As is the case with a fair value hedge, special hedge accounting is not available for a cash flow hedge unless a number of criteria are satisfied. Cash flow hedges must also meet the criteria regarding documentation and assessment of effectiveness. Although set forth in greater detail in the FASB’s Statements of Financial Accounting Standards,8 selected qualifying criteria for a cash flow hedge are set forth in below
1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.
1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.
2. Both at inception and on an ongoing basis, the hedging relationship must be assessed to determine if it is highly effective in achieving offsetting cash flows attributable to the hedged item’s fair value. The effectiveness of the hedging instrument must be assessed whenever financial statements or earnings are reported and at least every three months.
3. If a hedging instrument is used to modify variable interest rates on a recognized asset or liability to another variable interest rate (such instruments are known as basis swaps), the hedging instrument must be a link between a recognized asset with variable rates and a recognized liability with variable rates. For example, an entity with a variable rate loan receivable (e.g., prime rate 1%) and a variable rate loan payable (e.g., LIBOR) may use a hedging instrument (e.g., swap prime rate 1% for LIBOR) to link the two variable rate instruments.
4. The forecasted transaction is specifically identified as a single transaction or a group of individual transactions.
5. The forecasted transaction is with an external party, probably will occur, and presents exposure to variability in cash flows that could affect earnings.
6. The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be measured at fair value with changes in fair value being currently recognized in earnings. If the forecasted transaction relates to a recognized asset or liability, such asset or liability is not remeasured with changes in fair value being reported in current earnings.
7. For the forecasted purchase or sale of a nonfinancial item (such as inventory), the risk being hedged against is the change in cash flows due to price/rate changes rather than a change in cash flows due to a different location or a component part.
8. The forecasted purchase or sale of a financial asset or liability (or the interest payments on that asset or liability) or the variable cash flows associated with an existing financial asset or liability can be designated as a hedged item if certain types of risks, such as those related to changes in cash flows, benchmark interest rates, foreign currency exchange rates, and creditworthiness are being hedged. Two or more of the above risks may be hedged simultaneously. Prepayment risk may not be designated as the risk being hedged