4 Essential Facts to Demystify Basic Cash Flow Hedges

Cash flow risk is defined as the variability of functional cash flows for an anticipated transaction or on an existing asset/liability due to a particular risk (in this case, foreign currency risk).

Companies often use Cash Flow hedges to protect margins, revenues and expenses from foreign exchange risk.

When it comes to designating Cash Flow hedges, these four main facts are important to know:

1. Hedged exposures must meet specific guidelines to receive special accounting treatment
2. The timing and probability of exposures are critical to successful Cash Flow hedges
3. The birth of a Cash Flow exposure will inform when to start hedging
4. Hedging cash flows to exposure maturity reduces derivative trading volume

Types of Cash Flow Exposures

In order to apply Cash Flow special hedge accounting, you first have to identify a qualifying hedge-able exposure.

Anticipated foreign currency Cash Flow exposures must be denominated in a currency other than an entity’s functional currency. They also must be probable to occur — probable in this scenario means roughly 80% or higher confidence it will occur within the hedge period. The hedging of anticipated currency transactions (revenues and costs) is the most common application of Cash Flow hedging for corporations. Recently, companies have also started designating large, long dated non-functional currency assets and liabilities (such as leases) to take advantage of Cash Flow hedge treatment to straight-line the forward point impact into earnings.

Let’s take a look at different types of exposures and walk through a series of examples for a US company with subsidiaries in the UK, France and Japan and evaluate which scenarios would qualify as a Cash Flow exposures:

(1) GBP Denominated Sales in a UK subsidiary that is USD Functional

Since the sales are denominated in GBP but the entity is USD functional, anticipated and probable GBP sales qualify as a hedge-able exposure. Hedged revenues will be recognized in the P&L at the hedge rate.

(2) GBP Denominated Expenses in a UK subsidiary that is USD Functional

This works the exact same way as the first exposure — since the expenses are denominated in a currency other than the functional currency, the company can Cash Flow hedge the anticipated, probable GBP expenses. The hedged costs will be recognized in the P&L at the hedge rate.

(3) EUR Denominated Sales at a French subsidiary that is EUR Functional

The EUR sales do not qualify for Cash Flow hedge accounting since the sale and functional currencies are the same.

(4) JPY Denominated Inter-Company Sales to JPY Functional Subsidiary from a US functional entity

This one’s a little more complex. The inter-company sales are denominated in JPY and they are backed by third party JPY sales at the Japanese subsidiary, so if the inter-co transfer price is driven by the JPY 3rd party price, the USD functional entity can Cash Flow hedge the anticipated, probable JPY inter-company sales. Note: If the JPY transfer price is a USD value multiplied by the current JPY rate, then the Japanese subsidiary, not the USD entity, has the risk.

(5) EUR Denominated Lease Liability at an Irish subsidiary that is USD Functional

The non-functional monetary liability qualifies for Cash Flow Designation. Spot to spot changes impact earnings each month matching the liability. The designation allows for the orderly amortization of forward points (from a forward contract) or interest elements (from a cross currency swap), thereby protecting the company from what might otherwise be noisy time value related changes in value impacting the P&L.

Managing Uncertainty With Transaction Timing

Let’s assume you have an anticipated non-functional currency transaction that your company would like to hedge.

You’ve met the first condition — the exposure will be denominated in a currency other than the entity’s functional currency — but there is uncertainty around “when“ the forecasted transaction will occur. The accounting rules make it clear that you need to specify a time period in which the hedged exposure must be probable to occur.

How can you ensure probability with such uncertainty?

A hedge period can be a month, quarter or a year. One easy way to assert probability of the hedged item occurring is to define the hedge period to a time frame that encompasses potential delays.

For example, if your company expects a forecasted sale to close in Q1, and you’re confident it will close no later than Q2 of this year, you could designate the hedge period as follows: “The first 100M JPY denominated product revenue recorded after January 1, 2020 with a hedge period from January 1, 2020 through July 31, 2020. At designation the expected date is March 31, 2019”

This hedge period is a time frame that aligns with your confidence. Disconnects in the hedged item’s expected date and the hedge’s maturity date must be tested for a highly effective relationship. If you anticipated the transaction could happen anywhere from 3 months prior to the expected date and 3 months after, that testing should be part of the inception effectiveness assessment to avoid any need for ongoing testing. Generally speaking, timing mismatches as long as a year will pass as highly effective when hedging major currencies with forward contracts. Exotic currencies have a lower tolerance for timing disconnects.

Cash Flow Exposure Lifecycle

When thinking about hedging cash flows, it’s a good idea to understand when an exposure is created and when it ends.

For example, foreign currency cash flow risk ends when the hedged item is recorded on the financial statements as revenue/deferred revenue/expense/inventory/etc. So when does the risk begin? That answer can vary from company to company, depending on your exposure.

Classic Exposure Creation Examples

Budgeting – When FP&A selects the budget rate at which to convert the forecasted foreign expenses into USD, the exposure clock starts. Any currency rate changes between the budget rate and the current rate represents currency risk until the receivable is paid and converted to USD. This same exposure concept applies to any USD projections of foreign income or expense that are made to internal or external stakeholders. Many corporations report on the impact of year over year currency changes on their financial statements, suggesting that each year an exposure is created vis a vis the coming year.

Pricing – When companies fix the price of their goods and services in one currency and source those goods in another currency, they create margin exposure. For example, taking a widget that costs the company $100 and printing sales labels for that product at €100 starts the exposure clock. From this point, all changes in the EUR/USD exchange rate will change the margin in USD terms. The company might realize more or less than $12 (1.12 rate at this writing) on each widget sold due to the USD value of their EUR sales fluctuating. This same exposure concept applies when a company submits a bid for products and services that involve revenues or costs that are in different currencies, or when the sales margin is denominated in another currency.

Establishing an expectation through issuing or receiving a price/quote or providing a consolidated forecast can be thought of as an anchor point from which all movement in exchange rates will now change USD results.

Multi-Purpose Cash Flow Hedges

The last thing to consider when it comes to basic Cash Flow hedging is that a single hedge can serve two purposes.

Many companies hedging revenues or costs also hedge the re-measurement exposure of the related receivable or payable. There is no need to hedge Cash Flow risk and then close that hedge and replace it with a second Balance Sheet hedge when the transaction is recorded. If a hedge is designated as a Cash Flow hedge, the maturity of the derivative can be set to the expected collection date of the resulting accounts receivable. As the foreign revenue/cost is recorded, the Cash Flow hedge will be de-designated (it is no longer hedging an anticipated transaction), and future changes in value will offset the change in accounts receivable/payable in FX Gain/Loss.

Interested in learning more about ASC 815 Cash Flow exposures and hedges? Check out our webinars on the topic.