CHAPTER 4

Cash Flow Hedges

About This Chapter

Cash flow hedges are designed to lock in variable (floating) future expected cash flows of an anticipated or forecasted transaction. To review, fair value hedges convert fixed cash flows on an existing asset, liability, or firm commitment to variable cash flows and protect the hedged item’s fair value. For cash flow hedges the opposite is true; the company takes inherently variable forecasted cash flows and converts them to fixed cash flows. Cash flow hedges are designed as a hedge of the variable cash flows from a forecasted transaction that is expected to occur in the future.

This chapter will discuss the use of cash flow hedges that companies can use to manage their risk exposure given the relative uncertainty of forecasting operating and financial transactions that will change future cash flows for the company. Derivative instruments used in cash flow hedges can reduce the uncertainty, for companies, of the amount of cash to be received or paid for operating and financial transactions.

The chapter will conclude with three comprehensive examples that will illustrate the economics and financial statement impacts of cash flow hedges.

Forecasted (Anticipated) Transactions

Forecasted transactions are eligible for cash flow hedge accounting, while firm commitments are only eligible for fair value hedge accounting. Accounting guidance defines forecasted transactions as probable future transactions that do not meet the definition of a firm commitment (which are only permissible for fair value hedges). Forecasted transactions can be contractually established or merely probable because of a company‘s past or expected business practices. As discussed previously, for a contract to meet the definition of a firm commitment, all of its relevant terms must be contractually fixed (e.g., price, quantity, timing, interest, or exchange rate) and the performance must be contractually required. On the other hand, in a forecasted transaction, either some term of the transaction is variable or the transaction is not contractually certain. Therefore, the distinguishing characteristic between a forecasted transaction and a firm commitment is the certainty and enforceability of the terms of the transaction.¹

Because hedging a firm commitment and hedging a forecasted transaction give rise to different risk exposures, companies will need to deploy different risk management derivative instruments to accomplish their risk management strategies for the forecasted cash flows. For example, when hedging a firm commitment the company’s goal is to unlock the fixed price position and pay the variable (market) price. For the hedge of a forecasted transaction the company would use derivative instruments to “fix” the amount of cash flows paid or received.

As discussed in Chapter 2, hedge documentation is vital in qualifying for hedge accounting. This documentation can be particularly perplexing for forecasted transactions. The difficulty is in meeting the standard setter’s guidance that the transaction is probable of occurring. Accounting guidance for derivatives would indicate that the standard setters interpret probable at a high level, normally greater than or equal to a 75% probability of occurring. Useful guidelines when documenting the hedge include:

Accounting for Cash Flow Hedges

The effective portion of the gain or loss on a derivative instrument designated as a cash flow hedge is reported in other comprehensive income, and the ineffective portion is reported in earnings. The derivative instrument is carried at fair value of the balance sheet. However, unlike fair value hedges, since the hedged item is a forecasted transaction there is no existing asset, liability, or firm on which to “wash” out the transaction from the income statement. Cash flow hedge accounting will record the offset fair value change in the derivative instrument in a shareholder’s equity account called Other Comprehensive Income (OCI). It is this arbitrary accounting that makes cash flow hedge accounting difficult to understand. Until the hedge is settled it is difficult for the company to determine the hedge effectiveness as shown of the financial statements over the contractual term of the hedge.

Amounts in other comprehensive income (OCI) shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (e.g., when a forecasted sale actually occurs). If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).

This requirement, for recording interest expense over the term of the debt or recording depreciation expense over the useful life of the equipment purchases mandates that companies carefully track the hedge transaction over its entire contractual life, including the life of the “hedged item”. For example, if your cash flow hedge results in a purchase of machinery with a 10-year life the related OCI account in shareholder equity will be released to earnings over a 10-year period of time. This requirement substantially increases the documentation for companies using cash flow hedge derivatives.

Assessing Hedge Effectiveness

In order to qualify for hedge accounting, the hedge relationship must be expected to be highly effective at inception and on an ongoing basis throughout the term of the hedging relationship. However, determining the extent to which a cash flow hedge is ineffective is more complicated than in a fair value hedge where both the derivative and the hedged item are adjusted for changes in fair value (with respect to the hedged risk) through earnings. This complication develops because the “hedged item” is anticipated or forecast cash flows which may diverge from the changes in the fair value of the derivative instrument because of changing economic conditions of the forecasted transaction.

