Cash Flow Hedge Of A Net Position – FAQ | IFRS

Cash flow hedge of a net position

Many entities are exposed to foreign exchange risk arising from purchases and sales of goods or services denominated in foreign currencies. Cash inflows and outflows occurring on forecast transactions in the same foreign currency are often economically hedged on a net basis. For example, consider an entity that has forecast foreign currency sales of FC100 and purchases of FC80, both in 6 months. It hedges the net exposure using a single foreign exchange forward contract to sell FC20 in 6 months.

Hedging of such a net position does not qualify for hedge accounting under IAS 39. However, hedge accounting could still be achieved by designating the foreign exchange forward contract as hedging FC20 of the FC100 forecast sales. By doing so, hedge accounting would result in FC20 of the total forecast sales of FC100 being recorded at the hedged rate, while the remaining sales and the purchases will be measured at the then prevailing spot rate.

When managing the foreign exchange risk on forecast transactions, treasury departments typically determine the net positions by adding the expected cash inflows and cash outflows for a given date or time period (e.g., week or month). The resulting net exposure is then hedged using a financial instrument. Under IAS 39, if the individual cash flows forming the net position affect profit or loss in different reporting periods they will not offset each other in the income statement, i.e., there will be no ‘natural hedge’ for accounting purposes.

The IASB decided to allow net positions as eligible hedged items in cash flow hedges, including groups where the offseting risk positions affect profit or loss in different periods. This is, however, limited to hedges of foreign exchange risk. Cash flow hedge of a net position

The standard mechanics of cash flow hedge accounting cannot be applied to a hedged net position whose cash flows affect profit or loss in different periods. Applying standard cash flow hedge accounting to Example 15 above, the gain or loss accumulated in OCI on the FC20 of hedging instrument would be reclassified to profit or loss when the revenue transaction occurs. However, this will only set off the gain or loss on FC20 of the FC100 hedged revenue while the remaining revenue of FC80 and the fixed asset purchase of FC80 (i.e., the economic hedge) would still be measured at the spot rate. This would result in the bottom line profit for the period(s) not reflecting the economic hedge. Cash flow hedge of a net position

IFRS 9 changes the cash flow hedge accounting for such a net position in that the foreign exchange gain or loss on the FC80 revenue cash flows that affect profit or loss in the earlier period must be carried forward to offset the foreign exchange gain or loss on the fixed asset purchase cash flows that will affect profit or loss in later periods. This is achieved by deferring the gain or loss on the natural hedge in OCI, with a reclassification to profit or loss once the offsetting cash flows affect profit or loss. Cash flow hedge of a net position

However, the transactions that make up the net position would each need to be recognised when they arise and be measured at the spot foreign currency rate ruling at that time. Hence, they are not adjusted to reflect the result of the hedge. The whole impact of hedge accounting has to be presented in a separate line item in profit or loss. This separate line item includes:

  • The reclassification adjustment of gains or losses on the hedge of the net position
  • The gain or loss on the natural hedge, with the counter-entry being recognised in OCI
  • The later reclassification adjustment of the gain or loss on the natural hedge from OCI to profit or loss

The rather complicated accounting described above is best illustrated using an example: Cash flow hedge of a net position

Example — Cash flow hedge of a foreign currency net position continued

An entity having the CAD as functional currency anticipates sales of GBP100m in 12 months and also plans a major capital expenditure (fixed assets) of GBP80m in 12 months. The anticipated sales and capital expenditure (i.e., the group) are designated as hedged items and the resulting net position is hedged with a forward contract to sell GBP20m in 12 months. The fixed assets will be depreciated on a straight-line basis over eight years. For simplicity, assume the spot rate equals the forward rate.

The GBP/CAD spot rates are:

At inception of the hedge (beginning of year 1) Cash flow hedge of a net position

1.50

After 12 months (end of year 1) Cash flow hedge of a net position

1.60

The entity would record the following journal entries:

Year 1

(Amounts in millions)

Other comprehensive income 

CAD2

\ Hedging derivative

CAD2

To account for the fair value change in the hedging instrument (GBP20m × [1.50 – 1.60]).

Cash flow hedge of a net positionCash flow hedge of a net position

Cash

CAD160

\ Sales

Cash flow hedge of a net position

CAD160

To account for the sales of GBP100m at the current spot rate of 1.60 (GBP100m × 1.60).

Property, plant & equipment

CAD128

\ Cash

CAD128

To account for the purchase of GBP80m fixed assets at the current spot rate of 1.60 (GBP80m × 1.60).

Hedging derivative

CAD2

\ Cash

CAD2

To account for the settlement of the forward contract.

Net position hedging gains/losses

CAD2

\ Other comprehensive income

CAD2

To reclassify the cash flow hedge reserve from OCI to profit or loss.

Net position hedging gains/losses

CAD8

\ Other comprehensive income

CAD8

To defer the natural hedge gain from profit or loss to OCI (GBP80m × [1.60 – 1.50]).

The net profit for the period is CAD150m, which represents the sale of GBP100m at the hedged rate of 1.50 (albeit presented in two different line items).

Years 2 to 9

(amounts in millions)

Depreciation

CAD16

\ Property, plant & equipment

CAD16

To account for the straight line depreciation of the fixed assets (CAD128 × 12.5%).

Other comprehensive income

CAD1

\ Net position hedging gains/losses

CAD1

To reclassify part of the deferred gain from OCI to profit or loss (CAD8m × 12.5%).

The net loss for each period is CAD15m, which represents depreciation (at 12.5%) of a fixed asset of GBP80m purchased at the hedged rate of 1.50.

Overview

The transactions within a net position still have to be measured at their spot rates, with the effect of the hedge presented in a separate line item. In other words, although hedged from a bottom-line perspective, there is still volatility in the amounts reported for the individual hedged transactions.

For a net position to qualify for cash flow hedge accounting, the hedge documentation has to include, for each individual item within the net position, its amount and nature as well as the reporting period in which it is expected to affect profit or loss.

Nil net positions

As part of its introduction of the concept of net positions as hedged items, IFRS 9 also addresses hedges of nil net positions. Sometimes entities are hedging a group of items where the hedged items among themselves fully offset the risk that is managed. An entity is allowed to designate such a nil net position in a hedging relationship, provided that:

  • The hedge is part of a rolling net risk hedging strategy.
  • Hedging instruments are used to hedge the net risk when the hedged net position changes in size over the life of the rolling hedging strategy and is not a nil net position.
  • The entity would normally apply hedge accounting to such net positions when the net position is not nil.
  • Not applying hedge accounting to the nil net position would result in inconsistent accounting outcomes over time (because in a period in which the net position is nil, hedge accounting would not be available for what is otherwise the same type of exposure).

Cash flow hedge of a net position

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