 Hello everyone and welcome to the session. This is Professor Fahad and this session I'm going to look at a foreign currency per option under the IFRS 9. I'm going to work the cash flow hedge in detail then go over the fair value hedge very briefly. This topic is covered in international accounting the CPA exam as well the ACCA exam. As always I would like to remind you if you have not connected with me to connect with me only then YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lectures. If you have not subscribed please subscribe. If you subscribe please like my videos it's very important it helped me substantially. If you like my videos please share them put them in the playlist if they're benefiting you it means they might benefit other people share the wealth it's free. Also I have an Instagram account I'm trying to grow my Instagram account as well as Facebook and this is my website. If you are studying for your CPA exam I strongly suggest you check out studypal.co it's an artificial intelligence study body platform that match you with CPA, CFA, whatever exam you are working for. Studypal has users in 85 countries in 2800 cities and here's the link if you're interested in checking it out. Now in this session we're going to talk about options specifically we're going to talk about put options. Now before we proceed I just want to let you know I have two links in the description below so in the description below I have two links and those two links are for a forward contract foreign currency forward contract so it's very important that you understand how forward contract work and I have a cash flow hedge example cash flow hedge and I have I explain a fair value hedge. I'm going to be using the same example to illustrate how options work so in the prior session I went over cash flow hedge as well as fair value hedge when it comes to forward contract. Now an alternative option for companies an alternative option and that's not the only alternative option but this is one of the alternative option to forward contract is something called a put option or a call option so this is what we're going to be discussing in this session but it's very important to understand how does an option work and specifically we're going to be covering put option in this example but I'm going to explain both the put as well as the call option how does it work in general so what is the put and what's the call option and how do they differ how do they differ from the forward contract well under the forward contract you basically have an obligation to buy or sell that currency so you don't have an option basically if you remember we said we're going to sell the currency at dollar 48 basically we are in a sense stuck let's put it let's let's let me let me put stuck in quote you are stuck you have the obligation to sell it at 148 well the put option is a little bit different the put option said you have the right but not but not the obligation it means if you want to sell it you can sell it at dollar 48 but if the price is dollar 55 if the price is dollar 55 guess what why would you sell it at dollar 48 you let your option expire and you sell your currency at dollar 55 so that's what an option is it doesn't you're not stuck okay this is if you are selling if you are buying if you want to buy something let's assume you want to buy something for you want to buy a foreign currency at a rate of three dollars okay then and you pay the premium to have that right then the price of that currency dropped to 250 you can buy it for 250 well guess what you you have the option to buy it at three you option that if it's at 250 i'm gonna let my option expire and i'll buy it at 250 assuming it's it's worth it it's it's it's it at 250 it covers my premium and we'll talk about the premium in a moment the premium is what you have to pay to have that option so the option is more flexible so you can you can you can go ahead and exercise your option or if you don't think it's a good idea to exercise your option if you think it's a good idea to buy or sell the current currency at the spot rate you will go ahead and sell it at the spot rate the forward contract you can do that once you once you sign for it you have to deliver at that rate so we're gonna explain this in an example so let's go back and review our example from the beginning the one that we used for the forward contract we have x ximo co-shipped goods to a Spanish customer with a payment to be received on March 1st assume that the spot rate for euros is dollar 50 but December 31st the euro appreciated the dollar 51 so here's the deal we sold 1 million worth of euros the rate is dollar 50 on the date of the sale so when we record the sale we record it at the spot rate that's always the case so at the spot rate we have 1.5 million in receivable 1.5 million in sales 1231 the euro is dollar 51 well guess what we're going to have more receivable we increase the receivable 10 000 and we have a gain of 10 000 so we adjust adjust to the spot rate we adjust the receivable to the spot rate okay now March 1st the exchange rate is dollar 48 well when we receive the foreign currency we have basically the foreign currency went from dollar 51 to dollar 48 not good so we experience a $30 000 loss on the foreign currency because it went down by three pennies times a million that's a $30 000 loss so we write down the receivable and we book a loss then we receive the cash we receive the cash we received 1.1 million 480 but once