Cash flow hedges use the same effectiveness methodologies as used by fair value hedges. Most common is the dollar-offset approach whereby the change in the derivative instrument is compared to the change in the hedged item. Hedged transactions will qualify for the special hedge accounting when the changes between the two values are in the 80% to 125% effectiveness range. The major difference in determining hedge effectiveness is the calculation of the fair value change in the forecasted expected future cash flows. The preferred measurement methodology in determining the “hedged item” side of the formula in performing effectiveness tests is to determine the expected present value of future cash flows for the hedged transaction.

Hedges of cash flow exposures often involve a component of the total cash flow that is the source of its variability. Considering the source of variability in a hedged cash flow is one of the first steps in assessing ineffectiveness of a cash flow hedge. For example, if the hedged forecasted transaction is the variable interest payment on a debt obligation whose contractual terms provide for the payment of interest at the prime interest rate plus a fixed spread, changes in the prime interest rate are the only source of variability of the forecasted cash flow.

In situations where the variability of the hedged cash flow is solely attributable to changes in an interest rate index, ineffectiveness may be assessed solely by considering the effectiveness of the derivative in offsetting changes resulting from changes in the index. As a result, when the designated derivative is based on the same interest rate index as the cause of the variability of the hedged cash flow, and the other terms of the exposure and the derivative match, then we have a “perfect hedge. However, unlike the exception in the fair value hedge that ongoing effectiveness need not be assessed, for cash flow hedges ineffectiveness after hedge inception must always be assessed to determine any ineffectiveness. This assessment is done because any ineffectiveness goes directly to earnings while the highly effective portion of the hedge goes to an OCI account in the shareholder’s equity.

Similar to a fair value hedge when the critical terms match for the derivative instrument and the “hedged item” (forecasted cash flows) then at inception the company can assume that the hedge will be highly effective (changes in the derivative fair value will offset changes in fair value of the forecasted transaction). Critical terms would consist of the timing of the transaction, quantities of a commodity, and delivery dates. However, since the critical terms of the forecasted transaction can change as to timing and amounts, companies need to carefully monitor the critical terms match on an ongoing basis in determining any ineffectiveness which would be charged to earnings in the period under measurement which for derivative instruments is every three months.

Forecasted transactions may be based on the company’s historical experience, say of revenue projections for a particular region. At inception, the company could design a derivative instrument that matched their revenue expectations. However, generally as the settlement date gets closer the estimates of revenue are likely to change causing ineffectiveness in the hedging relationship.

Because the hedged item is forecasted cash flows, accounting guidance limits the amount that is recorded in OCI. The cash flow hedging model requires that companies determine if the change in fair value of the derivative instrument as compared to the change in fair value of the forecasted future cash flows represents an “underhedge” or an “overhedge”. An “underhedge” occurs when the cumulative change in the fair value of the derivative instrument is equal to or less than necessary to offset the cumulative change in expected future cash flows of the hedged item. When this is the case the entire change in the fair value of the derivative is recorded in OCI, and there is no ineffectiveness in earnings. However, if the cumulative change in the fair value of the derivative instrument is greater than the cumulative change in the fair value of expected future cash flows, then the amount in excess is changed to earnings with the remainder going to OCI in shareholder’s equity.

The following example on Measuring Hedge Effectiveness ¹ will be used to illustrate how to apply the accounting guidance for effectiveness measures for cash flow hedges. Company has designated the overall change in cash flows related to the forecasted transaction as the hedged risk. However, because of differences between the derivative instrument and the hedged item, some ineffectiveness is expected to occur. The example will first construct a table demonstrating the hedge effectiveness assessment, then provides the accounting impact on the financial statements, and finally provide a detailed examination of the OCI account on the balance sheet.

Measuring Hedge Effectiveness

Reading the Table

Computations represented by the table:

Measuring Hedge Effectiveness

Period	A	B	C	D	E	F
1	$100	$100	$(96)	$(96)	$96	$96
2	94	194	(101)	(197)	194	98
3	(162)	32	160	(37)	32	(162)
4	(101)	(69)	103	66	(66)	(98)
5	30	(39)	(32)	34	(4)	32

The following financial statement effects template walks you through the accounting for the five periods presented. Note that the account shareholder’s equity is a balance sheet account that offsets the cumulative change in the fair value of the derivative. The analysis below will include gain and loss accounts in shareholder’s equity. Entries to these accounts will appear on the income statement.

