Difference Between Fair Value Hedge and Cash

Flow Hedge
The first thing you need to do before you even start to play with hedge accounting is
to determine the TYPE of hedge relationship that youre dealing with.
Why?
Because: the type of hedge determines your accounting entries. Make no mistake
here. If you incorrectly identify the type of the hedge, then your hedge accounting will
go totally wrong.
But heres the thing:
Although all types of hedges are neatly defined in IAS 39/IFRS 9, we all struggle with
understanding the differences and distinguishing one type from the other one.
A few weeks ago I was giving a lecture about hedge accounting to the group of
auditors. Most of them were audit managers and seniors so not really freshmen, but
experienced and highly qualified people.
Yet after about 5 or 10 minutes of speaking about different types of hedges, one audit
manager interrupted me with the question:
Silvia, I get the definitions. I just dont get the difference. I mean the real substance of
a difference between fair value hedge and cash flow hedge. It looks the same in many
cases. Can you shed some light there?
Of course.

What types of hedges do we have?

Although I clearly explain a hedge accounting in details in my IFRS Kit, let me shortly
explain what type of hedges we have:
1 Fair Value Hedge;
2 Cash Flow Hedge, and
3 Hedge of a Net Investment in a Foreign Operation but we will not deal with this
one here, as its almost the same mechanics as a cash flow hedge.

First, lets explain the basics.

What is a Fair Value Hedge?

Fair value hedge is a hedge of the exposure to changes in fair value of a recognized
asset or liability or unrecognized firm commitment, or a component of any such item,

that is attributable to a particular risk and could affect profit or loss.

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Thats the definition in IFRS 9 and IAS 39.
So here, you have some fixed item and youre worried that its value will fluctuate
with the market. Ill come back to this later.

How to Account for a Fair Value Hedge?

OK, lets not go into details and lets just assume that your fair value hedge meets all
criteria for hedge accounting.
In such a case, you need to make the following steps:
Step 1:
Determine the fair value of both your hedged item and hedging instrument at the
reporting date;
Step 2:
Recognize any change in fair value (gain or loss) on the hedging instrument in profit
or loss (in most cases).
You need to do the same in most cases even if you dont apply the hedge
accounting, because you need to measure all derivatives (your hedging
instruments) at fair value anyway.
Step 3:
Recognize the hedging gain or loss on the hedged item in its carrying amount.
To sum up the accounting entries for a fair value hedge:
Description
Debit
Credit
Hedging instrument:
Loss on the hedging
P/L FV loss on hedging
FP Financial liabilities from
instrument
instrument
hedging instruments
OR
Gain on the hedging
FP Financial assets from P/L FV gain on hedging
instrument
hedging instruments
instrument
Hedged item:
Gain on the hedged item
FP Hedged item (e.g.
P/L Gain on the hedged item
inventories)
OR
Loss on the hedged item
P/L Loss on the hedged FP Hedged item (e.g.
item
inventories)
Note: P/L = profit or loss, FP = statement of financial position.

What is a Cash Flow Hedge?

Cash flow hedge is a hedge of the exposure to variability in cash flows that is
attributable to a particular risk associated with all or a component of a recognized
asset or liability or a highly probable forecast transaction, and could affect profit or
loss.
Again, thats the definition in IAS 39 and IFRS 9.

Here, you have some variable item and youre worried that you might get less
money or have to pay more money in the future than now.
Equally, you can have a highly probable forecast transaction that hasnt been
recognized in your accounts yet.

How to Account for a Cash Flow Hedge?

Assuming your cash flow hedge meets all hedge accounting criteria, youll need to
make the following steps:
Step 1:
Determine the gain or loss on your hedging instrument and hedge item at the
reporting date;
Step 2:
Calculate the effective and ineffective portions of the gain or loss on the hedging
instrument;
Step 3:
Recognize the effective portion of the gain or loss on the hedging instrument in
other comprehensive income (OCI). This item in OCI will be called Cash flow
hedge reserve in OCI.
Step 4:
Recognize the ineffective portion of the gain or loss on the hedging instrument in
profit or loss.
Step 5:
Deal with a cash flow hedge reserve when necessary. You would do this step
basically when the hedged expected future cash flows affect profit or loss, or
when a hedged forecast transaction occurs but lets not go in details here, as
its all covered in the IFRS Kit.
To sum up the accounting entries for a cash flow hedge:
Description
Debit
Credit
Loss on the hedging
OCI Cash flow hedge
FP Financial liabilities from
instrument effective
reserve
hedging instruments
portion
Loss on the hedging
P/L Ineffective portion of FP Financial liabilities from
instrument ineffective
loss on hedging
hedging instruments
portion
instrument
OR
Gain on the hedging
FP Financial assets from OCI Cash flow hedge reserve
instrument effective
hedging instruments
portion
Gain on the hedging
FP Financial assets from P/L Ineffective portion of
instrument ineffective
hedging instruments
gain on hedging instrument
portion
Note: P/L = profit or loss, FP = statement of financial position, OCI = other
comprehensive income.
As you can see, you dont even touch the hedged item here and you only deal with
the hedging instrument. So thats completely different from fair value hedge
accounting.