we exchange it we receive the euro we exchange it to dollar and we reduce our receivable we remove the receivable so this is when we have no protection no forward and no option i looked at forward contract before i worked the fair value at as well as the fair value as well as the cash flow hedge now we're gonna be looking at an option now we're gonna buy an option to protect our position to protect what is our position what is our exposure we have a million euros we're pending a million euros we're waiting to receive a million euros so let's take a look at this assume on December 31st we bought the the company bought an over-the-counter put option from the bank with the strike price of dollar 50 when the spot rate is dollar 50 and pay a premium of 0.00 per euro simply put here's what they did they went to the bank or actually not to the bank over the counter just basically they bought it somewhere on the market from somewhere on the market from another from another party and what they did they said well the strike price is dollar 50 therefore they can they can sell they can sell their euros at dollar 50 so now they kind of guarantee that price but to guarantee that price they have to pay 0.009 per contract that this doesn't come cheap why because somebody is buying selling you this option well you have to pay ten thousand nine thousand dollar for it okay but you are guaranteed you'll be able to sell your euros at dollar 50 so when you get the euros when you get the million dollar euro you can sell them at dollar 50 you are guaranteed one million five hundred thousand but remember you had to pay nine thousand dollar to have this option so copy this number down one million four hundred ninety one thousand this is your guaranteed amount at least or at least let's put it this way this is the least amount you would receive from the one million euros that's it you locked your price okay you locked your price why because this option this put option they said you can sell the euro at dollar 50 okay you can sell the euro at dollar 50 it means once you receive your euros you could always sell it at dollar 50 but you have to pay upfront nine thousand dollars so there's a cost for the for the for the euro now keep in mind this this option has no intrinsic value why it does have no intrinsic value because the spot rate is dollar 50 and the strike price is dollar 50 therefore you have no you have no gain if you exercise this option today therefore there's no intrinsic value well remember the option has two pieces intrinsic value and time value yes there is a time value the time value is the time from december first and remember the payment it's going to be made march first so from here to here from here to here if the price drops then you'll be good this put this put option is good so what you're doing is you're protecting yourself so what you're saying is your fear is the price is gonna drop to dollar 40 okay and if it drops to dollar 40 you have a million euros you would receive if you're not protected 1.4 million but also the price of the euro could go up to dollar 60 well in that case you're gonna let the option expired and exercise your euros at dollar 60 and receive 1.6 million okay so we don't know what's gonna happen but you know you you are guaranteed at least 1 million 491 so if it drops to dollar 40 on the on march first you can sell it at dollar 50 if it goes up to dollar 60 you will you would let your you would let your option expire you will throw it in the garbage and you will exercise at the market price okay so you are guaranteed at least as i said you're guaranteed at least 1 million 491 thousand 1 million 491 thousand okay all right sorry about that let's go back here okay just trying to clear my screen there we go okay so there is there is only time value in this option and it has more value as the as the as the price drops below below dollar 50 okay so if the if the stock price in three months is greater than the strike price of dollar 50 then you will not exercise as i said if it's a dollar 60 you let it expire by purchasing this option you are guaranteed a minimum cash flow of 1 million 900 1 million 491 thousand i already told you this okay and remember there's no limit to the maximum number of us dollar you could receive if if the price went up to two dollars and guess what you would receive a million times two dollar two million okay so you don't have to exercise at dollar 50 you just have the option to exercise the option to exercise so foreign currency options are derivatives therefore they must be reported on the balance sheet at fair value okay so the fair value of the foreign currency option at the balance sheet is determined by referencing the premium quoted by banks on that date for an option with similar expiration date now here they use the black shawl method we don't have to worry about how they come up with that market value of the option so the option by itself has a market value okay the option by itself has a market value that's the hedge that's the hedged instrument the hedged is the account receivable you're hedging your account receivable with an option okay so the change in value of for the euro account receivable and the foreign currency are summarized below so what i suggest you do if you don't have the powerpoint slides you know take those numbers down because when i when i'm working the journal entries i cannot keep referencing back and forth to this okay so on december 1st the spot rate is dollar 