# How to Account for a Cash Flow Hedge

by Bryan Keythman

A cash flow hedge is the use of a hedging instrument to limit the risk of uncertain cash flows from a future transaction, such as purchasing building materials. A hedging instrument is an investment vehicle, such as a futures contract, that allows you to lock in a fixed price for a future transaction, which can reduce uncertainty. An increase in value of a hedging instrument increases your stockholders’ equity while you hold the hedging instrument. You later transfer this value to an income statement account, which increases your profit.

1. Determine the terms of a hedging instrument that you purchased to use as a cash flow hedge. Determine the number of units of the item the hedging instrument allows you to buy, and the price for which you can buy each unit. For example, assume a futures contract allows you to buy 100 bushels of corn within 90 days for \$6 per bushel. Also assume you will use the corn to make food to sell in your store.

2. Determine at the end of the accounting period the market price of the item that your hedging instrument allows you to buy. Subtract your contract price per unit from the market price per unit. Multiply the result by the number of units that your contract allows you to buy to determine the hedging instrument’s value. In the example from the previous step, if the market price per bushel of corn is \$7 at the end of the period, subtract \$6 from \$7 to get \$1. Multiply \$1 by 100 bushels to get a \$100 value of the futures contract.

3. Create a new journal entry in your records at the end of the accounting period. Debit the “futures contract” account by the contract’s value. Credit the “unrealized holding gain or loss - equity” account by the same amount, which increases your stockholders’ equity. In this example, debit the futures contract account by \$100 and credit the unrealized holding gain or loss equity account by \$100

4. Create a new journal entry when you settle, or complete, the hedging instrument contract, which is when you purchase the underlying item. Debit the cash account by the hedging instrument’s value. Credit the futures contract account by the same amount. In this example, debit cash by \$100 and credit the futures contract account by \$100.

5. Create a new journal entry when you sell the products that you made using the underlying item. Debit the unrealized holding gain or loss - equity account by the hedging instrument’s value. Credit the cost of goods sold account by the same amount. This transfers the value of the hedging instrument from your equity to your income statement by reducing cost of goods sold, which increases your profit. Continuing with the example, debit unrealized holding gain or loss - equity by \$100. Credit cost of goods sold by \$100.

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