Question

Define and differentiate the differences between a cash flow hedge and a fair value hedge, including when (in or under which particular or specific circumstances) a U.S.-based firm would consider using one hedge vs. the other type of hedge. Be specific. Summarize the differences that exist, if any, between the US GAAP and IFRS on the accounting for derivatives designated as hedges at the current date you are answering this question. Prepare an example of a U.S.-based firm managing an exposed foreign currency net liability position including the journal entries required from the date the U.S. firm purchases goods on account from a foreign-based supplier until the date the purchase is settled, including all journal entries required over a 3-month period of time.

Answer 1

Definition-

A hedge is a financial instrument that mitigates risk.

Fair Value Hedge- Fair value hedges mitigate the risk of changes in the fair (market) value of an asset, a liability of an unrecognized firm commitment. A fair value hedge is a type of hedging instrument designed to limit exposure to changes in the value of an asset or liability.

Cash Value Hedge- manage the risk associated with cash flows rather than asset or liability values. A cash flow hedge is designed to minimize the risk that a company will have to pay more than it expects.

Difference between Cash Value Hedge and Fair Value Hedge

Apart from the above difference, another major difference is in their accounting process.

In Fair Value Hedge, the value of the hedge and the asset that is protected , both must be included in the current period's income statement. That is gain or loss in fair value hedge are recorded in the income statement.

But in Cash Value hedge, there is no underlying asset as we are hedging cashflow rather than any asset . So when the value of hedging instrument changes , the gain or loss is recorded as other comprehensive income until the contract is executed and the gain or loss in transfeered to income statement.