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A cash flow hedge is used to manage variability in cash flows of a future transaction and can be related to either a financial or nonfinancial item. This exposure could be the result of a recognized asset or liability (e.g., variable-rate debt) or a forecasted transaction (e.g., planned purchase of a commodity or forecasted interest payment). A cash flow hedge involves the use of a hedging instrument (a derivative) that essentially locks in the amount of a future cash inflow or outflow that would otherwise be impacted by movements in the market.
The primary purpose of cash flow hedge accounting is to link the income statement recognition of a hedging instrument and a hedged transaction whose changes in cash flows are expected to offset each other. For a reporting entity to achieve this offsetting or “matching” of cash flows, the change in the fair value of the derivative (or in some cases, a portion of the change in fair value) designated as a cash flow hedge is initially reported as a component of other comprehensive income (OCI) and later reclassified into earnings in the same period(s) when the hedged transaction affects earnings (e.g., when a forecasted sale occurs). This reclassification is reported in the same income statement line item in which the hedged transaction is reported.
Example DH 5-1 illustrates a cash flow hedge used to offset the volatility in future interest payments.
EXAMPLE DH 5-1
Cash flow hedge of floating interest payments
DH Corp issues debt with a term of 10 years. The debt requires DH Corp to make monthly interest payments based on LIBOR. DH Corp manages the uncertainty associated with changes in LIBOR with a swap in which it pays a fixed rate and receives the LIBOR rate.
The LIBOR payments DH Corp receives from the swap counterparty (C) will offset the payments it needs to make on its debt (A), and as a result, the net of payments and receipts on the swap and the debt will be fixed (B).
How should DH Corp recognize the swap?
Analysis
If the swap qualifies as a cash flow hedge of the variability in the contractually specified interest rate, DH Corp would reflect the change in fair value of the swap in OCI and reclassify a portion to earnings when each applicable interest payment is made. The net result would reflect interest expense after consideration of the hedging transaction. In other words, “net” interest expense would reflect the fixed rate.
If the hedging relationship does not qualify for hedge accounting, DH Corp would reflect changes in the fair value of the swap in earnings each reporting period. This amount would include the changes in fair value of the swap stemming from estimated cash flows over the full 10-year term.
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