Cash flow hedge
A hedge of the variability of future cash flows — such as a highly probable foreign currency receipt — whose effective gains and losses are held in equity until the hedged cash flow hits profit and loss.
In plain language
Some risks are about what an asset is worth today (fair value). Others are about how much cash you will actually get or pay later. An exporter expecting dollars next quarter faces the second kind: the rupee amount of that future receipt is uncertain.
A hedge of that uncertainty is a cash flow hedge. The workbook defines the model as applying when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency, and describes it as seeking to offset certain risks of the variability of cash flows in respect of an existing asset or liability or a highly probable forecast transaction that may be reflected in the statement of profit and loss in a future period.
The accounting twist is where the hedge's gains and losses go while waiting. Under a cash flow hedge, the hedging instrument is measured at fair value, but the effective gain or loss is recognised in equity — for example in a cash flow hedge reserve (Ind AS 109 calls this Other Comprehensive Income). The ineffective portion goes to profit and loss.
How it works
Why equity? The workbook explains the aim: to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein. The forecast transaction has not happened yet, so its gain or loss is not in profit and loss; parking the hedge result in equity keeps the two together.
Extra condition. Of the Guidance Note's requirements for hedge accounting, one applies specifically here: the entity must demonstrate that the hedged cash flows are highly probable of occurring.
Contrast with the other two types:
| Cash flow hedge | Fair value hedge | Net investment hedge | |
|---|---|---|---|
| Risk hedged | Variability of future cash flows | Change in fair value of a recognised item or firm commitment | FX on net assets of a foreign operation |
| Effective result | Equity / OCI | Profit and loss | Equity |
| Ineffective result | P&L | P&L | P&L |
Presentation. The Guidance Note does not permit netting of derivative assets and liabilities, except where basis adjustment is applied under cash flow hedges. Derivatives hedging forecast transactions are classified as current or non-current based on the derivative's settlement or maturity date.
A worked example
Illustrative. The company, amounts and rates are hypothetical; the treatment follows the workbook.
Deccan Pharma expects to import raw material worth USD 2,00,000 in five months — highly probable, not yet contracted. On 1 February it buys 200 lots of USDINR futures at 83.00 and designates them as a cash flow hedge.
At the 31 March year-end, the futures are at 83.60:
Fair value gain = (83.60 − 83.00) × 200 × 1,000 = Rs 1,20,000
The expected rupee cost of the import has risen by (83.60 − 83.00) × 2,00,000 = Rs 1,20,000 too — a fully effective hedge.
| Year ending 31 March | Profit and loss | Cash flow hedge reserve (equity) |
|---|---|---|
| Hedge gain | nil | +Rs 1,20,000 |
In July, the import happens at a higher rupee cost. The Rs 1,20,000 is released from equity and matched against it, so profit reflects roughly the 83.00 rate Deccan locked in.
If ineffective in part. Had the expected import cost risen by only Rs 1,10,000, then Rs 1,10,000 goes to equity and Rs 10,000 to profit and loss at once.
Why NISM asks about it
Chapter 9, section 9.1.1, defines the cash flow hedge accounting model among the three types recognised by the ICAI Guidance Note and explains why its effective gains and losses go to equity; section 9.1.3 restates it under Ind AS 109 with OCI. The Chapter 9 sample question lists the fair value and cash flow hedge accounting models as options.
Common exam traps
- Cash flow hedge: effective portion to equity (OCI); fair value hedge: to profit and loss. This is the single most examined distinction.
- The ineffective portion always goes to profit and loss.
- The hedged cash flow must be highly probable — a vague possibility does not qualify.
- A firm commitment in a foreign currency can be hedged under the cash flow model, per the workbook.
- It is still fair value accounting for the derivative on the balance sheet; only the destination of the gain or loss differs.
Check yourself
1.Under a cash flow hedge, where is the effective portion of the gain or loss on the hedging instrument recognised, and why?
- a)In the statement of profit and loss, matching the hedged item
- b)In equity, such as cash flow hedge reserves, to avoid volatility in profit and loss in a period when the hedged item's gains and losses are not recognised there
- c)Not recognised at all until settlement
- d)Split equally between equity and profit and loss
Show the answer
Answer: (b) In equity, such as cash flow hedge reserves, to avoid volatility in profit and loss in a period when the hedged item's gains and losses are not recognised there
Under the cash flow hedge, the hedging instrument is measured at fair value, but any gain or loss that is determined to be an effective hedge is recognized in equity, for e.g. cash flow hedge reserves.
And the reason is given explicitly: this is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein.
The mismatch it solves: a highly probable future receivable is not yet in the accounts, so booking the hedge's gain alone would show a profit with no offsetting loss.
Option A describes the fair value hedge instead. A fair value hedge seeks to offset the risk of changes in the fair value of an existing asset or liability or an unrecognised firm commitment that may give rise to a gain or loss being recognized in the statement of profit and loss — there both sides are already in P&L, so they offset naturally.
Option C is wrong: the hedging instrument is measured at fair value from the outset, and all derivative contracts should be recognized on the balance sheet and measured at fair value.
Option D confuses effective with ineffective. The split is by effectiveness, not proportion: the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss immediately.