50 you have 1.5 million receivable in us dollar at this at this rate the premium you paid 0.009 therefore basically your option is worth the day nine thousand dollars it's all it all has to do with time so it has a nine thousand dollar time value on december 31st the the the rate went up the dollar 51 therefore your receivable went up your receivable went up by 10 000 the up the premium went down notice it was 0.009 it went down to 0.006 so simply put you lost 0.003 okay as time expired well this is basically time expiration of the option okay and also remember the the why did it go down to in addition to time expiration remember the the euro versus the dollar now dollar 51 that's against what you want against your protection your protection is going down and the rate went up it didn't really help you okay but by march 1st the rate went down to dollar 48 now you are happy now your your option is worth more okay now your receivable is worth 1 million 480 your receivable went down went well from dollar 51 to dollar 48 there's a 30 000 dollar change but your premium went up because you are protected remember you can sell it at dollar 50 and the rate is dollar 48 therefore you you are protected you you are in good shape so the premium the premium went up from 0.06 to 0.002 which is you have a fair value now the premium has a fair value of 20 000 it changed 16 000 the change in the fair value of the premium okay so let's take a look at the journal entries and see how we how we record those transactions again we're going I'm going to be referencing to this table but let's look at the journal entries assuming this is a cash flow hedge so we're going to look at a cash flow hedge rather than a fair value hedge we'll we'll talk about the fair value hedge toward the end okay so what I suggest you do right from the front use the accounts to keep track of all the accounts because we're going to have many accounts we're going to be dealing with so the best way to look at this is to keep track keep track of them okay let's take a look at the first entry the first entry will be debit account receivable credit sales and this is the sell I'm sorry not the sell to record the sale at the spot rate that's the first thing we have to do then what else do we have to do we bought the we bought the option now we're going to have an asset called foreign currency option this is an asset basically this is an asset it's basically an investment and we credit cash and this is to record the purchase of the foreign currency option as an asset at its fair value of 9 000 why 9 000 because they told us the fair value is 9 000 because the strike price and the spot price were the same dollar 50 dollar 50 the spot as well as the strike and you paid 9 000 it's worth 9 000 okay that's basically it okay now let's take a look at December 31st remember what happened December 31st now we're dealing with a rate of dollar 51 dollar 51 your account receivable will go up and you have a foreign currency gain why do you have a foreign currency gain because you have a receivable and the and you're in the exchange rate for your receivable went up so this is to adjust your account receivable at a spot rate of dollar 51 now remember if you have a if you have a gain of dollar 10 000 dollar you're gonna have to record a corresponding loss so there's the hedged instrument the hedged instrument the receivable i'm sorry the hedged item the receivable this is the item and the instrument they work the same way the the work exact the opposite way not the same way so if you had the gain on the hedged item you're gonna have a loss on the on the exact the exact loss on the on the instrument so you're gonna debit loss on foreign currency option notice you had a gain of 10 000 you have to record a corresponding loss and we're gonna you're gonna credit accumulated other comprehensive income 10 000 so notice those two on the income statement the net effect zero they can't solve each other out and this is the purpose of the hedge is to whatever gain you have on the option you would lose it on the hedged item whatever you gain you have on the hedged item you would lose it in the option okay then you will have this you will credit accumulated other comprehensive income and i suggest you keep track of this account a a oci now you have in the year 10 000 dollar okay we're not done yet we have to remember we have to reduce the option from 9 000 to 6 000 why do we have to reduce it from 9 000 to 6 000 because the the value of the option was 0.009 by December 33rd was 0.006 it went down 0.003 therefore we're we're gonna record this debit other comprehensive income and credit foreign currency option now we're gonna be reducing the foreign currency option by 3 000 it's that the asset okay we're gonna be reducing it by 3 000 and this is to reflect also the change in the option that the option was worth only 6 000 therefore we reduce we reduce it by 3000 it was 9 now it's down to 6 okay now we have to expense we have to expense time value so we're gonna we're gonna debit option expense 3000 this is for the time value of the option this is for the change in the time value of the option okay so we're gonna assume that that that's three pennies because time has passed okay now notice here that you debited OCI let me highlight it in a different color you debited OCI you credited OCI basically what you're left with is you expense 3 000 of the stock option and you credited foreign currency option of 3 000 so this