[Anonymous]

Hi! I keep having trouble on FAR questions because I know how to classify the gains and losses, but I can’t tell whether they are a fair value hedge or a cash flow hedge (which obviously changes the classifications)! Will the questions specify which type they are? Or can someone explain? Thank you!

[NYaccountingstudent]

im looking for the answer to this aswell

[Anonymous]

No problem. I would also expect not to be told which it is.

Cash flow hedges attempt to fix streams of payments – affecting the statement of cash flows. Fair value hedges try to fix the net value (net of the hedge) of an asset or liability. It has balance sheet effects.

Example: Cash flow hedge
Interest rate hedge – you are receiving/paying interest at a rate which varies depending on the libor or 10 year treasury rate. You think rates will go down/up, so you hedge the cash flows to fix the money you receive/pay. It will leave you better off if your prediction is true. Changes the characteristics of how cash will be flowing in.

Fair value hedge:
You are a real estate company. You bought a ton of property. For some reason, you have to hold the property at fair value on your books and mark the changes Year to year. Maybe it messes with your asset to liability ratios every year; maybe it messes up your income statement. You get something which moves in “value” in the opposite direction as your asset/liability – so the non-cash based fluctuations of value cease.

One alters cash while the other corresponds with changes to asset/liability value on the balance sheet.

[Anonymous]

There is a REALLY good article about this that I downloaded awhile back. Nevermind that it says IFRS. The explanation applies to GAAP too.

https://www.ifrsbox.com/difference-fair-value-hedge-cash-flow-hedge/

I will tell you, this area is not generally heavily tested on FAR. You just need to know the basics. The way I think of it…and my explanation is rather thumb-nail and lacking anything in depth because trying to remember the JE's for derivatives and hedging instruments is a godawful nightmare…except for those who say that FAR is a walk in the park on a sunny day.

Cash flow hedge – any gain/loss on the hedging instrument goes into AOCI (Accum Other Comprehensive Income) and the reason is because you're hedging a subsequent event. Therefore, you can't recognize it in regular income. Want to fix your cash flows (amt paid/amt received) at a certain percent instead of paying/receiving whatever the market (fair value) is? Then you have a cash flow hedge. And, the accounting entries don't even touch the hedged item (foreign currency, cash, or other assets.)

Fair value hedge – any gain/loss on the hedging instrument is recognized in income and the reason is because you're NOT hedging a subsequent event. Therefore, you have to recognize gains and losses in regular income. Want to ONLY pay the market value or receive the market value instead of paying/receiving a fixed percent? Then you have a fair value hedge.
The accounting entries DO touch the hedged item.

Check out the article though, it's very informative.

[Anonymous]

Thank you guys!! Is it safe to assume that if it has to do with exchange rates that it is a cash flow hedge?

[Anonymous]

Foreign currency hedge? Yes, usually that's a cash flow hedge.

[Author]

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