Cash flow hedge reserve

Cash flow hedge reserve – Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that by addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements will better reflect the company’s true economic performance.

Reducing the volatility in earnings results in a number of additional benefits:Cash flow hedge reserve

  • Enterprise value. Earnings volatility is negatively perceived by investors.
  • Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
  • Risk management. Statements reflect better and more accurately how FX-risk is managed.
  • Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.

But it can also go very wrong, see this article from Reuters: Dutch housing coop Vestia seeks damages from Deutsche Bank for derivatives

If the criteria for applying cash flow hedge accounting are met, the accounting entries during the duration of the hedge are as follows:

  • Change in fair value related to the change in spot rate of the hedging instrument (‘change in fair value attributable to spot’) is recognised in other comprehensive income (and in the cash flow hedge reserve in equity). This is the hedged risk. The standard does not prescribe how this should be calculated, but requires time value of money to be considered. As such Entity A calculates this change in fair value by identifying at inception of the hedge which part of the expected cash flows is related to the spot rate (‘the spot component’) expressed in functional currency. At each testing date this spot component is recalculated using the market spot rate at the time of calculation. The movement in the spot component is equal to the change in expected cash flows due to spot rate changes. This change is discounted to identify the part of the fair value change which is related to change in spot risk taking into account time value of money; and
  • Change in fair value of the forward points (‘the forward element’) is recognised in other comprehensive income (and in the cost of hedging reserve in equity) to the extent that it relates to the hedged item.
  • Any ineffectiveness in the relationship is recognised directly in P&L.
  • When the hedged forecast transaction subsequently results in the recognition of a non-financial asset (Raw material inventory), Entity A shall remove the accumulated hedging gain or loss at that date from the cash flow hedge/cost of hedging reserve and include it directly in the initial cost or other carrying amount of the asset. (This is referred to as a basis adjustment)
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Allocation amounts to such capital reserves means these amounts are ‘permanently’ available to the entity and will not be available to be paid as dividends.

Example: Time value of options – transaction related hedged item3

The case: Gains/losses arising on the effective portion of hedging instruments carried at fair value in a qualifying cash flow hedge.

Entity X is a copper producer and enters into a put option to hedge sales that are forecast to take place on 30 September 20X4:

  • On 1 January 20X4 Entity X enters into a put option to sell 1,000 tonnes of copper for CU50/tonne. The put option expires on 30 September 20X4 (assume that the hedge is 100% effective)
  • The copper spot price on 1 January 20X4 is CU50/tonne
  • Entity X pays CU2,000 for the put option
  • Initial time value (i.e. fair value; less, intrinsic value) is CU2,000. [i.e. CU2,000 – ((CU50-CU50) x 1,000 tonnes)]

1 January 20X4

CU

CU

DR Option

2,000

CR Cash

2,000

To recognise the purchase of the option.

Subsequently, on 1 March 20X4:

  • The fair value of the option is CU5,000
  • The copper spot price is CU46/tonne
  • Intrinsic value is CU4,000 [i.e. (CU50-CU46) x 1,000 tonnes)], the effective portion of the option
  • The time value of the option (i.e. fair value; less, intrinsic value) is CU1,000 [i.e. CU5,000 – CU4,000].

1 March 20X4

CU

CU

DR Option

3,000

DR OCI – Option time value reserve

1,000

CR OCI – Cash flow hedge reserve

4,000

To recognise the change in fair value of the option, taking the change in the intrinsic component (the hedging instrument) to the CFH reserve, and recognising the change in time value in the option time value reserve.

Cash flow hedge reserve

Cash flow hedge reserve

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