Ind AS 109 says the same in newer language: for a Cash Flow Hedge, effective portions of gains/losses go to Other Comprehensive Income (OCI), ineffective portions to profit or loss.
When this model applies: the cash flow hedge accounting model is applied when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency.
And one documentation requirement is specific to it: the entity must demonstrate in cases of hedging a future cash flow that the cash flows are highly probable of occurring.
2.The ICAI Guidance Note on Accounting for Derivatives Contract recognises which types of hedging for hedge accounting?
- a)All of the above
- b)The fair value hedge accounting model
- c)The cash flow hedge accounting model
- d)The hedge of a net investment in a foreign operation
Show the answer
Answer: (a) All of the above
This Guidance Note recognises the following three types of hedging:
The fair value hedge accounting model is applied when hedging the risk of a fair value change of assets and liabilities already recognized in the balance sheet, or a firm commitment that is not yet recognized.
The cash flow hedge accounting model is applied when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency.
The hedge of a net investment in a foreign operation.
Ind AS 109 recognises the same three: Fair Value Hedge · Cash Flow Hedge · Net Investment Hedge.
Where the effective gains go differs by model. For a fair value hedge, to the statement of profit and loss. For a cash flow hedge, any gain or loss that is determined to be an effective hedge is recognized in equity, for e.g. cash flow hedge reserves — because this is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein. For a net investment hedge, directly in equity to the extent that the hedge is considered to be effective.
And in every case: the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss immediately.
Designation is a choice: an entity is permitted but not required to designate a derivatives contract as a hedging instrument.
If it does not: it will be measured at fair value and changes in fair value will be recognized immediately in the statement of profit and loss.
3.How should a derivative held purely for trading be classified in the balance sheet?
- a)As current assets and liabilities, regardless of the contract's tenor
- b)Based on the settlement or maturity date of the contract
- c)Based on the classification of the hedged item
- d)Netted against other derivative positions
Show the answer
Answer: (a) As current assets and liabilities, regardless of the contract's tenor
Derivatives that are intended for trading or speculative purposes should be reflected as current assets and liabilities.
No tenor test at all — purpose alone decides.
The other three rules do use dates or linkage:
Derivatives that are hedges of recognized assets or liabilities should be classified as current or non-current based on the classification of the hedged item. (Option C's rule, for a different case.)
Derivatives that are hedges of forecasted transactions and firm commitments should be classified as current or non-current based on the settlement date/maturity dates of the derivative contracts. (Option B's rule, again for a different case.)
Derivatives that have periodic or multiple settlements such as interest rate swaps should not be bifurcated into current and non-current elements. Their classification should be based on when a predominant portion of their cash flows are due for settlement as per their contractual terms.
Option D is expressly prohibited: this Guidance Note does not permit any netting of assets and liabilities except where basis adjustment is applied under cash flow hedges and hence all the amounts presented in the financial statements should be gross amounts.
One narrow exception exists, and only in the income statement: amounts recognized in the statement of profit and loss for derivatives not designated as hedges may be presented on a net basis.
Balance sheet gross; P&L may be net for undesignated derivatives.
Underlying all of it: all derivative contracts should be recognized on the balance sheet and measured at fair value since a derivative contract represents a contractual right or an obligation — with fair value meaning the 'exit price', incorporating the effect of credit risk and factoring in the extent and availability of collateral.
Where this is taught
- Series IV · Chapter 9: Accounting and Taxation of IRDintroduced here
- Series XVI · Chapter 9: Accounting and Taxationintroduced here
- Series I · Chapter 9: Accounting and Taxation of ETCDintroduced here
Related terms
- Other Comprehensive IncomeGains and losses that Ind AS requires or permits to bypass the profit and loss account — they change shareholders' equity and never touch earnings per share.
- Currency futuresA standardised exchange-traded contract to buy or sell one currency against another on a future date at a price fixed today; in India, cash-settled in rupees, USD 1,000 a lot for USDINR.
- Fair value hedgeA hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, attributable to a particular risk that could affect profit and loss.
- Hedge accountingAn optional accounting treatment that matches the timing of gains and losses on a designated hedging derivative with the item it hedges, instead of taking the derivative's fair value changes straight to profit and loss.
- Hedge effectivenessThe degree to which changes in the fair value or cash flows of a hedged item, attributable to the hedged risk, are offset by changes in the fair value or cash flows of the hedging instrument.
- Net investment hedgeA hedge of the foreign exchange risk on a net investment in a non-integral foreign operation, with the effective gains and losses on the hedging instrument recognised directly in equity.
- Hedged itemThe asset, liability, cash flow or firm commitment that carries the risk being protected — the exposure a hedging instrument is designated against, and without which there is no hedge at all.
- ICAI Guidance NoteICAI's revised 2021 note on accounting for derivative contracts, effective for accounting periods beginning on or after 1 April 2021, requiring every derivative on the balance sheet at fair value.
- Inventory hedge accounting adjustmentA separate basis adjustment carrying the fair value change of hedged inventory, kept apart from the AS 2 valuation, and released to cost of goods sold when the inventory is finally sold.