How to Distinguish Fair Value Hedge and Cash Flow

Hedge?

What Im going to explain right now is my own logic of looking at this issue. Its not
covered in any book.
Its how I look at most hedging transactions and this is a very simplified view. But
maybe it opens up your mind to logical thinking about hedges.
Please, ask first:

What kind of item are we hedging?

Basically, you can hedge a fixed item or a variable item.

Hedging a Fixed Item

A fixed item means that the item has a fixed value in your accounts and it may
provide or require fixed amount of cash in the future.
The same applies for unrecognized firm commitments that have not been sitting in
your accounts yet, but they will be in the future.
And when it comes to hedging fixed items, then youre practically dealing with the
fair value hedge.
Why is that?
Well, here, you are worried, that in the future, you would be paying or receiving a
different amount than the market or fair value will be. So you dont want to FIX the
amount, you want to GET or PAY exactly in line with the market.
Im referring to GET or PAY only for the sake of simplicity. In fact, you dont even
need to get or pay anything in the future youre just worried that the item will have a
different carrying amount in your books that its fair value.

Fair Value Hedge Example

You issued some bonds with coupon 2% p.a.

Its nice that you always know how much youll pay in the future.
BUT you are worried that in the future, market interest rate will be much lower than
2% and you will be overpaying (in other words, you could get the loan at much lower
interest in the future than you will be paying at the fixed rate of 2%).
Therefore, you enter into interest rate swap to receive 2% fixed / pay LIBOR12M +
0.5%. This is a fair value hedge you tied the fair value of your interest payments to
market rates.

Hedging a Variable Item

A variable item means that the expected future cash flows from this item change
as a result of certain risk exposure, for example, variable interest rates or foreign
currencies.
When it comes to hedging variable items, youre practically speaking of a cash flow
hedge.
Why is that?
Here, you are worried that you will get or pay a different amount of moneyin certain
currency in the future that you would get now.
In fact, in a cash flow hedge, you want to FIX the amount of money youll get or pay
so that this amount would be the same NOW and IN THE FUTURE.

Cash Flow Hedge Example

You issued some bonds with coupon LIBOR 12M+0.5%.
It means that in the future, you will pay interest in line with the market, because LIBOR
reflects the market conditions.
BUT you dont want to pay in line with market. You want to know how much you will
pay in the future, as you need to make some budget, etc.
Therefore you enter into interest rate swap to receive LIBOR 12 M + 0.5% / pay 2%
fixed. This is cash flow hedge you fixed your cash flows and you will always pay 2%.

To Sum This All Up

Now you can see that the same derivative interest rate swap can be a hedging
instrument in a cash flow hedge as well as in a fair value hedge.
The key to differentiate is WHAT RISK you hedge. Always ask yourself, why you
undertake the hedging instrument.
But its not that simple as it seems because there are some exceptions in IAS 39 and
IFRS 9.
For example, even when you have a fixed item, you can still hedge it under cash flow
hedge and protect it against foreign currency risk.
Equally, you can hedge a variable rate debt against fair value changes and thats the
fair value hedge.
Therefore, please refer to the following table summarizing the types of hedges
according to risks and items hedged:
Item hedged
Risk hedged
Type of hedge
Fixed-rate assets and
Interest rates, Fair value,
Fair value hedge
liabilities
Termination Options
Fixed-rate assets and
Foreign currency, credit
Fair value hedge or cash
liabilities
risk
flow hedge
Unrecognized firm
Interest rates, Fair value,
Fair value hedge

commitments
Unrecognized firm
commitments
Variable-rate assets and
liabilities
Variable-rate assets and
liabilities
Highly probable forecast
transactions

Credit risk
Foreign currency

Fair value hedge or cash

flow hedge
Fair value hedge

Fair value, termination

options
Interest rates, foreign
Cash flow hedge (most
currencies, credit risk
cases)
Fair value, interest rates,
Cash flow hedge
credit risk, foreign
currency
Now, Id like to hear from you. Please leave me a comment and let me know whether
you have dealt with some hedge accounting in practice, what issues you faced and
how you solved them. Thank you!