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This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.

Cash flow hedge: example

A UK trading company prepares accounts to 31 December. In October 2005, it receives an order from a Spanish customer, which it expects to fulfil early in January 2006. The customer will be invoiced in euros, and the company expects to receive 鈧�1.5 million in late January. It wishes to hedge the foreign exchange risk consequent on this forecast transaction, which is highly probable

The company enters into a forward currency contract on 15 October to sell 鈧�1.5 million on 15 January 2006, designating the forecast cash flow as the hedged item and the currency contract as the hedging instrument. Management prepares hedge documentation and assesses the hedge prospectively as almost 100% effective (the hedge is not perfectly effective because it is not certain that the transaction will occur on the same date that the currency contract matures).

At 31 December 2005, sterling has strengthened against the euro and the currency contract has a positive fair value of 拢50,000. The company assesses the hedge as being 102% effective, that is to say the fair value increase of 拢50,000 in the hedging instrument would be matched by a 拢49,000 decrease in the fair value of the forecast cash flow.

The effective portion of the hedge - the 鈥榤atched鈥� 拢49,000 increase in fair value - is credited to other comprehensive income (OCI) as the lesser of the cumulative gain on the hedging instrument and the cumulative change in the fair value of the expected future cash-flows. This will typically be taken to a cash flow hedging reserve (CFHR). The ineffective portion - 拢1,000 - is credited to profit or loss. The accounting entries will be:

• Dr currency contract - 拢50,000
• Cr CFHR (OCI) - 拢49,000
• Cr Income Statement 拢1,000

On 10 January 2006 - somewhat earlier than expected - the company receives the sales proceeds of 鈧�1.5 million. It terminates the currency contract, which has a fair value of 拢52,000 at that date, receiving 拢52,000 cash on termination. As at 10 January, the hedge is tested and found to be 100% effective.

The fair value of the hedge has increased by 拢2,000. However, the hedge is now fully effective, so that the cumulative amount in OCI needs to reflect the entire 拢52,000 increase in fair value. This means the accounting is:

• Dr currency contract - 拢2,000
• Cr CFHR (OCI) - 拢3,000
• Dr Income Statement 拢1,000

On 10 January 2006 the forecast transaction takes place, so the cumulative fair value in equity must be 鈥榬ecycled鈥� to P&L. The accounting entries are:

• Dr CFHR (OCI) - 拢52,000
• Cr Income Statement - 拢52,000

The currency contract is net settled:

• Dr cash - 拢52,000
• Cr currency contract - 拢52,000

The net result is that 拢1,000 of the 鈥榗ash profit鈥� on the currency contract is recognised in profit or loss in year ended 31 December 2005, and the remaining 拢51,000 in year ended 31 December 2006. At the same time, the company records the receipt of the 鈧�1.5 million from the customers (Dr cash, Cr sales). This is translated into sterling at the spot rate for 10 January.

Footnotes

1. The above example is very simplistic, and designed to give an overview of the accounting entries only. The example does not take into account the movement in the fair value of the foreign currency forward which is related to the interest rate differential between the currencies in the forward contract, often described as 鈥榝orward points鈥�. It is common to exclude the fair value movements on the forward points from the hedge relationship in order to improve hedge efficiency. If the forward points movement is excluded from the hedge relationship, the gain or loss arising from this variable is recognised in profit or loss, usually as interest income or expense.
2. The above example also assumes that the sale is recognised at the same point in time that cash is received. In reality, a debtor would be recognised for a period between revenue recognition and cash receipt. This debtor is a monetary item and will be re-translated at the closing rate of a reporting period with any gain or loss being recognised in the income statement. A company may de-designate the hedge relationship in order that the movement on the fair value of the derivative offsets currency movements of the receivable.