 Hello and welcome to this session. This is Professor Farhad and this session we're going to look at hedge of forecasted foreign currency, the nominee, the transaction. This topic is covered in international accounting, the CPA exam as well as the ACCA exam. If you have not connected with me on LinkedIn, please do so. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lectures. I do also have my website, farhadlectures.com on my website. You can find additional resources and lectures such as multiple choice through false CPA questions and dozens of exercises that complement your education as well as your CPA review preparation. Also, if you're looking for a study body, studypal.co is an artificial intelligence driven body platform that make that make that matches you with a CPA or a CFA. They have users in 85 countries in 2800 cities in the US from LA to New York. Just want to let you know that this topic, there's previous topic to the to this topic basically previous means similar to it related to it. It's in the same playlist such as forward contract cash flow hedge forward contract fair, fair value hedge forward currency option cash cash value hedge and fair value hedge and recognize foreign currency for commitment using forward contract and using a put option. Now this topic is about forecasted transaction. So basically what do we mean by forecasted transaction forecasted foreign currency? Well, what we do is we forecast the weather. What is forecasting? It means you're guessing we're guessing with a great degree of accuracy. What's going to happen and the weather is getting better and better. So so now we can definitely say it's a forecasted transaction. So cash flow hedge accounting is used for foreign currency currency derivatives that hedge the cash flow risk associated with a forecasted foreign currency transaction. What does that mean? It means when you think you're going to have a transaction down the road. You are pretty much certain you're going to have to pay in a foreign currency or receive a foreign currency. Nothing happened yet. You did not buy anything. You did not sell anything. But you know in the future sometime in the future you are forecasting forecasting the future. You will have a transaction. So for hedge accounting to work. If you want to use hedge accounting for such transaction, the associated transaction must be probable. Probable means it's likely to occur and how do you know it's likely to occur? It's something that you need. It's something that it's a repeated transaction. It happens on every quarter every month every year or you know for a fact you're going to have to enter that transaction. The hedge must be highly effective and offsetting fluctuation in cash flow associated with the foreign currency risk and simply put the hedge position that you take the sole purpose of it or not the sole purpose, but the purpose of it actually is to hedge hedge means it's protect your cash flow. It means when the foreign currency fluctuate you are protected whether it went up or went down. You are protected and obviously the last thing the hedging relationship must be properly documented. Properly documented means for hedge accounting to work. You have to have properly that you have to properly document your policies. When do you hedge? When don't you hedge? What type of transaction do you hedge? In order to use this type of transaction. Now we talked about firm commitment earlier in the prior session. This is different than firm commitment. So the accounting for hedge of a forecasted transaction differ from that of firm commitment. How does it differ? I mean I already told you, but let's kind of spell it out. And a firm commitment, you made the commitment. Here there's no commitment. You did not make any commitment there. You're kind of guessing, but you're not really guessing. You know you're going to have a transaction. Therefore you protect yourself. So this is how it works. So unlike accounting for a firm commitment, there is no recognition of the forecasted transaction. Simply put when you have a firm commitment, you'll have an asset or reliability on the books. There is no such a thing. Or gain on losses on the forecasted transaction. Also, since nothing exists, there's no transaction yet. Therefore you have no gain and no losses on the forecasted transaction. The hedging instrument, whether it's a forward contract or option is reported at fair value. Obviously, but because there is no gain or loss on the forecasted transaction to offset it, changes in the fair value of the hedging instrument does not go on the net income. Where does it go then? If it doesn't go on the net income, it goes into OCI. Once again, this is an important distinction between forecasted transaction and all the other transaction that we looked at earlier. And all the other transaction that we said, we said if the hedging instrument went up, your hedging, if the hedging item went up, the hedging instrument went down. If the hedging item went down, the hedging instrument went up, they offset each other. Well, guess what? In a forecasted transaction, you don't have an hedging item. You don't have a hedging item. All what you have is the instrument, whether the option or the contract. So this is important to understand. And hopefully as you understand this, you're starting to go back and understand, okay, now this makes sense. I hope so. Instead, they are reported in OCI, which is other comprehensive income. And on the projected date, projected date is when the transaction is settled. Okay. The cumulative change in the fair value of the hedging instrument is basically recycled, transferred from comprehensive income to the income statement. So eventually it's going to hit the income statement, but first it stays on OCI until that transaction is settled. We call this the projected date or we call it the settlement date, the date that the actual transaction takes place. The best