Financial Statement Template

Assets =	Liabilities +	Shareholder’s equity (OCI)
		+ Gain on derivative – Loss on derivative

Period 1: Adjust the derivative to fair value and the OCI by the calculated amount (column F) in Measuring Hedge Effectiveness

Assets =	Liabilities +	Stockholder’s equity
+ Derivative instrument		+ OCI 96
+ 100		+ Gain on derivative
		+ 4

Period 2: Adjust the derivative to fair value and the OCI by the calculated amount (column F) in table on Measuring Hedge Effectiveness

Assets =	Liabilities +	Stockholder’s equity
+ Derivative instrument		+OCI
+94		+98
		– Loss on derivative
		–4

Period 3: Adjust the derivative to fair value and the OCI by the calculated amount (column F) in table on Measuring Hedge Effectiveness

Assets =	Liabilities +	Stockholder’s equity
	+ Derivative instrument	– OCI
	+ 162	– 162

Period 4: Adjust the derivative to fair value and the OCI by the calculated amount (column F) in table on Measuring Hedge Effectiveness

Assets =	Liabilities +	Stockholder’s equity
	+ Derivative instrument	– OCI
	+ 101	– 98
		– Loss on derivative
		– 3

Period 5: Adjust the derivative to fair value and the OCI by the calculated amount (column F) in table on Measuring Hedge Effectiveness

Assets =	Liabilities +	Stockholder’s equity
+ Derivative instrument		+OCI
+ 30		+ 32
		–Loss on derivative
		–2

Cash flow hedges, until settlement date, have their primary effect on the balance sheet. The following roll-forward schedule illustrates the impact in the shareholder’s equity account OCI over the 5 periods.

Accumulated OCI (+ increases balance and – decreases balance)

Roll-Forward Schedule for Fair Value Changes in the Derivative Instrument

Period	Beginning balance	Change in fair value	Reclassification	Ending balance
1	$–	$+96	$–	$+96
2	+96	+94	+4	+ 194
3	+ 194	–162	–	+32
4	+32	–98	–	–66
5	–66	+30	–2	–34

Caution the following explanation for the changes in the balance sheet account OCI will take some time to go through. The easiest way to understand the changes is to correlate the OCI changes to the financial statement effects template found above.

The reclassification column relates to reclassifications between earnings and other comprehensive income. In Period 2, the +$4 in that column relates to the prior period’s derivative gain that was previously recognized in earnings. That amount is reclassified to other comprehensive income in Period 2 because the cumulative gain on the derivative is less than the amount necessary to offset the cumulative change in the present value of expected future cash flows on the hedged transaction. In Period 5, the –$2 in the reclassification column relates to the derivative loss that was recognized in other comprehensive income in a prior period. At the end of Period 4, the derivative’s cumulative loss of $69 was greater in absolute terms than the $66 increase in the present value of expected future cash flows on the hedged transaction. That +$3 excess had been recognized in earnings during Period 4.

In Period 5, the value of the derivative increased (and reduced the cumulative loss) by $30. The present value of the expected future cash flows on the hedged transaction decreased (and reduced the cumulative gain) by $32. The gain on the derivative in Period 5 was –$2 smaller, in absolute terms, than the decrease in the present value of the expected future cash flows on the hedged transaction. Consequently, the entire gain on the derivative is recognized in other comprehensive income. In addition, in absolute terms, the –$3 cumulative excess of the loss on the derivative over the increase in the present value of the expected future cash flows on the hedged transaction (which had previously been recognized in earnings) increased to $5. As a result, $2 is reclassified from other comprehensive income to earnings so that the $5 cumulative excess has been recognized in earnings.

The remainder of this chapter will illustrate four of the more common cash flow hedges used by companies to hedge their forecasted future cash flow needs. The four hedges are:

Cash Flow Hedge of Fixed-Rate Debt Using an Interest Rate Swap

Description of the Hedge Transaction

On June 30, 20X1, a Manufacturing Company (Company) borrows $10,000,000 of three-year 7.5% fixed-rate debt. The debt is due at maturity and contains no prepayment option. The Company, at the same time, enters into a three-year interest rate swap with a Finance Company to convert the debt’s fixed rate to a variable (or floating) rate.

Under the terms of the swap, the Company receives interest at a fixed rate of 7.5% and agrees to pay interest at a variable rate equal to six-month U.S. LIBOR, based on the notional amount of $10,000,000. Both the debt and the swap require that payments be made or received on December 31 and June 30.