is basically what it boils what it boils down to so you reduced an asset and you you increased an expense basically that 9 000 that we paid 3 000 of it is expense it's expired because time went by time went by so let's take a look at year one effect year one we recorded sale of 1.5 million we recorded foreign exchange gain under receivable we record the foreign exchange loss on the currency option therefore the effect is zero the only thing that goes in addition to the 1.5 million is the expensing reducing the option by 3 000 because time has passed time value on the balance sheet here's here's the effect we reduced cash by 9 000 this is obviously just showing you the change the counter receivable is up by 1 million 510 you have a foreign currency option it was 9 000 when you started with then you reduced it by 3 now it has a 6 000 value retained earning is 1 million 497 which is net income and you have an AOCI of 10 000 dollar 10 000 so those are the effect now we're going to look at the transaction what happened on march 1st on march 1st remember in this example we are assuming that it's dollar 48 now before we proceed i'm gonna stop right here and tell you something after i'm done with this dollar 48 i'm gonna use another another price another spot rate for march 1st so on march 1st year 2 the option has increased in value by 14 000 time value decreased by 6 000 and intrinsic value increased so the intrinsic value increased by 1 000 elder the time value is gone because by march 1st the time value is gone but the intrinsic value increased why because the spot rate was dollar 48 now once i'm done with this spot rate dollar 48 i'm gonna change the spot rate to something above the strike price and once i do so i will start the entries like here march 1st so December 31st entry will not will not be any different okay but now we're gonna assume that the strike the spot rate on march 1st is dollar 48 what it means good for us in what sense it's good it's not really good good but it's good in a sense that we are protected it's dollar 48 but we can sell our currency at dollar 50 so compared to other people we did good because we protected ourselves so the first thing we have to do is adjust our receivable so we reduce our receivable and we record the loss okay we reduce our receivable then we record the loss then remember when we have when we have a loss on the receivable we have a gain on the corresponding on the corresponding hedging instrument therefore if we have a loss here we're going to have a gain here exact opposite therefore we debit accumulated other comprehensive income we credit gain on foreign currency option this is to record the gain on the foreign currency option to offset the foreign exchange gain on the account receivable with the corresponding debit to AOC I accumulated other comprehensive income remember whatever happened to the receivable if it if it if it went up the option will go down if receivable went down the option will go up that's the purpose of the whole hedging the purpose of the whole hedging position that's the purpose of it now what else do we have to do foreign currency option we're gonna increase foreign currency option we're gonna increase the asset by 14 000 why do we increase the asset by 14 000 it was 6 now we add 14 it's equal to 20 000 why did it go up because the the foreign currency went down as the foreign currency went down our option is worth more because we are protected at dollar 50 and it's dollar 48 okay so now the foreign currency option is 20 000 therefore we debit foreign currency option we credit other accumulated other other accumulated other comprehensive income we're not done yet we have many more entries to go through then we're gonna expense the option that's that's left we're gonna expense the option that's left we're gonna debit up we're gonna debit option expense okay why do we debit the option expense because that's the time value remember we had a six thousand dollar time value we have to expense the time value of it because then we're gonna debit foreign currency because we received the foreign currency and we credit the receivable we received the foreign currency 1 million 480 because we received 1 million euros 1 million at a rate of dollar 48 at a rate of dollar 48 then we're gonna convert everything we're gonna debit cash 1.5 million because we can we can convert this 1 million euros at 1.5 at 1.5 therefore we're gonna get 1.5 million we're gonna credit the foreign currency receive we're gonna credit the foreign currency we're gonna give up 1.4 million and credit foreign currency option of 20 000 basically on this transaction specifically we made 20 000 but that's not done at our net gain so let's see what happened overall for the whole for the whole transaction hopefully you were keeping track of things here's what happened in year two you had a foreign foreign exchange loss a foreign exchange gain that cancelled each other out then you expense the remaining option of 6 000 the time value of money therefore the impact on their income is negative six negative six thousand that's the that's the that's the effect on year year one so negative six thousand no this negative six thousand year one year two let's go back to year one and show you how much was year one was and the net effect on year one was the losses were 3 000 so 3 plus 6 equal to 9 okay and remember remember what i told you the maximum you would receive is 1.991 000 so let's see so over two accounting