Cash Flow hedging

Cash Flow hedging is a practice of managing risks arising from variability in cash flows that is attributable to a particular risk associated with all or a component of an asset or liability on a company’s balance sheet or a highly probable forecasted transaction and could affect future profit or loss.

For instance, let's take a UK-based importing business that accounts in Pounds Sterling but pays its providers in US Dollars. To hedge their exposure to the possibility of the Pound Sterling depreciating against the USD, the company may choose to mitigate FX risks every time they sign a deal with their suppliers. To hedge, they would enter into a forward contract to sell GBP and buy USD with the maturity date on the date of the expected payment for the contract.

This hedge would fix the GBP value of future cash flows to be paid in USD. It would protect the importer against fluctuations, particularly – against a potential increase in costs should the Pound weaken between the time of contract signing and the actual payment. 

Because the sale has not yet been invoiced, there are no Accounts Payable, and this variability due to FX fluctuations is not yet recognized on the company’s balance sheet. Nevertheless, given that the cash flows are likely (“highly probable”) to take place in the future, accounting standards such as IAS 39 and IFRS 9 allow recognizing Cash Flow hedges as a reserve in Other Comprehensive Income (OCI) part of an income statement.