In our last issue we described the best practices for accounting forFair Value hedges, which are in effect when a hedge instrument offsets an inventory on hand (or a "firm commitment" to buy or sell). The most common example for agriculture is when a hedge is initiated against a crop that has already been harvested and is available for immediate sale.
What are the best accounting practices for hedges that are initiated before a crop or group of animals is harvested?
This scenario requires using a Cash Flow hedge. As its name implies cash flow hedges are used to establish a fixed price when future cash flows could vary due to changes in prices. With cash flow hedges there are no market-ready inventories to "mark to market." Instead the product being hedged is either in a "work-in-process" stage (growing crops or livestock with no ready market) or "forecasted transaction"(a future crop, animal production or feed purchase).
Management accounting for cash flow hedges can be much more challenging and complex than for fair value hedges due to these factors:
- Cash flow hedges are initiated to lock in prices in a future period so hedging gain and loss must be "pushed" into that future period to match costs with sales.
- Futures and option positions may be rolled several timesbetween delivery months and/or contract types.
- Livestock producers who hedge feed as well as animals must be able to match past and future trades to the appropriate inputs and delivery periods.
- Trading months for feed and livestock commodities rarely correspond. (For example cattle and hogs trade October contracts, but corn doesn't.)
Fortunately, cash flow hedges be tracked easily through carefully-defined ledger accounts and cost centers.
Other Comprehensive Income Ledger Accounts
These are income and equity accounts used to book profit and loss to be recognized in a future period. The accounting termcomprehensive income refers to all changes in equity except for transactions from owners and distributions to owners. Most changes to equity are "driven" through the income statement and are assigned as Net Income (current period) or Retained Earnings (prior periods) accounts. However there are special cases such as management accounting for cash flow hedges where changes in equity do not go directly or immediately through the income statement, which is defined as Other Comprehensive Income (OCI).
You'll need one Other Comprehensive Income revenue account and one Accumulated Other Comprehensive Income equity account foreach commodity you trade. For example:
Delivery Period Centers
In addition to equity accounts you'll also need to set up special cost/profit centers for assigning current trades to future time periods. For crop production the best practice for inventory control and cost analysis has usually been to define a unique crop Marketing Center for each crop production/marketing year. Therefore a corn grower planning to initiate cash flow hedges for the 2013 and 2014 crops will need these marketing centers:
- 2013 Corn Marketing
- 2014 Corn Marketing
FBS E.CLIPSE Management Accounting users will also define a Marketing Project corresponding to each of these Marketing Centers.
Livestock feeders are faced with even more time period options for assigning cash flow hedges:
- By year
- By quarter
- By month
- By group
Because of the mismatch between commodity trading months described earlier, the quarter method offers the optimum blend of simplicity and analysis for most livestock producers.
The last option (group), while technically possible, may not be practical for all but the most detail-obsessed users because deliveries rarely match up exactly with the original group that was hedged. At the very least we recommend starting with either the quarter or month time increments before progressing to the complexity created by tying hedge positions to groups.
These livestock delivery period centers should be defined as F (Feeding) centers with codes for each delivery period and "flow" of animals. Note that only one center is needed track all commodities-feed, feeders, livestock sale contracts-tied to animal sales in a specific delivery period. Here are some center coding examples for a "single flow" system for tracking by year, quarter or month.
For a larger system with multiple flows codes can be adapted to identity the species or production system to be tracked. See the examples below.
As simplified alternative to specific delivery period centers, the commodity's Profit Center (C center for crops, F center for livestock) may be used; however resorting to this practice will sacrifice the ability to evaluate complex cash flow hedging strategies initiated over long periods of time.
Next month we will describe how all these components fit together in the accounting process for cash flow hedges.
for Cash Flow Hedges
