Cash Flow Accounting Treatment

Overview

Coverage

Accounting
   Cash Flow
   Fair Value
   Foreign Operations
   Speculative Trades

Effectiveness

Disclosure

Disclosure

A hedge of an upcoming, forecasted event is a "cash flow hedge." To qualify for cash flow hedge treatment, a key requirement is that exposure involves the risk of an uncertain (i.e., variable) cash flow. Derivative results must be evaluated, with a determination made as to how much of the result is "effective" and how much is "ineffective." The ineffective component of the hedge results must be realized in current income, while the effective portion is initially posted to "other comprehensive income" (OCI) and later re-classified to income in the same time frame in which the forecasted cash flow affects earnings.

For purposes of determining the amount that is appropriate to be posted to OCI, this assessment must be made on a cumulative basis. Contributions to earnings are required only if the derivative results exceed the cash flow effects of the hedged items. (Paragraph 30b)

Cash flow hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for cash flow accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, any accumulated OCI would remain there, unless (except in extenuating circumstances) it is probable that the forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter. (Paragraph 33)

Reporting entities have complete discretion to un-designate cash flow hedge relationships at will and later re-designate them, assuming all hedge criteria are again (or still) satisfied. (Paragraph 32c)

Examples of exposures that qualify for cash flow hedge accounting

• Interest rate exposures that relate to a variable or floating interest rates
• Planned purchases or sales of assets
• Planned issuances of debt or deposits
• Planned purchases or sales of foreign currencies
• Currency risk associated with prospective cashflows that are not denominated in the functional currency

Eligible risks (Paragraphs 29g and 29h)

• Currency risk associated with (a) a forecasted transaction in a currency other than the functional currency, (b) an unrecognized firm commitment, or (c) a recognized foreign-currency denominated debt instrument.
• The entire price risk associated with purchases or sales of non-financial goods. That is, unless the purchase or sale specifically relates to buying or selling individual components, the full price of the good in question must be viewed as the hedged item.
• For financial instruments, hedgeable exposures include cash flow effects to (a) changes in the full price of the instrument in question, (b) changes the benchmark rate of interest (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), (c) changes associated with the hedged item's credit spread relative to the interest rate bench mark (d) changes in cash flows associated with default or the obligors' creditworthiness, and (e) changes in currency exchange rates. (Paragraph 29h)

Prerequisite requirements to qualify for cash flow accounting treatment

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. (Paragraph 28a)
• Dates (or periods) for the expected forecasted events and the nature of the exposure involved (including quantitative measures of the size of the exposure) must be explicitly documented. (Paragraph 28a)
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to changes in the cash flows associated with the hedged item. (Paragraph 28b)
• The forecasted transaction must be probable. (Paragraph 29b)
• The forecasted transaction must be made with a different counterparty than the reporting entity. (Paragraph 29c)

Dis-allowed situations (i.e., when cash flow accounting may not be applied)

• In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option. (Paragraph 28c)
• In general, basis swaps do not qualify for cash flow accounting treatment unless both of the variables of the basis swap are linked to two distinct variables associated with two distinct cash flow exposures. (Paragraph 28d)
• Cross currency interest rate swaps do not qualify for cash flow hedge accounting treatment if the combined position results in exposure to a variable rate of interest in the functional currency. This hedge would qualify, however, as a fair value hedge.
• With held-to-maturity fixed income securities under Statement 115, interest rate risk may not be designated as the risk exposure in a cash flow relationship. (Paragraph 29e)
• The forecasted transaction may not involve a business combination subject to Opinion 16 and does not involve (a) a parent's interest in consolidated subsidiaries, (b) a minority interest in a consolidated subsidiary, (c) an equity-method investment, or (d) an entity's own equity instruments. (Paragraph 29f)
• Prepayment risk may not be designated as the hedged item. (Paragraph 29h)
• The interest rate risk to be hedged in a cash flow hedge may not be identified as a benchmark interest rate, if a different variable interest rate is the specified exposure -- e.g., if the exposure is the risk of a higher prime rate, LIBOR may not be designated as the risk being hedged. (Paragraph 29h)

Internal derivatives contracts

• Except in the case when currency derivatives are used in cashflow hedges, derivatives between members of a consolidated group (i.e., internal derivatives) cannot qualify as hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis. (Paragraph 36)
• For an internal currency derivative to qualify as a hedging instrument in a consolidated statement, it must be used as a cashflow hedge only for a foreign currency forecasted borrowing, a purchase or sale, or an unrecognized firm commitment, but the exposurefollowing conditions apply:
  • The non-hedging counterpart to the internal derivative must offset its net currency exposure with a third party within 3 days of the internal contract's hedge designation date. (Paragraph 40)
  • The third-party derivative must mature within 31 days of the internal derivative's maturity date. (Paragraph 40)