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What is the difference between Cash Flow Hedge and Fair Value Hedge? Would you please illustrate it with an example?
Hi,
Have you watched the video and read through the notes? I do need to do a little bit more on hedging but there is enough to understand the difference between the two types of hedge accounting.
If you are more specific about what you don’t understand then I can help.
Thanks
(1) “Chive has a firm commitment to buy an item of machinery for CU 2m on 31 March 20×2. The Directors are worried about the risk of exchange rate fluctuations……….”
This is a question from Kaplan Text and in the answer it says this is a Fair Value Hedge.
(2) “In January, Grayton, whose functional currency is the dollar ($), decided that it was highly probable that it would buy an item of plant in one year’s time for KR 200,000. As a result of being risk averse, it wished to hedge the risk that the cost of buying KRs would rise and so entered into a forward rate agreement to buy KR 200,000 in one year’s time for the fixed sum of $100,000……………….”
This is another question from Kaplan Text and in the answer it says it is a Cash Flow Hedge.
Now my question is in both the questions, the entity is thinking of buying an asset in the future and is accordingly exposed to the risk of FOREX. I don’t see any difference between the two, but how come the (1) is Fair Value Hedge and the (2) is Cash Flow Hedge??
Please sir help me out……..
Hi,
Thanks for the extra detail and I can see where the confusion arises. The key aspect of (1) is that the purchase is “a firm commitment” and hence is designated as a fair value hedge. Why? Well we are going to buy the asset, given the firm commitment, and so it will appear in the financial statements and so we are looking to protect its fair value in the accounts. It also states in IFRS 9.
In (2) it is only highly probable, there is no firm commitment, so it is therefore a cash flow hedge.
Thanks
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