Cash Flow Hedge

What is Cash Flow Hedge?

IFRS 9.6.5.2(b) defines a cash flow hedge as a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset, a recognised liability, or a highly probable forecast transaction. The entity designates a hedging instrument (typically a forward, swap, or purchased option) and documents the hedged risk, the hedge ratio, and the method for assessing effectiveness at inception.

At each reporting date, the entity separates the hedging instrument's fair value change into an effective portion and an ineffective portion. IFRS 9.6.5.11(a) requires the effective portion to be recognised in OCI within a separate component of equity (the cash flow hedge reserve). The ineffective portion goes directly to profit or loss under IFRS 9.6.5.11(b). The auditor's focus under ISA 540.13 falls on whether the entity correctly measured and split these two components, and whether the hedge designation documentation existed at inception rather than being prepared after the fact.

Reclassification from OCI to profit or loss happens when the hedged forecast transaction affects earnings. If the hedged item is a non-financial asset or liability (inventory purchased in a foreign currency, for example), the entity can transfer the OCI balance into the initial cost of that asset under IFRS 9.6.5.11(d)(i). This is the "basis adjustment" option, and it changes the carrying amount that feeds into cost of goods sold or depreciation.

Worked example

Client: Danish maritime logistics company, FY2025, revenue EUR 140M, IFRS reporter. Henriksen has a five-year floating-rate loan of EUR 20M (EURIBOR + 1.20%) drawn on 1 July 2023. To fix its interest cost, Henriksen enters an interest rate swap on 1 January 2025 (receiving 3-month EURIBOR, paying fixed 3.10%) with a notional of EUR 20M, maturing 30 June 2028.

Step 1 — Designation at inception

On 1 January 2025, the treasury function designates the swap as a cash flow hedge of the variability in EURIBOR-linked interest payments on the EUR 20M loan for the period January 2025 to June 2028. The hedge documentation identifies the hedged risk (benchmark interest rate risk only), the hedge ratio (1:1, matching notional and repricing dates), and the effectiveness assessment method (hypothetical derivative comparison).

Documentation note: file the hedge designation memo dated 1 January 2025, signed by the CFO, specifying all elements required by IFRS 9.6.4.1(b). Retain the swap confirmation from the bank counterparty alongside the designation.

Step 2 — Effectiveness assessment at 31 December 2025

At year-end, 3-month EURIBOR stands at 3.45%, up from 2.80% at designation. The swap has a positive fair value to Henriksen of EUR 312,000 (the present value of receiving a higher floating rate than the fixed rate Henriksen pays). The hypothetical derivative (a perfect swap matching the loan's EURIBOR resets exactly) shows a fair value change of EUR 318,000. The hedge is highly effective; the EUR 6,000 difference represents ineffectiveness.

Documentation note: attach the swap valuation from an independent pricing source, the hypothetical derivative calculation, and the ineffectiveness computation. Record the qualitative assessment confirming the economic relationship persists under IFRS 9.6.4.1(c).

Step 3 — Journal entries at 31 December 2025

Henriksen recognises the EUR 312,000 effective portion in OCI (Dr: Derivative asset EUR 318,000 / Cr: OCI EUR 312,000 / Cr: Profit or loss EUR 6,000). The EUR 6,000 ineffective portion hits finance costs immediately.

Documentation note: post the split entry with a cross-reference to the ineffectiveness calculation. Disclose the cash flow hedge reserve movement in the notes per IFRS 7.24A, including the amount reclassified during the period and the balance remaining in OCI.

Step 4 — Reclassification to profit or loss

Each quarter, as the hedged interest payments occur, Henriksen reclassifies a portion of the OCI balance to finance costs under IFRS 9.6.5.11(d)(i). For Q1 2026, the reclassification matches the difference between what Henriksen would have paid at floating (3.45%) and the fixed rate effectively locked in (3.10%) on the EUR 20M notional for the quarter.

Documentation note: reconcile the reclassification amount to the actual interest payment differential. The OCI balance should decline as each hedged cash flow occurs and increase or decrease only for new fair value changes on the remaining hedge term.

Conclusion: the swap's EUR 312,000 gain deferred in OCI offsets the higher floating interest Henriksen will pay over the hedge term, and the designation is defensible because the memo predates the swap trade, the hedge ratio matches the loan's repricing profile, and ineffectiveness of EUR 6,000 has been separately recognised in profit or loss.

Why it matters in practice

• The FRC's 2022/23 annual review of corporate reporting identified that entities frequently failed to provide the IFRS 7.24A disclosures for cash flow hedges, including the amounts remaining in the hedge reserve, the timing of expected reclassifications, and the line items affected. The finding applied even where the hedge qualification itself was correct.
• Teams routinely designate a cash flow hedge weeks after the derivative trade date, then backdate the designation memo. IFRS 9.6.4.1(b) requires formal documentation at inception. ISA 540.20 directs the auditor to evaluate whether the entity's method was applied consistently from the outset, which means inspecting the memo date against the trade confirmation date. A discrepancy invalidates the hedge from day one.

Cash flow hedge vs. fair value hedge

The choice between cash flow and fair value designation depends on the nature of the exposure. A floating-rate borrower hedging interest variability designates a cash flow hedge. A fixed-rate borrower converting to floating designates a fair value hedge.

Related terms

Frequently asked questions