period we reported a sale of 1.5 million an accumulative option expense of 9 000 we expense 3 000 year one we expense 6 000 in year two that's the 6 000 and the year one was 3 000 then at the fact on the balance sheet is an increase of 1.491 000 with the corresponding retained earnings of 1.491 000 you remember what i told you from the get go the minimum we would receive is this much and we did receive the minimum we could receive more we're gonna see that's possible we could receive more but the point is we will not receive less than 1.491 000 okay the net benefit from acquiring this option is 11 000 why the net benefit is 11 000 if we were not protected we would have received 1.480 if we had no protection because we had protection we received 1.491 therefore the net benefit is 11 000 we received 11 000 more than if we did not have any protection which is good so the gain is reflected in net income okay as the net change on foreign currency less cumulative option expense so we have 20 000 on the currency we did good on the currency but we had to pay 9 000 so we did good on the selecting our investment so we had again on the foreign currency option but the cost of the foreign currency option was 9 so 20 minus 9 equal to 11 so we made 11 000 we are better off 11 000 over two accounting period by having this option so let's assume now remember i told you i'm gonna change the spot rate let's assume the spot rate on march first was dollar 0.505 what does that mean it means it's more than 0.5 it's 0.05 so why would i convert at 1.5 so would i convert at 1.5 or would i convert at 1.05 obviously i'm gonna let my option expire and i'm gonna convert at this at this at this at this rate and as a result if you can think about it i'm making 0.005 more times a million i'm gonna be making an additional five thousand dollar okay why because i'm gonna let the option expire let's let's take a look at it so December 31st entries will be the same now we're gonna be changing the example now we're gonna have to adjust the receivable the receivable is adjusted it was point 1.51 December 31st now it's 1.505 so the receivable went down by 5000 we're gonna reduce the receivable don't worry we're gonna we're gonna book a corresponding gain so notice we have a loss on the receivable okay because the it went down from 1.51 to 1.50 you're comparing it to December 31st then you're gonna get root of the option so the time value of the option you're gonna credit foreign currency option debit a loss for 6000 this is to record the to record the time value the time value of the option expired that's it's gone goes down to zero now we're gonna debit accumulate another comprehensive income and credit gain on for gain on foreign currency option so notice you have a loss here you have a gain here okay now then you're gonna go ahead and reverse this entry and transfer the gain to net income at the end of the period but the point is for every loss you have a gain okay so to offset the loss this entry should be here but that's okay then we're gonna receive foreign currency we're gonna be receiving 1,505,000 why because we're gonna we're gonna convert the currency at 1.505 then we're gonna take the currency and convert it to cash at 1,505,000 and we're gonna remove the foreign currency give them the foreign currency and they will give us us dollar so notice what happened here is we received an additional five thousand dollars so we received 1,491 plus an additional five thousand dollars and you will see this in a moment so now at the end of the period we we debit this account and we remove we move the five thousand to that income so because the transaction has settled so here's what happened that income related to this hedge transaction is 1,496 the sale is 1.5 million we paid 9,040 option then we made a five thousand dollar because we let the option expired and we exercise at a higher than dollar 50 we because we were guaranteed 1,491 but if the price is higher than dollar 50 we're gonna get more this is how the put option work let's assume this option was designated as a fair value hedge what will be the differences the gain and the loss would be directly going to that income remember we don't go through the OCI no separate recognition for the change in the time value of the option so that three thousand and six thousand that we removed we don't account for that the net gain recognize in year one and year two would be different from the amount recognized under the cash flow but over a two-year period it will be the same so the way we compute the gain the income from year one to year two it might be different between the fair value fair value hedge and the cash flow hedge but over a two-year period they will be the same okay so the accounting method has no impact on cash flow or net income recognized overall so at the end of the day the cash flow and the net income is the same just how much you record it in year one versus year two under the cash flow hedge versus the versus the fair value hedge if you have any questions any comments about this recording please email me and the next recording I will maybe maybe work a purchase commitment explain purchase commitment foreign currency when we have a purchase commitment and if you have any questions email me if you're studying for your CPA or ACCA study hard these these topics are covered and if you happen to visit my website please consider supporting the channel by donating good luck and see you on the other side of success