Final answer:
The cash flow hedge is a strategy to mitigate the risk of variability in expected future cash flows due to certain risks. An ineffective portion of a hedge doesn't offset this risk properly and must be included in the income statement while the effective part is recorded in other comprehensive income.
Step-by-step explanation:
When dealing with cash flow hedges, you're essentially talking about a risk management strategy used by companies to protect themselves from the volatility in cash flows due to changes in exchange rates, interest rates, commodity prices, etc. A cash flow hedge is used to reduce the risk that future cash flows will vary due to changes in the specified risk. However, in practice, not all of the hedge is perfectly effective in offsetting the variability of the hedged item.
The ineffective portion of the hedge refers to the part that does not successfully offset the changes in cash flow of the hedged item. Under accounting standards such as the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) in the United States, the ineffective portion of a cash flow hedge must be recognized immediately in the income statement. This can result in volatility in earnings, as the effective portion is recorded in other comprehensive income and reclassified into earnings in the same period(s) during which the hedged transaction affects earnings.
There are specific guidelines and calculations used to determine the effectiveness of the hedge and how to account for the ineffective portion. Understanding and applying these rules is essential for accurately presenting a company's financial health and risk management practices.