Question

A regional bakery is forecasting a major purchase of flour and is considering the use of a cash flow hedge. explain how a cash flow hedge affects operating income currently and in the future as well as how such amounts are calculated.

Answer 1

Ans : A cash flow hedge is an investment method used to deflect sudden changes in cash inflows and cash outflow related to an asset liability or a forecasted transactions.

A forecasted transaction is a transaction with another party expected to take place in future.Every manufacturing or service firm regularly purchases commodities such as cotton, wheat, meat, sugar, oil etc. We don't know what will happen to the price after several months from now.

Hence, the eventual cash payment varies depending on the market price on purchase date. Creating a cash flow hedge could minimize that risk by converting your variable future payment into a fixed future payment.

To hedge regional bakery can enter into a forward contract with another party for major purchasing of flour. With the forward contract regional bakery is able to lock in the price of flour at current market price regardless of market price of flour at the date of purchase.

The effective portion of gain or loss on a cash flow derivative is a component of other comprehensive income and reclassified to income in the same period or periods in which the hedged forecasted transaction effects income.

Any remaining gain or losses in the derivative appears in current income.

So, cash flow hedge effects both current and future operating income.