Note: For illustrative purposes, we will only account for the two semiannual interest periods for this interest rate swap. For an interest rate swap in which the critical terms match, accounting guidance allows companies to treat the hedge as a perfect hedge. The entries for the remaining life of the swap for the changes in the derivative instrument and the hedged item will perfectly offset in earnings.

The six-month U.S. LIBOR rate on each reset date determines the variable portion of the interest rate swap for the following six-month period. The Company designates the swap as a cash-flow hedge, which will hedge the exposure to variability in the cash flows of the variable-rate debt, with changes in cash flows that are due the changes in the six-month LIBOR the specific risk being hedged.

Hedge Documentation

a. Risk Management Strategy

The objective of entering into the hedge is to fix its cash flows associated with the risk of variability in the six-month U.S. LIBOR. In order to meet its risk management objective, the Company has decided to enter into the interest rate swap described below for the same notional amount and period of the $10,000,000 million debt entered into on June 30, X1. It is expected that this swap will fix the cash flows associated with the forecasting interest payments on the entire notional amount of the debt. The company is hedging its interest rate risk.

b. Hedging Instrument

$10,000,000 notional amount, pay fixed at 7.5% and receive variable at U.S. LIBOR, dated June 30, 20X1, with semi annual payments due on December 31, X1 and June 30, X2 and ending on June 30, 20X4.

c. Hedged Item

Forecasted interest payments on notional of $10,000,000 debt entered into on June 30, X1, and ending on June 30, X4. Reset dates for December 31, X1 and June 30, X2 determine the interest rates to be paid. These reset rates will be determined by U.S. LIBOR. The six-month U.S. LIBOR variable rate on the reset date determines the variable interest amount for the following six-month period.

d. Assessing Hedge Effectiveness

The Company has determined that the critical terms match for the derivative instrument and the hedged item and is, therefore, assuming no ineffectiveness at inception and over the term of the interest rate swap. Since there is no ineffectiveness all changes in the fair value of the interest rate swap will be recorded in OCI in the shareholder’s equity.

Accounting Guidance to qualify as a perfect hedge for an interest rate swap requires that companies perform the following steps:

Note: For illustration purposes, we will only use the December 30, X1 and the June 30, X2 semiannual interest payment dates.

Calculation of Interest Expense

Date	(a) Difference between variable rates	(b) Fixed rate on the swap	(c) Sum (a) + (b)	(d) Principal amount of debt	(e) Semiannual interest Expense ((c) x (d))/2
12/31/X1	0.00%	7.5%	7.5%	$10 Million	$375,000
6/30/X2	0.00%	7.5%	7.5%	$10 Million	$375,000

Date	Six-month U.S. LIBOR rate	Swap fair value + Asset – Liability
6/30/X1	6.00%	Zero value at inception
12/31/X1	7.00%	$+323,000 Obtained from dealer quotes
06/30/X2	5.50%	$–55,000 Obtained from dealer quotes

The following accounting entries will demonstrate the financial statement impacts of a cash flow hedge on the variability of interest payments.

Assets =	Liabilities +	Stockholder’s equity
		+ OCI – Interest Expense

June 30, X1

To record the issuance of debt

Assets =	Liabilities +	Stockholder’s equity
+ Cash + 10,000,000	+ Debt + 10,000,000

Note: the swap asset/liability has zero value at inception because the underlying value driver (U.S. LIBOR) has not changed

December 31, X1

To record semiannual interest on the debt a 6.00% annual percentage rate (APR):

Assets =	Liabilities +	Stockholder’s equity
–Cash –300,000		–Interest expense –300,000

Calculation is $10,000,000 x (6%/2) = $300,000

To record settlement of the semiannual swap payment at 7.5% less the amount receivable at 6% U.S. LIBOR, as an adjustment to interest expense:

Assets =	Liabilities +	Stockholder’s equity
–Cash –75,000		–Interest expense –75,000

Calculation is $10,000,000 x (7.5% – 6%)/2 = $75,000

To record the change in fair value of the interest rate swap with the offset amount to OCI:

Assets =	Liabilities +	Stockholder’s equity
+ Swap contract + 323,000		+ OCI + 323,000

Amount is taken from the table above and is the result from a dealer quote.

