What is a Cash Flow Hedge?

A cash flow hedge uses a hedging instrument to lock down specific cash inflows or outflows that would otherwise have been subject to the variability in market movements. It is possible to only hedge the risks associated with a portion of an asset, liability, or forecasted transaction, as long as the effectiveness of the related hedge can be measured.

Examples of Cash Flow Hedges

Here are several examples of how cash flow hedges can be used:

Foreign currency cash flow hedge. A U.S.-based company exports goods to Europe and expects to receive €500,000 in six months. However, the company is concerned that the Euro might depreciate against the Dollar, reducing its future cash inflows. The company enters into a foreign exchange forward contract to sell €500,000 for USD at the current exchange rate. If the Euro depreciates in six months, the forward contract allows the company to exchange the Euros at the predetermined rate, offsetting the loss it would incur from the unfavorable currency fluctuation. This cash flow hedge stabilizes the company’s expected cash inflows from the Euro, allowing more predictable revenue in USD, even if the Euro weakens
Commodity price cash flow hedge. An airline company expects to purchase 1 million gallons of jet fuel in six months. Concerned about potential fuel price increases, the airline wants to lock in current prices to avoid higher cash outflows in the future. The airline enters into a futures contract to buy 1 million gallons of jet fuel at the current price. If fuel prices rise, the hedge gains in value, offsetting the increase in cash outflows for fuel purchases. If fuel prices decrease, the hedge may lose value, but the airline still benefits from lower fuel costs. This cash flow hedge allows the airline to stabilize its fuel costs, protecting against price volatility and providing more predictable cash flow for budgeting.

Accounting for a Cash Flow Hedge

The accounting for a cash flow hedge for the hedging item is to recognize the effective portion of any gain or loss in other comprehensive income, and recognize the ineffective portion of any gain or loss in earnings. The accounting for a cash flow hedge for the hedged item is to initially recognize the effective portion of any gain or loss in other comprehensive income. Reclassify these gains or losses into earnings when the forecasted transaction affects earnings.

A key issue with cash flow hedges is when to recognize gains or losses in earnings when the hedging transaction relates to a forecasted transaction. These gains or losses should be reclassified from other comprehensive income to earnings when the hedged transaction affects earnings.

Cash flow hedge accounting should be terminated at once if any of the following situations arises: