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How do I calculate the effective and ineffective portion for a cash flow hedge?
@wesbyss said:
The maximum effective portion will be the change in fair value of the hedged item.If the change in fair value of the hedging instrument is greater, the excess will be the ineffective portion.
Can you provide me with an example? Thank you.
@wesbyss said:
You have a financial assets (“hedged item”). You expect that the future cash flow of the financial assets will drop in future, so you enters into a derivative contract (“hedging instrucment”) and document the relationship of these two items as a cash flow hedge. Assume the fair value of the hedging item is 0 when you enter.Say the fair value of the future cash flow of the hedged item now actually drops, say by $700.
The accounting treatment will be different if the fair value of the hedging item is $1000.
$700 is effective and $300 is ineffective.
A perfectly effective hedge means that the upside of hedge item and the downside of hedging item is the same, and vice versa.
I don’t quite understand this example. This is a very confusing example.
How can the fair value of the hedging item is 0?
If the FV of future cash flow of hedged item dropped by $700, how can the fair value of hedging item be $1,000? Do you actually mean this $1,000 is hedge instrument?Hey wesbyss… have you written p2? and if so when did you write…. i have noticed that you are very knowledgeable about the content. is it possible to tell me a little about yourself and how you understand the material so clearly?
@wesbyss said:
The maximum effective portion will be the change in fair value of the hedged item.If the change in fair value of the hedging instrument is greater, the excess will be the ineffective portion.
Hi,
Based on your first reply it seems that the $1,000 is a hedge instrument. Since the $1,000 (increase) is greater than the the change in future cash flow of the hedged item which is $700 (decrease):$700 – effective portion (Gain)
Debit – Financial assets $700
Credit – OCI (Cash flow hedge reserve) $700$300 – ineffective portion (Gain)
Debit – Financial assets $300
Credit – P/L (Ineffective portion of gain on hedging instrument)Am I getting it right?
And 1 more question. What if the change in hedged instrument is lesser than the change in hedged item? How to deal with it?
Thanks.@wesbyss said:
The amount of gain / loss is recognised in OCI until the hedge is greater than the gain / loss in the hedged item. You are correct that the excess portion is recognized in P/L.In other words, if the change in hedging instrument is less than the change in hedged item (say 500), the full amount should go to OCI. (i.e. you dont treat the shortage portion as ineffective.)
By the way, the debit side should be the “derivative” (or the “hedged item”), if it is a CASH FLOW hedge.
Hi,
I thought the derivative is a hedge instrument? And based on what I know, we do not touch the hedged item for a cash flow hedge. Only the hedge instrument is affected when it comes to accounting treatment. Can you clarify this?
Thanks.
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