Note: For cash flow hedges, there is no income statement component (unless there is some hedge ineffectiveness) until settlement of the hedge for the derivative instrument. In the accounting entry above the asset swap contract will be offset by the change in the OCI account in shareholders equity. There is, however, an income statement effect on interest expense. The company records its variable rate payment of interest expense at 6% times the notional amount and also pays an additional $75,000 to counterparty, which is calculated as notional × (7.5%–6%)/2.

The attractiveness of a using a cash flow hedge on the variability of payments set by the benchmark rate (in this case U.S. LIBOR) is that the variable interest amounts are fixed (known with certainty) over the term of the swap.

June 30, X2

To record the interest payment to debt holders at the 7% variable rate:

Assets =	Liabilities +	Stockholder’s Equity
–Cash –350,000		–Interest expense –350,000

Calculation is $10,000,000 x (7%/2) = $350,000

To record the payment of semiannual interest at 7.5%, less amount receivable of 7% as an adjustment to interest expense:

Assets =	Liabilities +	Stockholders Equity
–Cash –25,000		–Interest expense –25,000

To record change in fair value of the swap contract from dealer quote:

Assets =	Liabilities +	Stockholder’s Equity
–Swap Contract –378,000		–OCI –378,000

Note: The derivative instrument (swap contract) will continue to be recorded at its fair value of the balance sheet over the term of the swap agreement with the offset being to OCI in shareholders equity. The change in fair value of the derivative instrument should be thought of as a gain (in the money) or as a loss (out of the money). However, the gain or loss amount is an adjustment to the OCI in shareholders equity until the hedge is settled.

In the accounting entries above for interest expense, the amounts accumulated in OCI are “indirectly” recognized as periodic settlements of the swap in interest expense at each reset date. At the end of the term of the swap, the OCI account will go to zero and the cumulative adjustments to interest expense will have been indirectly charged to earnings. It is this arbitrary accounting that can cause difficulty in determining hedge effectiveness by examining the impacts of the balance sheet. Compare this accounting to a fair value hedge where we can closely track the changes of the derivative instrument and the hedged item fair value changes on the balance sheet.

For our next comprehensive illustration, we will examine the financial statement effects of a cash flow hedge of a forecasted purchase. What makes this an interesting hedge is that we will use one commodity to hedge a different commodity.

Cash Flow Hedge of a Forecasted Purchase Using a Futures Contract

On January 1, X1, the Company, a large airline company, forecasts the purchase of 84 million gallons of jet fuel in six months. The company is concerned that jet fuel prices will rise over the coming months, so it enters into 2,000 long (purchase) contracts for purchase of 42,000 gallons per contract of heating oil futures. Each contract of heating oil is for $0.4649/gallon with settlement date on June 30, X1. We will assume that no premium was required to enter into the contracts and that any interest earned or expensed is ignored. These exceptions will allow us to focus on the hedged transaction.

The Company’s risk management strategy is to hedge its exposure the price risk due to adverse changes in jet fuel prices. The Company expects some ineffectiveness in the hedged transaction because it is hedging heating oil futures contracts against the expected rise in the jet fuel prices over the term of the hedge. The Company has accepted the basis risk (changes in price between two different commodities), but still expects the hedged transaction to be highly effective.

The Company prepares the following analysis for the period ending March 31, X1, and for June 30, X1, as a basis for determining hedge effectiveness and the potential financial statement effects.

Analysis to determine fair value as of March 31, X1

Period Ending 3/31/X1	6/30/X1 Heating oil futures contracts	6/30/X1 Expected cash flows of jet fuel purchases
Futures price—end of period	$0.4726	$0.4759
Futures price—beginning of period	0.4649	0.4688
Change in price over since 1/1/X1	0.0077	0.0071
Gallons hedged under contract	84,000,000	84,000,000
Change in fair value—gain (loss)	$646,800
Change in expected cash flows—gain (loss)		$(596,400)

Note: Using the cumulative dollar-offset method in determining hedge effectiveness, we get ($646,800/$596,400) = 108%. This amount is within the 80% to 125% and the hedge is considered highly effective.