way to illustrate this as always is to work an example. And we're going to go back to Axiom Co. has a long term relationship with a Spanish customer. Notice it's a long term. So they know what they're doing on a repeated basis and can reliably forecast. They didn't go into anything yet. They didn't make a firm commitment. They didn't buy anything. They didn't sell anything. They just, they know they are going to have to buy or sell and receive money or pay money. They would require the delivery of goods costing a 1 million euro on March 2nd of year two. So that's all what they know now. They're going to receive 1 million euros when the spot rate is 0.98. Now the spot rate is 0.98. They don't want to take their chances. Confident, they're confident. Notice they're confident. How are they confident? They document why they are confident. Okay. This is what documenting hedging document is. It would receive the 1 million euros, March 1st, year two. Aximo hedges. It's forecasted for an currency transaction by purchasing a million dollar put option and they paid $9,000 for that put option. Okay, December 1st. So once they knew they're going to buy it, the fact are essentially the same as the option hedge of the firm commitment, except that we did not receive a sales order from the Spanish customer. So it's the same thing as firm commitment, except the Spanish customer did not place an order, but we have to document that this is a forecasted transaction for us to be able to do hedge accounting. So the option which expires on March 1st has a strike price of 1.5 and the premium of 0.00 per euro, which is times a million euro. We have to pay upfront $9,000 to buy this premium and despite strike price is $1.50. So what do we do? Here's the data that we are giving December 1st, March 1231 and March 1st. Here's the option premium that we paid. Here's the value of the option and obviously there's no value except the time value now for this option. December 31st, well let's do it step by step. On December 1st, we have a foreign currency option asset hedging instrument and we credit cash because we paid $9,000 for the transaction. December 31st, $3,000 expired, $3,000 expired. We have $9,000, $3,000 expired. Okay, well that's fine. We expense it and we credit this account. We reduce it by $3,000 because of the time value of money as time goes by, the value of it goes down. So all that happened is in year one we have a $3,000 expense on the income statement as a result of the $3,000 expiration of the time value. Notice in the other examples we had a loss then we had a gain. We had a loss on one hand, we had a gain on the other hand. Here we don't have anything to offset the loss with. Okay, we have a loss. That's it. That's the impact on net income, $12,31. Now we're looking at $3,000, March 1st. The premium is $20,000. So notice the premium went up in value. The fair value of the premium is $20,000. So the premium went up. It went up by $14,000. Notice it went up from $6,000 to $14,000. But obviously at that point the premium is going to expire because the time value will be gone because March 1st, there is no value for that put option that you purchase because that's it. It expired. Okay, so let's take it step by step. We're going to expense the $6,000, get done with it. Then we are going to increase the foreign currency option because it went up in value by $14,000. And the credit is accumulated other comprehensive income, which is an OCI. Now you might be saying, why don't we just put it in net income? That's fine. We're going to transfer it to net income. But the point to understand is, first it sits in OCI, then it's going to be transferred. You're going to see in net income. Now you might be saying, why don't I just put it in net income? If your professor accepts it, go ahead. All powers for you. Okay, but I'm just telling you the proper way. Then now we have, we received the foreign currency. The foreign currency is $1,450,000 and we credit sales because we made the sale on March 1st. We made the sale on March 1st. Now we're going to take the foreign currency and exchange it. So we're going to take the foreign currency and exchange it to $1.5 million US dollar because the rate that we can execute this currency at is the strike price 1.5. We gave them the euros and we have a foreign currency option to remove of $20,000. Now at the end, what we're going to do, we're going to remove the $20,000 from OCI and put it in net income. Again, could you have done so right from the get go? Yes, but you need to understand that first it goes into OCI. So this is important. You might be asked on your exam, where does it go? It goes into OCI. For example, in practice, it might just go right into net income on that date and they will not have to transaction. I mean, it's interesting in the real world how this transaction is handled, whether it's handled, whether account, whether you make a proper adjustment for this and it needs to be approved, or whether it's all computerized and system exercise the option and, you know, book the transaction where it's supposed to be booked and you don't have to worry about this. But the real world is different. So what's the impact on year two on the income statement? We made a sale. This is year two. We made a sale. We expense the option of $6,000, the remaining time value. We transfer to income $20,000. So notice this is so net is we have $14,000 gain and year one from the option. But remember, we paid $3,000 for the prior year. So all in all, the option gave us more $11,000 more and this is the impact on net income for year two. Now, if you have any questions, any comments about this topic, please let me know. Email me. If you want to see additional topic or work exercises, please visit my website. And if you'd like to subscribe, it's not bad. One price you would subscribe for all my services, all the courses, all the material. So good luck and stay motivated.