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Simplifying Fair Value Hedge vs. Cash Flow Hedge

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Hedging is primarily about protecting against adverse price movements in various financial metrics, including costs, interest rates, foreign exchange rates, and asset values. The focus of hedging is on future uncertainties and the goal is to mitigate potential negative impacts on financial performance.

In this article, we aim to simplify two accounting standards, namely fair value hedge and cash flow hedge by defining each one and then examining their use as accounting methods.

In our current climate of economic uncertainty, effective risk management is crucial for businesses aiming to maintain stability and predictability in their financial performance. One of the key strategies for achieving this is hedging. Hall Accounting Company offers fractional CFO services to SMEs that want to focus on strategic financial planning.

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Introduction to hedge accounting

Hedge accounting is governed by specific standards that ensure consistency and transparency in financial reporting. The main standards are:

  • ASC 815

  • IFRS 9

These standards outline the criteria for fair value hedges and cash flow hedging, including the designation, documentation, and effectiveness assessment of hedging relationships. They also specify the accounting treatment for the different types of hedges, ensuring the financial statements reflect the economic effects of hedging activities.

Accurate compliance with these standards is crucial for maintaining the integrity of financial reports. For instance, a fractional CFO will ensure that hedging activities are properly documented and reported in accordance with acceptable accounting practices, helping businesses avoid financial misrepresentation.

This issue has actually become pretty important of late as more reports of abuse arise from hedging practices. In truth no CFO, CEO, or COO wants to deal with the unsystematic use of hedges, leading to inaccurate financials. That is why hedge accounting in the hands of a competent CFO is invaluable. Priceless in fact.


Types of hedges

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Fair value hedge

A fair value hedge aims to offset changes in the fair value of a recognized asset, liability, or an unrecognized firm commitment that can affect reported earnings. Both the hedged item and the hedging instrument are marked to market, with changes in their fair values recognized in earnings. This approach ensures that the gains or losses from the hedging instruments are matched with the losses or gains from the hedged item.

Let’s simplify this with an example: A company has issued $10 million in fixed-rate bonds at 5% interest rate. To hedge (or protect) against rising interest rates, the company enters into an interest rate swap, converting the fixed rate payments into variable rate payments. The changes in the fair value of both the bonds and the swap are recognized as earnings.

Cash flow hedge

Cash flow hedges aim to offset variability in cash flows that could affect the income statement, such as forecasted transactions.

Cash flow hedge accounting requires that the effective portion of gains or losses on the hedging instrument is initially recorded in other comprehensive income (OCI), and later reclassified into earnings when the hedged item affects earnings. The ineffective portion is recognized in current earnings.

Let’s consider another example to illustrate the effect of cash flow hedging. A U.S. based company expects to sell goods worth €3m to a European customer in three months. To hedge against euro/dollar exchange rate fluctuations, the company enters into a forward contract to sell €3m in three months at a predetermined rate. The effective rate of gains or losses on the forward contract is recorded in OCI and reclassified to earnings when the sale occurs.

Net investment hedge vs. cash flow hedge

A common confusion here is cash flow hedges vs net investment hedges. A net investment hedge is used to mitigate the foreign exchange risk associated with a company's net investment in a foreign operation. This type of hedge helps protect the value of the investment against currency fluctuations, stabilizing the consolidated financial statements of the parent company.

What does this look like practically?

A U.S.-based company operates a subsidiary in Europe, with significant sales and investments in euros. To manage its exposure to euro/dollar exchange rate fluctuations, the company employs both cash flow hedges and a net investment hedge:

Cash Flow Hedging

A company expects to sell goods worth €3 million to a European customer in three months. It enters into a forward contract to sell €3 million at a predetermined rate.

The effective portion of gains or losses on the forward contract is recorded in OCI and reclassified to earnings when the sale occurs, thus stabilizing future cash flows.

Net Investment Hedging

To protect its net investment in the European subsidiary, a company takes out a loan in euros. Foreign exchange gains or losses on the loan are recorded in OCI and accumulate in the cumulative translation adjustment. These gains and losses offset the currency translation effects on the net investment in the subsidiary, providing stability to the consolidated financial statements.

Risk management - practical applications

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Fair value hedging

  • Hedging fixed-rate debt: A company with $10 million in fixed-rate debt uses an interest rate swap to convert fixed payments to variable payments, mitigating interest rate risk.

  • Hedging inventory: A company holding significant oil inventory enters into futures contracts to sell oil at a fixed price, protecting against price declines

  • Hedging firm commitment: A company with a firm commitment to purchase machinery in six months for €4 million uses a forward contract to lock in the exchange rate, mitigating interest risk.

Cash flow hedging

  • Hedging forecasted sales: A company expecting to sell goods in a foreign currency uses a forward contract to hedge against exchange rate fluctuations.

  • Hedging variable rate debt: A company with a variable rate debt uses an interest rate swap to pay a fixed interest rate and receive variable interest, protecting against rising interest rates.

  • Hedging future purchases: A company planning to purchase raw materials enters into futures contracts to hedge against rising prices.

