Final answer:
A fair value hedge is used to mitigate the risk of changes in the fair value of an asset or liability due to interest rate or foreign exchange risk, and gains or losses are recognized in the profit or loss statement. Meanwhile, a cash flow hedge is for variability in cash flows due to risks like commodity price risk, with gains or losses initially recognized in other comprehensive income and later reclassified to profit or loss.
Step-by-step explanation:
The distinction between a fair value hedge and a cash flow hedge lies in the type of risk they are designed to protect against and the accounting treatment of gains or losses. A fair value hedge is primarily used to offset exposure to changes in the fair value of an asset or a liability or an identified portion of such an asset or liability that is attributable to a particular risk, which could affect profit or loss. Often, this would include interest rate risk or foreign exchange risk. On the other hand, a cash flow hedge is used to hedge exposure to variability in cash flows that is attributable to a particular risk associated with an asset, a liability, or a forecasted transaction, such as commodity price risk.
In terms of accounting for a forward exchange contract that qualifies for hedge accounting:
- For a fair value hedge, any gains or losses from the hedging instrument are recognized in the profit or loss statement along with the offsetting loss or gain on the hedged item attributable to the hedged risk.
- For a cash flow hedge, the effective portion of the gain or loss on the hedging instrument is initially recognized in other comprehensive income and subsequently reclassified to profit or loss in the periods when the hedged expected future cash flows affect profit or loss.