Analysis to determine fair value as of June 30, X1

Period ending 6/30/X1	6/30/X1 Heating oil futures contracts	6/30/X1 Expected cash flow on jet fuel purchase
Spot and futures price at end of period	$0.4768	$0.4810
Futures price at beginning of period 3/31/X1	0.4726	0.4759
Change in price per gallon	0.0042	0.0051
Gallons hedged	84,000,000	84,000,000
Change in fair value—gain (loss)	$352,800
Change in expected cash flows—gain (loss)		$(428,400)
Cumulative change in fair value/expected cash flows over the term of the hedge	$999,600	$(1,024,800)

Note: Cumulative dollar offset is ($999,600/1,024,800) = 98% Risk Management Strategy

The objective of the hedge is to reduce the variability of the expected cash flows of the forecasted purchase of jet fuel on June 30, X1. Changes in the fair values of heating oil futures are expected to be highly effective at offsetting changes in the expected future cash flows of jet fuel due to changes in price.

Hedging Instrument

2,000 long (purchase) for June 30, X1, for heating oil futures contracts at $0.4649 per gallon. Each contract is 42,000 gallons.

Hedged Item

Forecasted purchase of 84,000,000 million gallons of jet fuel on the same date the heating oil futures contract matures on June 30, X1.

Assessing Hedge Effectiveness

Based on performing a regression analysis using past six-month periods of time the Company determined that there is a high correlation between the price of heating oil and the price of jet fuel. Based on that determination, the company concluded that the correlation will continue in the future and deemed the hedge to be highly effective as of the inception of the hedge on Jan 1, X1. On an ongoing basis in determining hedge effectiveness, the Company will use the cumulative dollar-offset method. The Company will compare the estimated cash flows on the heating oil futures contracts with the expected cash flows on the jet fuel contracts. Both the derivative instrument and the hedged item (forecasted cash flows) will be based on the forward prices. Ongoing effectiveness analysis will be updated on March 30, X1, and June 30, X1. (see above)

The following transactions will now illustrate the financial statement effects of the hedged transaction.

Financial Statement Template

Assets =	Liabilities +	+Stockholder’s Equity
		+ OCI + Income from hedge ineffective – Expense for hedge ineffectiveness

Jan 1, X1

No entry required because the futures contact has zero value at inception

March 31, X2

To record the changes in fair value of the futures contracts and the change in forecasted expected cash flows.

Assets =	Liabilities +	Stockholder’s Equity
+ Future contract + 646,800		+ OCI + 596,400 + Expense + 50,400

Note: The change in fair value of the futures contract is recorded as an asset based on the analysis of fair value as of March 31, X1. The offset account OCI is limited to the amount of the changes in expected future cash flows (hedged item). The remainder would be recorded as an expense due to hedge ineffectiveness.

In cash flow hedge, the amount of the “overhedge” ($646,800 – $596,400) = $50,400 is recognized in earnings normally as other expense. In the “underhedge” (in this case the change in the expected future cash flows would be greater than the change in the derivative instrument), the change in fair value of the derivative would be recognized entirely with an equal offset amount to OCI.

June 30, X1

To record the change in fair value of the futures contracts and the change in expected cash flows from purchase of jet fuel:

Assets =	Liabilities +	Stockholder’s Equity
+ Futures contracts + 352,800		+ OCI + 403,200 –Expense –50,400

Note: The asset account futures contract is now valued at $999,600 as is the OCI account. The calculation for the OCI account is ($596,400 + $403,200) = $699,600. Also, note the income and expense from hedge ineffectiveness offset each other by the settlement date. To record the settlement of the futures contract:

Assets =	Liabilities +	Stockholder’s Equity
+ Cash + 996,600 – Futures contract – 999,600

To record the purchase of jet fuel:

Assets =	Liabilities +	Stockholder’s Equity
+ Jet fuel inventory + 40,404,000 – Cash – 40,404,000

Note: the 84,000,000 gallons of jet fuel are purchased at the spot price on June 30, X1, which is $0.4810

To record the use of the jet fuel used in the following period (entry would be made on September 30, X1):

Assets =	Liabilities +	Stockholders Equity
– Jet fuel inventory – 40,400,000		Air fuel expense – 39,404,400 – OCI – 999,600

Note: The balance in the OCI account is written off to earnings when the company uses the inventory. The amount written off then reduces the aircraft fuel expense. Think of a credit balance in OCI as a deferred gain.

Analysis

The financial statement impact of the hedged transaction was to lock in the price of the 84,000,000 gallons of jet fuel at $0.4691 ($39,404,000/84,000,000) instead of the spot price of $0.4810. The hedge wasn’t perfectly effective, however, resulting in ($1,024,800 –999,600) going to earnings. The final illustration in this chapter of a cash flow hedge will be:

Accounting for a Forecasted Transaction That Becomes a Firm Commitment

On November 1, X1, a company which produces a bread-based product, determines that it needs 100,000 bushels of wheat in the last week of February, X2.

