Cash Flow Hedge Journal Entries
Cash flow hedges are used to mitigate the risk of variability in cash flows associated with a particular risk, such as changes in interest rates or foreign currency exchange rates. When a hedge is effective, it helps stabilize the underlying exposure's cash flows.
Scenario: Hedging Foreign Currency Exposure
Assume a company expects to receive $100,000 in six months from a foreign customer. To hedge against the risk of adverse foreign exchange movements, the company enters into a forward contract to sell $100,000 at a fixed exchange rate of ₹75 per USD.
Initial Recognition of the Hedge
When the hedge is designated and the forward contract is entered into:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Cash Flow Hedge A/c | | |
| To Forward Contract Liability A/c | | |
| (Being initial recognition of forward contract) | | |
Subsequent Measurement (Recognizing Hedge Effectiveness)
Assume after three months, the forward rate changes and the fair value of the forward contract is ₹2,00,000 in favor of the company:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Forward Contract Asset A/c | 2,00,000 | |
| To Cash Flow Hedge A/c | | 2,00,000 |
| (Being recognition of hedge effectiveness) | | |
Settlement of the Forward Contract
When the forward contract is settled at maturity:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Cash/Bank A/c | 75,00,000 | |
| To Forward Contract Asset A/c | | 75,00,000 |
| (Being settlement of forward contract) | | |
Recognizing the Hedged Item (Receipt of Foreign Currency)
When the foreign currency is received from the customer:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Accounts Receivable A/c | 75,00,000 | |
| To Sales Revenue A/c | | 75,00,000 |
| (Being recognition of foreign currency receipt) | | |
Explanation:
- Initial Recognition: No journal entry is typically needed; it's just a designation of the hedge relationship.
- Subsequent Measurement: Recognizes changes in the fair value of the forward contract.
- Settlement of Forward Contract: Reflects the receipt of cash upon settlement.
- Recognizing the Hedged Item: Records the actual receipt of foreign currency against sales revenue.
Detailed Example:
Initial Recognition of the Hedge:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Cash Flow Hedge A/c | | |
| To Forward Contract Liability A/c | | |
| (Being initial recognition of forward contract) | | |
Subsequent Measurement:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Forward Contract Asset A/c | 2,00,000 | |
| To Cash Flow Hedge A/c | | 2,00,000 |
| (Being recognition of hedge effectiveness) | | |
Settlement of the Forward Contract:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Cash/Bank A/c | 75,00,000 | |
| To Forward Contract Asset A/c | | 75,00,000 |
| (Being settlement of forward contract) | | |
Recognizing the Hedged Item:
| Particulars | Debit (₹) | Credit (₹) |
|---|
| Accounts Receivable A/c | 75,00,000 | |
| To Sales Revenue A/c | | 75,00,000 |
| (Being recognition of foreign currency receipt) |
