecast transaction takes place, so the cumulative fair value in equity must be ‘recycled’ to P&L. The accounting entries are:

  • Dr CFHR (OCI) - £52,000
  • Cr Income Statement - £52,000

The currency contract is net settled:

  • Dr cash - £52,000
  • Cr currency contract - £52,000

The net result is that £1,000 of the ‘cash profit’ on the currency contract is recognised in profit or loss in year ended 31 December 2005, and the remaining £51,000 in year ended 31 December 2006. At the same time, the company records the receipt of the €1.5 million from the customers (Dr cash, Cr sales). This is translated into sterling at the spot rate for 10 January.

Footnotes

  1. The above example is very simplistic, and designed to give an overview of the accounting entries only. The example does not take into account the movement in the fair value of the foreign currency forward which is related to the interest rate differential between the currencies in the forward contract, often described as ‘forward points’. It is common to exclude the fair value movements on the forward points from the hedge relationship in order to improve hedge efficiency. If the forward points movement is excluded from the hedge relationship, the gain or loss arising from this variable is recognised in profit or loss, usually as interest income or expense.
  2. The above example also assumes that the sale is recognised at the same point in time that cash is received. In reality, a debtor would be recognised for a period between revenue recognition and cash receipt. This debtor is a monetary item and will be re-translated at the closing rate of a reporting period with any gain or loss being recognised in the income statement. A company may de-designate the hedge relationship in order that the movement on the fair value of the derivative offsets currency movements of the receivable.