Solve Cash Flow Hedge Accounting Journal Entries Example

by ADAMSeptember 19, 20230 Comments

 Hello Readers


                       Today we are going to talk about the cash flow hedge journal entries Examples will help you to understand all the basics of cash flow hedge in accounting.


Now let me tell you a little definition of cash flow hedge and why we use it.


Check also:- Revenue Recognition Journal Entries Example


What is a Cash Flow Hedge?

This method is used for businesses to protect themselves from adverse cash flow movements and this financial strategy involves using derivative instruments like forward contracts, options, or swaps to offset the impact of fluctuating cash flows arising from various sources, such as variable interest rates, foreign exchange rates, or commodity prices.



Why do we use a cash flow hedge?

So many businesses face substantial uncertainty in their cash flows due to the volatile financial markets this method helps businesses to stabilize cash flow projections and protect profitability.


Types of Cash Flow Hedges


  • fair value hedges
  • cash flow hedge
  • net investment hedges


Cash Flow Hedge Example Journal Entries


Example 1:


OZY Inc. is a manufacturing company that operates internationally. It has a loan with a variable interest rate, and the management is concerned about the potential increase in interest rates, which could lead to higher interest payments and impact their cash flows. To hedge against this risk, OZY Inc. decided to enter into an interest rate swap agreement.

                       

Solution:


Details:


  • Current Loan Principal: $1,000,000
  • Current Variable Interest Rate: 5%
  • Term of the Loan: 5 years
  • Notional Amount of Interest Rate Swap: $1,000,000
  • Fixed Interest Rate in the Swap: 4%


Cash Flow Hedge Journal Entries

Initial Recording of the Loan:


OZY Inc. records the initial loan:


  • Debit: Cash - $1,000,000
  • Credit: Loan Payable - $1,000,000


In this entry, you can see the company borrowing $1,000,000 at the current variable interest rate.


Step 2:- Entering into the Interest Rate Swap:


  • No journal entry is required at this stage.


Step 3: - Periodic Interest Payment (Before Hedge):


OYZ Inc. makes an interest payment on the loan based on the variable interest rate:

  • Debit: Interest Expense - $50,000 ([$1,000,000 * 5%])
  • Credit: Cash - $50,000


Note:-  interest expense is paid at the variable rate.


Step 4:- Effect of the Interest Rate Swap (Before Hedge):


makes an adjusting journal entry due to the impact of the interest rate swap:


  • Debit: Interest Expense - $10,000 ([$1,000,000 * (5% - 4%)])
  • Credit: Cash Flow Hedge Reserve - $10,000


Step 5:- Periodic Interest Payment (After Hedge):


After implementing the hedge, OYZ Inc. makes another interest payment, but this time with the effect of the hedge:


  • Debit: Interest Expense - $40,000 ([$1,000,000 * 4%])
  • Credit: Cash - $40,000

This entry reflects the reduced interest expense due to the interest rate swap.


Step 6:- Effect of the Interest Rate Swap (After Hedge):


To account for the effect of the hedge after the interest payment:


  • Debit: Cash Flow Hedge Reserve - $10,000
  • Credit: Interest Expense - $10,000


Now the example is completed.


Conclusion


This example shows how the cash flow hedge works and how to make cash flow hedge journal entries in accounting. I hope you understand this topic if you want to learn more topics then please keep visiting our blog.

0 Comments