 Hello and welcome to the session. This is Professor Farhad and this session we would look at IFRS 9 specifically We're gonna look at an example for forward contract Designated as a cash flow hedge. This topic is covered in an international accounting course The CPA exam as well the ACCA exam as always I would like to remind you to connect with me on LinkedIn if you haven't done so YouTube is where you would need to subscribe I have 1500 plus accounting auditing and tax lectures if you like my lectures Please like them share them put them in the playlist. Let the world know about them. This is my Instagram account Please follow me on Instagram as I'm trying to increase my following and this is my Facebook account. I do have a Gumroad account and I do have a website on my website if you choose to you can Post you can donate to support the channel also on my website I do have offers for example right now becker CPA is offering a discount on their CPA course It's a limited offer with unlimited access So let's go ahead and do a quick review about the fair value for hedging for fair value Once we say the forward contract the hedging instrument has to be reported that fair value It means we have a profit and a loss to have to worry about so remember. We said if you're a speculator arbitrage Participating in an arbitrage or a gambler basically you want to buy and sell those contract All the gains and losses all the profit goes into the income statement If you are protecting your assets or liabilities or protecting your cash flow Basically looking into the future to see how you can protect your asset then under those circumstances You would either treat the hedge as a fair value hedge, which will go on the income statement Any fair value changes all you would treat it as a cash flow hedge, which will go into OCI in this session We will focus on the OCI and if you recall from the prior session We looked at the journal entries. We just looked at the fair value. I'm not going to go over this today I'm going to go over the cash flow hedge So the cash flow hedge at the end of the period the hedged asset or the liability is adjusted the fair value According to the change in the spot exchange rate and the foreign exchange gain or loss And the gain and loss recognize in their income So this is what we have to do Then also we have to an amount equal to the foreign exchange gain or loss So if you have a gain you have to report a loss if you have to if you reported a loss here You have to report again here if you reported a gain here Again in step one you have to report a loss in step two and you will see how we're going to work an example An amount equal to the foreign exchange gain or loss recognize in that income and then transferred and you will see how to accumulated OCI To offset any gain or loss on the hedged item asset or liability. We will see how in an example The derivative hedging instrument is adjusted to fair value Then we have then we have now a hedging instrument. It could be an asset. It could be a liability Then we have to put it on the balance sheet with the counterpart recognize as a change in OCI Then if we have an asset then we have a gain in OCI if we have a liability We have a loss in OCI and we'll see this shortly And an additional amount is removed from OCI and recognized in their income to reflect two things The current period amortization of the original discount So if we have any discount on the forward contract, which will work with a discount We'll have to amortize it or if we have a premium we'll amortize the premium And the change in the time value of the option of the option is a hedging instrument And also we amortize this part. So the best way to illustrate these concepts is to work an actual example So let's take a look at an example where we work earlier with no hedging if you remember AXIEM co shipped goods to a Spanish customer with the payment to be received March 1st Assumed that December 1st the spot rate is $1.50 but December 31st the euro was $1.51 So here's what we did in the prior session We debit the receivable credited sales 1.5 million you said once we credit the sales we never changed the sale At the end of the accounting period we debit account receivable and we credit foreign exchange gain So by the end of the year we were plus 10 000 of the receivable and plus 10 000 of the gain because the Euro was $1.51. By the time we got the payment what happened is the euro went down to $1.48 Therefore we debited an exchange loss foreign exchange loss For 30 000 credited the receivable 30 000 Then we accepted the cash 1 million 450 and credited the account receivable 1 million 450 So all in all we had losses Of 20 000 so keep that number in mind and under this example we had no protection We had no forward contract or option contract. Well in the next now. We're going to be looking at what if this company Xeemco Buy a forward contract and treated that forward contract as a cash flow hedge Okay, so let's go ahead and take a look at the the new information and we'll work this example So keep in mind just have to remember what happened here in order to appreciate the value of the hedge okay Now assume on December 1st when we make that sale A three year three year forward contract for euros is at 0.485 And the company signs a contract with first national bank to deliver 1 million in three months in exchange for 1 million 480 now what Xeemco wanted to do said you know what we're not going to wait until march first and be surprised with any Nasty surprises. What's going to happen is we're going to buy a forward contract to sell the 1 million euros At dollar 48. So the bank says I will buy your euro at dollar 48 50 Although the euro today is dollar 50. So notice the first thing you are willing to take less money You are willing to lose upfront $15,000. Okay So no change no no cash changes hands on December 1st So because the amount of the contract is so minimal. So we don't have to worry about this So the euro was selling at a discount because it's selling less. So Xkimo will receive $15,000 less than the payment if they receive the goods today So if they receive the goods today, they would receive 1.5 million now They are guaranteed from the bank 1 million 485 therefore they took a discount They took a reduction in the cash flow So this reduction in the cash flow is technically a cost of doing business in a foreign currency So when you deal with foreign currency, you have a risk and that risk is currency Well currency is spelled. I'm not going to change it. But yes, so this $15,000 and we're going to see what we're going