These practical examples may sound pretty straightforward, but in reality, hedge accounting must be carefully applied and managed in order to achieve risk management objectives. A hedged transaction requires meticulous documentation and compliance with accounting standards.

Let’s look at some of the criteria you will have to meet in recording these transactions. This will give you a taste of what you’re in for.

Hedge documentation

Hedge designation memos must contain the following information:

  1. Type of hedging relationship (fair value, cash flow, net investment)

  2. Risk management objective and strategy

  3. The nature of the risk being hedged

  4. Identification of the hedging instrument

  5. Identification of hedged item or transaction

  6. Specificity - must be identifiable when it occurs

  7. Probability - must be probable that it will occur

  8. How hedge effectiveness will be assessed

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A fractional CFO has the skills and knowledge you need to strategically manage the future risks you face in business. Compliance with international accounting standards is critical for the correct practice of hedge accounting. Speak to a fractional CFO today!


Benefits of hedging for a business

Understandably when there are strict accounting standards you will need to apply to manage future business risks, you need to be sure that the implementation of hedging will ultimately benefit your business.

1. You protect the profitability of your business

Through strict control of costs and revenues, hedging can help to maintain the profitability of your business. This is particularly important in industries with thin profit margins. Think of an airline. They are constantly affected by changes in fuel prices. The major challenge here is to stabilize operating costs and ticket prices. We can all understand the volatility of the airline industry.

So how does the airline handle this?

They enter into futures contracts to lock in the price of fuel on future dates. This means that regardless of future price fluctuations, the airline will pay the agreed-upon price, thus securing cost control and ticket pricing.

Stable ticket prices enhance customer trust and satisfaction as airline passengers appreciate competitive and fair pricing. Airlines that manage their pricing strategy can offer more competitive prices to budget-conscious travelers and in return maintain their market share.

Two real-world examples come from Southwest Airlines and Delta Airlines. Southwest Airlines applied an aggressive fuel hedging strategy in the mid-2000s and this helped to maintain its competitiveness when fuel prices soared. Delta Airlines took a unique route and purchased its own oil refinery. This vertical integration allowed Delta to control fuel costs and pricing. [1,2]

2. Improves credit ratings and access to capital

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Companies with stable and predictable financial performance are viewed more favorably by credit rating agencies and lenders. Lower borrowing costs can give huge benefits to a company that wants to engage in expansion and product development.

ExxonMobil is one of the largest publicly traded oil and gas companies in the world. Given the inherent volatility in oil prices, ExxonMobil employs various hedging strategies to manage its exposure to fluctuations in crude oil prices, foreign exchange rates, and interest rates.

They employ futures contracts to manage and regulate the pricing of crude oil, forward contracts, and currency swaps to protect against adverse movements in exchange rates and use interest rate swaps to guarantee predictable interest rate payments.

Because of these hedging strategies, credit rating agencies, such as Moody's and S&P Global Ratings, consider ExxonMobil’s comprehensive risk management strategies when assessing its creditworthiness. The company’s proactive approach to risk management is reflected in its high credit ratings.

ExxonMobil has been able to maintain high credit ratings, even in times of low oil prices because of their future-forward hedging strategies.

What role can a fractional CFO play in risk management strategies?

Employing a fractional CFO to execute hedging strategies has significant advantages for businesses, particularly in managing financial risks. Here are three key reasons why we recommend hiring a qualified CFO:

  • A fractional CFO brings specialized expertise in financial risk management, including in-depth knowledge of hedging instruments such as futures, options, and swaps. This expertise is crucial for designing and implementing effective hedging strategies that align with the company’s risk tolerance and financial goals.

  • Hiring a fractional CFO is more cost-effective than employing a full-time CFO, especially for small and medium-sized enterprises (SMEs) that may not need or afford a full-time executive. A fractional CFO provides high-level financial expertise on a part-time basis, tailored to the company’s specific needs.

  • Implementing hedging strategies requires strict adherence to accounting standards such as ASC 815 and IFRS 9. A fractional CFO ensures that all hedging activities are properly documented, reported, and compliant with these regulations, thereby reducing the risk of financial misstatements and regulatory penalties.

There are other reasons for hiring a fractional CFO to manage your hedge strategy and we would be happy to discuss those with you after discussing your needs and evaluating your risk management objectives.


Final Thoughts

Fair value hedging, as well as cash flow hedging, are two highly effective accounting methods for protecting your business interests in the future against losses. If your business is subject to market volatility due to exchange rates, interest rates, and fluctuating prices then employing these risk management strategies is the right way to go.

However, the worst-case scenario would be to do this without compliance to the accounting standards, using the methods incorrectly, and having no real business case for using hedging. These kinds of things lead to financial misrepresentation that can ultimately land you in hot water.

Speak to someone who is qualified to understand, manage, and accurately employ these risk management strategies and it will be the best decision you’ll make to protect your business against changing economic conditions.

We would love to work with you on this. If you think you need help, you can give us a call and there won’t be any obligation to take up our services after the call. We understand that choosing a CPA accounting firm is as important as choosing a lawyer. You need to be sure that you’re going to get the expertise you came looking for.

We’re ready to talk, are you?




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