Cash Flow Hedges Notes (IFRS)

42.4 Cash flow hedges

42.4.1 Hedging an unrecognized firm commitment
  • An unrecognized firm commitment is an executory contract that represents both a right and an obligation. For a purchase, the right is to receive the goods and the obligation is to pay the supplier; for a sale, the obligation is to provide the goods and the right is to receive cash from the customer.
  • Forward contracts used to hedge an unrecognized firm commitment are recorded at the time the hedge is entered into. FX gains/losses arise on the variable side as rates update.
  • If hedge accounting is elected (and criteria are met), the FX gain/loss on the variable side is deferred (not in profit or loss) until the purchase or sale being hedged is recorded. At that time, the FX gain/loss is accounted for as an adjustment to the selling or purchase price.
  • Regardless of whether the hedging instrument is designated as a fair value hedge or a cash flow hedge, the result is the same: a FX gain/loss arises between the date the forward contract is entered into and the date the hedged purchase/sale is recorded, and this gain/loss is an adjustment to the price of the hedged item.
  • If hedge accounting is used for an unrecognized firm commitment, the forward contract’s gains/losses on the variable side are deferred to OCI and later reclassified to adjust the selling/purchase price when the sale/purchase is recorded.
Conceptual example (text only, no numerical Rates provided)
  • A Canadian company signs an agreement on December 1, Year 1 to sell goods to a U.S. company for US$100,000, with shipment and payment on January 15, Year 2.
  • To hedge the sale, a forward to sell US$100,000 is entered for January 15, Year 2.
  • The company has a December 31 year end. By entering the forward, the Canadian company fixes the Canadian dollar amount to be received, reducing FX risk.
  • Under general rules, the variable side (the payable to the bank) would be updated from the forward date to the forward rate on December 31, Year 1 and then to the spot rate on January 15, Year 2, with the resulting FX gain/loss recognized in profit or loss unless hedge accounting is elected.
  • If hedge accounting is elected and qualifies, the FX gain/loss on the variable side is deferred in OCI until the sale is recorded, at which time it is recognized as an adjustment to the selling price. If designated as a cash flow hedge (or a fair value hedge), the end result is the same in terms of the initial FX gain/loss deferral and subsequent reclassification.

IFRS stance (summary): Gains/losses on the forward’s variable side are deferred in OCI for cash flow hedges of unrecognized firm commitments and then reclassified to affect the recorded price when the hedged transaction occurs. The same economic outcome occurs if designated as a fair value hedge, but the accounting mechanics differ in the presentation pace.