The company enters into a March 20, X2, forward contract (20,000 bushels per contract) to purchase wheat at $3.00 per bushel. The company designates the forward contracts as a hedge of forecasted cash flow purchases of inventory of 100,000 bushels of wheat on February 25, X2.

On December 31, X2, the company issues a purchase order to buy 100,000 bushels of wheat at $2.80 per bushel, to be delivered on February 25, X2. The company closes out its forward contracts purchased on November 1, X1 on February 25, 20X2.

Risk Management Strategy

The designated risk being hedged is risk of changes in cash flows relating to all the changes in the purchase price of the wheat inventory. This is cash-flow hedge of a forecasted transaction from the period November 1, X1 to December 31, X2. At that date, the company enters into a firm commitment to purchase 100,000 bushels of wheat at $2.80, which is a fair value hedge.

Hedging Instrument

On November 1, X1, the company enters into forward contracts to by 100,000 bushels of wheat at $3.00 per bushel. The company designates the forward contracts as a hedge on forecasted wheat inventory purchases on February 25, X2.

Hedged Item

From the period November 1, X1 to the period February 24, X2 the company is hedging its exposure to the variability of cash flows for the 100,000 bushels of wheat inventory needed on Feb 25, X2.

On December 31, X1, the company enters into a firm commitment to purchase 100,000 bushels of wheat at $2.80 per bushel.

After cash flow hedge accounting has been discontinued of December 31, X1, for the forecasted transaction, the forward contracts can be redesignated as fair value hedge. However, in a fair value hedge we are turning fixed cash flows into variable cash flows and the forward contract is a fixed price. The forward contracts do not represent a fair value hedge of the firm commitment. We could however get a fair value hedge on the firm commitment if we sell an equivalent number of forward contracts on wheat inventory.

Assessing Hedge Effectiveness

The company will assess hedge effectiveness based on the changes in forward prices. The company expects the forward price changes on the forward contracts to be highly effective when compared to expected future cash flows for the purchase of bushels of wheat.

Note: The forward contract can be net settled at any time because of the ready market for bushels of wheat contracts that are convertible into cash.

Changes in the fair value of the contracts during the term of the hedge(s)

	December 31, X1	February 25, X2
Forward price at beginning of period	$3.00	$2.80
Forward price at end of period	2.80	3.10
Change in price, per bushel	(0.20)	0.30
Bushels under contract	100,000	100,000
Change in fair value of contracts—gain (loss)	$20,000	$30,000

The financial statement effects and related explanations are as follows:

Assets =	Liabilities +	Stockholder’s Equity
		+ OCI + Gain on hedge – Loss on hedge + Gain on forward contract – Cost of sales

November 1, X1

No entry is recorded because the forward contract has zero value at inception.

December 31, X1

To record the change in fair value of the forward contract and the offsetting entry to OCI

Assets =	Liabilities +	Stockholder’s Equity
	Forward contract – 20,000	OCI 20,000

Note: Forward contract is a liability with an amount of $20,000 with the same amount recorded in OCI representing a deferred loss. The amount in the OCI account will stay on the financial statements until we purchase the inventory.

Feb 24, X2

To record the change in fair value of the forward contracts:

Assets =	Liabilities +	Stockholder’s Equity
+ Forward contracts + 30,000		+ Gain on forward contracts + 30,000

Note: The cash flow hedge expired on December 31, X1 and the remaining term of the forward contracts did not qualify as a hedge of the firm commitment. The forward contract is recorded as a gain to earnings.

To net settle the forward contracts:

Assets =	Liabilities +	Stockholder’s Equity
+ Cash + 10,000 – Forward contracts – 10,000

Note: The company settles the forward contracts for cash. The amount is the net of the $20,000 deferred loss in OCI and the $30,000 gain on forward contract.

To record the purchase of wheat inventory:

Assets =	Liabilities +	Stockholder’s Equity
+ Wheat inventory + 280,000 – Cash – 280,000

Note: Inventory is purchased at the firm commitment price of $2.80 per bushel X 100,000 bushels.

To record write off of OCI when the cereal products are sold:

Assets =	Liabilities +	Stockholder’s Equity
		+ OCI + of sales – 20,000