to do with this This is basically an expense And this expense will be amortized and we'll see how we're going to amortize it. Okay Given that the future spot rate turns out to be only dollar 48 Now we know what this future spot spot rate is selling euros at a forward rate of dollar $1.485 is obviously better So now we know after the fact that that was a good option selling the euros At 1.485 and accepting the discount because if we did not we would have sold them at dollar 48 But now this is beside, you know, you know, this is like seeing in the future Which is you don't but i'm just telling you up front that we are five We're going to be $5,000 off by by by going into this forward contract Okay, so this can be viewed as a game resulting from the use of the forward contract So hopefully I hope you can see this. I hope that you can see up front We didn't go into the journal entries that we did good by entering into this contract But you don't know how good or how bad until down the road, but now we know the future here. Okay So what's going to happen? We must account for the foreign currency transaction and the related forward contract simultaneously But separately so notice and the entries we're going to be doing now We're going to be taking care of the receivable and taking care of the forward contract So we basically have two different instruments and we have to account for them differently Now, how do we account for them depending on the changes and interest rate depending on the changes not an interest rate Depending on the changes in the foreign currency transaction. So let's go over this Information here in this table because we're going to be using this information to process the journal entries So you can copy this information down if you went to my website and if you happen to download it That's good. That's a good idea. So here's where we stand here December 1st year one The spot rate is dollar 50. So we have a receivable of 1.5 million the forward rate This is one. We bought the forward rate is 1.485. So there's no change in fear value on that date On December 31st year one the spot rate is dollar 51. The receivable is going to go up by 10 000 So the receivable go up by 10 000. We'll have again the forward rate is one 1.496 Now the forward rate went up. Well, we made a mistake We made a mistake buying the forward rate on december 1st. If we waited till december 31st The forward rate would have been 1.496. So what happened here If you notice We we made a mistake in what sense it's the forward rate went up. It means we should have waited We have technically a loss. So basically if you look at the difference between those two, it's 11 pennies 11 pennies times a million That's an 11 000 dollar and loss on the forward contract on the forward contract now. We did good on the The the spot rate helped us but the forward contract Went when the opposite way. Okay, so basically we have a loss of 11 000 Why do you say the loss is only the fair value negative 10 783 because what we do is we take the loss And we discount the loss and we're going to discount the loss at 12. It doesn't matter So the discounted loss is 10 7 83 but think of it as 10 000. It doesn't matter So the fair value of the count of the forward contract went down to negative 10 7 83 March 1st the spot rate was dollar 48 and when the spot rate is dollar 48 The forward rate at that point will be dollar 48 too So now now the receivable is 1 480 We are at a loss of 30 000 because by december 31st The receivable was 1 million 510 now it went down 30 000. We are at a loss for the receivable of 30 000 The forward rate and the spot rate are the same because this is what you're going to execute the Transaction and what happened is now the change in fair value now now because you saved yourself because if you waited if you waited You would have get dollar 48 the spot rate, but you're going to get 1.485 So you're going to get a five thousand dollar increase in your fair value. So the change in fair value. So you went from negative 10 7 83 Up to five thousand So you moved the fact the change in your fair value is 15 7 83 So you moved up 15 7 83 because by december on december 31st The fair value of the hedge right here was negative negative 10 7 83 the fair value of the hedge by the time you Realize the transaction you you booked the transaction. It was five thousand. So it went up 10 5 000 i'm sorry the change is 15 7 83. So you are at again a five thousand dollar Why are you again at five thousand dollar because instead of getting 1 million 480 you get 1 million 485 Okay, so let's take a look at the at the transaction From from a journal entry perspective. So the first entry is pretty straightforward We debit account receivable credit sales on december 31st when we made the sale There is no formal entry for the forward contract. No no cash changes hand It has a zero value as of 12 one year one So the forward contract has no value although we went we sign that contract Now let's go ahead and start to look at the journal at the journal entries What's going to happen is this the first thing we have to do on december 31st We have to report the receivable at fair value. So you remember the receivable at fair value We made a 10 000 dollar gain because the value of the euro is dollar 51 Okay, so notice this is to account for the receivable Now we have to account for the Forward contract if we made the gain here, but that I tell you what's going to happen to the forward contract The forward contract will have a loss. So it's like the opposite and that's why it's called the hedging So again, we'll offset a loss. So what's going to happen? We're going to have a loss On a forward contract and we're going to put that in accumulated other comprehensive income So notice the gain and the loss if you notice here, we have a gain of 10 000 A loss of 10 000. So what happened on the income statement the effect is zero Okay, that's what we mean by hedging. That's what we mean by hedging then We have to create a liability We have to create a now we have to put the the contract the fair value contract. So we're going to get it out of We're going to get we're going to get it out of oci We're going to debit oci get this credit out and credit the forward contract. Now the forward contract is a liability Now we have a liability And a loss because when we when we debit Accumulated other comprehensive income. This is basically a loss when we debit it Therefore what's going to happen? We debit a loss and and we created a liability and that's what happened but notice no Income statement effect from this transaction