42.4.2 Hedging a firm commitment and a payable or receivable arising from the firm commitment
  • In many cases, when a firm commitment is made to purchase or sell goods, payment is after the goods are received/sold. A forward contract maturing when payment is due can hedge both the initial transaction and the payable/receivable arising from that transaction.
  • Summary of accounting rules (date-driven):
    • Date forward contract is entered into: Record both sides of the forward contract at the forward contract rate.
    • Reporting date: Update the variable side of the forward to the forward rate on that date with an offsetting entry to OCI.
    • Date of purchase/sale: Update the variable side of the forward to the forward rate on that date with an offsetting entry to OCI.
    • Settlement date: Record the purchase/sale at the spot rate on the purchase/sale date; adjust the balances in OCI/AOCI related to the contract to the purchase price or selling price; update the accounts payable or receivable arising from the purchase/sale to the spot rate and recognize the difference as FX gain/loss in profit or loss; record the settlement of the forward contract.
  • The mechanics ensure that FX gains/losses on the hedge affect OCI/AOCI until the hedged item is recorded, after which any relevant OCI/AOCI balances are reclassified to adjust the carrying amount of the hedged item.
42.4.2 Summary of rules (stepwise)
  • Date forward contract is entered into: Record both sides at the forward contract rate.
  • Reporting date: Update the variable side to the forward rate with an offsetting entry to OCI.
  • Date of purchase or sale: Update the variable side to the forward rate on that date with an offsetting entry to OCI.
  • Settlement date: Record the purchase or sale at the spot rate on that date; adjust OCI/AOCI balances to the purchase price or selling price.
  • Settlement of the forward contract: Record the settlement of the forward contract.
  • Update accounts payable/receivable arising from the purchase/sale to the spot rate at settlement and recognize the FX difference in profit or loss.
42.4c Let's look at an example (cash flow hedge of an unrecognized firm commitment)
  • Date: December 18, Year 1; MRI (Canadian company) orders €300,000 from a supplier in Italy; delivery February 18, Year 2; payment on delivery.
  • Hedge: Forward to purchase €300,000 on February 18, Year 2; MRI’s year end is December 31.
  • Rates (illustrative):
    • Date: December 18, Year 1 — Spot: €1 = C$1.3600
    • Date: December 31, Year 1 — Forward rate used for hedging: €1 = C$1.3700
    • Date: February 18, Year 2 — Spot: €1 = C$1.3500
    • Forward rate for delivery on February 18, Year 2: €1 = C$1.3525
    • Final observation: On February 18, Year 2, spot equals €1 = C$1.3500; forward rate settled at €1 = C$1.3525.
  • Journal entries (summary; amounts shown for key lines):
    • December 18, Year 1
    • DR Receivable from bank (€300{,}000 × C$1.3525)
    • CR Payable to bank (C$) = €300,000imesConus1.3525€300{,}000 imes C onus 1.3525 → 405,750405{,}750
    • December 31, Year 1
    • DR Receivable from bank [€300{,}000 × (C$1.3565 − C$1.3525)] = 1,2001{,}200
    • CR OCI = 1,2001{,}200
    • February 18, Year 2
    • DR OCI
    • CR Receivable from bank [€300{,}000 × (C$1.35 − C$1.3565)] = 1,9501{,}950
  • Note: On Dec 31 Year 1, the variable side is updated into OCI; at settlement (Feb 18 Year 2), the OCI balance is realized in the current period as the forward is settled.
  • Inventory recognition and cost: On settlement, the inventory is recorded at spot rate on the purchase date; any OCI/AOCI amounts related to the contract are recognized so that the inventory carries cost equal to the forward hedge amount.
    • On settlement: Inventory recorded at spot rate with the corresponding cash outlay to the supplier and the forward hedge effects reflected in the inventory cost:
    • DR Inventory (€300{,}000 × C$1.35) = 405,000405{,}000
    • CR Accounts payable = 405,000405{,}000
  • The net effect on inventory cost reflects the forward hedge rate: the inventory carrying amount becomes 405,750405{,}750, and there is no current-period P&L impact from the forward contract when hedge accounting is applied.
  • IFRS treatment for non-financial assets: Since the hedge results in the recognition of a non-financial asset (inventory) or liability, any OCI/AOCI amounts are adjusted directly in the carrying amount of the asset or liability; no reclassification adjustment is required, and there is no net effect on current period OCI beyond the adjustment to the asset.
  • After all steps, there is no remaining balance in AOCI/OCI related to this contract at period-end.
42.4d Let’s look at a second example (cash flow hedge of an unrecognized firm commitment with a payables timing difference)
  • This example differs from the first in that inventory is paid for a month after it is received.
  • Date: December 18, Year 1; MRI orders €300,000; delivery February 18, Year 2; payment March 18, Year 2; year end December 31.
  • Hedge: Forward contract to purchase €300,000 on March 18, Year 2; forward/spot rate observations: On December 18, Year 1 the same as above; on December 31 Year 1 the same, with an updated forward rate for March 18 Year 2; on February 18 Year 2 the inventory is received; on March 18 Year 2 the payment is made.
  • Rates (illustrative):
    • December 18, Year 1: Spot €1 = C$1.3600
    • December 31, Year 1: Forward €1 = C$1.3700
    • February 18, Year 2: Spot €1 = C$1.3500
    • March 18, Year 2: Forward €1 = C$1.3525
    • March 18, Year 2: Spot €1 = C$1.3550
  • Journal entries (highlights):
    • December 18, Year 1
    • DR Receivable from bank (€300{,}000 × C$1.3525)
    • CR Payable to bank (C$) → 405,750405{,}750
    • December 31, Year 1
    • DR Receivable from bank [€300{,}000 × (C$1.3565 − C$1.3525)] = 1,2001{,}200
    • CR OCI = 1,2001{,}200
    • February 18, Year 2
    • DR Receivable from bank [€300{,}000 × (C$1.3475 − C$1.3565)] = 2,7002{,}700
    • DR OCI to close prior period OCI balance to AOCI (see note below)
  • The OCI balance is closed out to AOCI at year-end as part of period-end consolidation.
  • February 18, Year 2 (inventory receipt)
    • DR Inventory (€300{,}000 × C$1.35) = 405,000405{,}000
    • DR AOCI / CR OCI (net effect reflecting the contract)
    • Adjust the purchase price for the hedge: total net effect equals the sum of the OCI movements to date
  • Between December 18 Year 1 and February 18 Year 2, there is a net FX loss on the forward contract of 2,700−1,200=1,5002{,}700 - 1{,}200 = 1{,}500, which, under cash flow hedge accounting, is reflected in the inventory adjustment rather than in current period P&L.
  • On February 18, Year 2 through March 18, Year 2, the forward contract hedges an exposed payable (a monetary liability), so this is treated largely as a fair value hedge for the period between the hedge initiation and the settlement: FX gains/losses on the receivable and payable are recognized in income as they arise.
  • March 18, Year 2 (settlement of the forward and payment to supplier)
    • Update accounts payable to the March 18 spot rate (FX loss): 1,5001{,}500
    • Update the receivable from bank to the March 18 spot rate (FX gain): 2,2502{,}250
    • Settlement of forward contract:
    • DR Payable to bank (C$) (€300{,}000 × C$1.3525) = 405,750405{,}750
    • CR Cash (C$) = 405,750405{,}750
    • DR Cash (€) (€300{,}000 × C$1.3550) = 406,500406{,}500
    • CR Receivable from bank = 406,500406{,}500
    • Payment to Italian supplier:
    • DR Accounts payable (€300{,}000 × C$1.3550) = 406,500406{,}500
    • CR Cash (€) = 406,500406{,}500
  • Overall impact on profit and loss for MRI (summary):
    • Inventory becomes cost of sales: 405,000+1,500=406,500405{,}000 + 1{,}500 = 406{,}500
    • FX loss on accounts payable: 1,5001{,}500
    • FX gain on forward contract: −2,250-2{,}250
    • Net impact on P&L: +$405{,}750 (the cash outlay settled remains the amount paid to the bank for the fungible forward hedge)
  • Bottom line: By using hedge accounting, the cash outlay to pay for inventory is fixed at the forward rate, with no immediate P&L impact from the forward hedge until the inventory is sold or costs are recognized. There is no remaining OCI/AOCI balance related to the contract at period end.
Key takeaways
  • Cash flow hedges defer FX gains/losses on the hedged item’s variability in OCI (or AOCI), and reclassify to affect the carrying amount of the hedged asset, liability, or purchase/sale price when the hedged transaction occurs.
  • For hedges of a firm commitment with a payable/receivable arising from that commitment, the accounting mirrors the same principle: OCI movements are recognized and then embodied in the carrying amount of the hedged item when appropriate.
  • If the hedge is progressively turned into a fair value hedge (e.g., hedging an exposed payable), FX gains/losses on both the payable and the hedging instrument are recognized in profit or loss as they arise.
  • IFRS treatment for hedges that result in non-financial assets or liabilities involves adjusting the asset/liability carrying amount directly with OCI/AOCI, with no separate reclassification adjustments affecting current period P&L beyond the asset’s carrying amount.

Note: All monetary values and FX rates shown above come from the provided transcript. When applying in practice, ensure you capture the exact forward/spot rates and dates relevant to the specific hedge and refer to the applicable IFRS guidance for the classification (cash flow hedge vs fair value hedge) and the level of documentation required to qualify for hedge accounting.