and whatever income statement happened it's zeroed out So notice we have a gain. We have a loss and here. This is no income statement effect So simply what i'm trying to say this is a cash flow hedge Nothing is affecting the income statement although we kind of booked 10 000 then we reduced it by 10 000 So this 10 000 here gain was reduced by the loss and this is what we mean by the hedge By the cash flow hedge It just it eliminate the loss would eliminate the gain as far as the income statement is Concerned okay, then what we have to do the last thing we have to do we have to amortize You remember the 15 000 discount. I told you it's a part of doing business now. We're going to amortize it We're going to debit discount expense and credit Accumulated other comprehensive income So we booked the 15 000 in oci and now we're releasing some of it from oci To the income to the income statement So those are the entries that we book on december 31st We do the fair value of the receivable. We have set it by if it's again We have set it by a loss then we transfer then we if it's a loss if there's a loss We have to put the loss in oci. Therefore we debit oci credit the forward credit the forward contract Now if we had again everything would be the opposite obviously Then we have to we have to record the discount. Okay, so basically think of this. This is separate than all of them This is separate than the other three transactions So this is what we did and this is what how things will show on the income statement for year one We have a sales of 1.5 million A gain of 10 000 a lot a loss of 10 000 So notice those gain and losses offset each other out zero The only expense we're going to have on the income statement is the discount expense Which is happens to come from the 15 000 Discount now you might be saying why 5 000 and 17 dollar they use the discount rate that the company won't just They could they could do this on a straight line basis. They basically they can take 15 000 and divided by how many months the discount is for but here they use is they used a Formula which is You don't have to know it just know that the 15 of the 15 000 discount on the On the forward contract 5 000 17 17 dollar is expensed. So this is the Impact on the income statement. What is the impact on the balance sheet? On the balance sheet we report the asset the receivable at fair value And we have a liability called the forward contract. This is a liability This is the hedge the liability 10 7 83 and retained earning is 1 499 49 83 Which is net income for that year from the sale minus the discount And remember the loss the true loss is sitting in here. This is the loss But the loss is on an oci notice There is no loss on the income statement any loss is offset it by the gain any gain is offset it by the loss The the the expense is different. The expense is not a loss the expense is it is like a loss But it's like it's not a loss. Okay, so this is the this is how things would look like on On december 31st. Okay back to this picture. So so far we took care of this this This section here we did the entries for this which was very simple. Then we did the entries for The second line, let me highlight it in a different color then we just did the end what what needs to be happened on December 31st. The last thing we have to do is we have to book the entries that took place on march first So let's go ahead and look at these entries on march first We're gonna have we're gonna have the first thing we're gonna have to report the receivable at fair value the receivable lost So we have a 30 000 dollar loss. So we have to credit receivable at 30 000 debit foreign exchange loss Now you might saying why because the spot rate is dollar 48. So that's the loss Remember any loss on the receivable will be offset it by a gain So the loss by the receivable is offset it by a gain Again, so let me get my pen back This is how hedging works. So the loss on the receivable Is offset it by a gain on the forward contract. So we credit the gain and we debit oci. We debit oci 30 000 Then We get it out of oci 15 7 83 and we debit the forward contract Now we have to remove the liability because that said the contract is over remember We had a liability of 15 7 83 in the prior From the prior entry now we have to remove the liability and it offset oci now You're gonna see what's gonna happen to oci. Hopefully you are keeping track of your oci Then what we have to do is we have to discount we have to amortize the remaining of the discount Remember, this is part of the 15 000 we debit discount credit oci. So let me show you what happened to oci The balance in oci started at 4234 then negative 30 000 then plus 15 7 83 plus 9 9 83 Overall oci is zero. So if you look at oci oci, it's gonna be gone as a result of this transaction So we parked in there the gains and the losses then oci then the amortization of the discount and it's it's all gone So on march 1st we debit foreign currency. We credit receivable Then we debit cash We can combine those two entries because notice we can take the foreign currency out Okay, so we debit cash. This is how much cash we receive The account receivable is 1 480 and we we credit the forward contract What's left of that liability of 5000 and basically this is the gain Component of the whole transaction. This is the gain component So this is to settle the transaction and this is what things would look like in year two We have a foreign exchange loss on the receivable. We have a gain on the On the forward contract again The hedged item and the hedging instrument they work the opposite when one has a loss The other one has a gain the only thing we have a discount We only expense that we're going to report related to that transaction is the remember the 15 000 dollar of expense In the first year we amortized 5,017 and now in the following year we amortized 9,983 therefore we amortize all the 15 000 of the discount so the impact on that income is 9,983 it's coming from an expense not gains or losses So all in all okay the net effect on the balance sheet over the two-year period Okay, so overall the net effect after all things said and done we have 1,485 in cash So cash went up by that much and a corresponding obviously retained earning went up by that much Okay, so this is on the balance sheet The cumulative discount is 15 000 which is was broken down into two years 5,017 year one And 9,983 in year two. So this is the 15 000 Okay, the net benefit of entering under this contract is five thousand dollar because we received five thousand dollar Then we would we wouldn't have to receive if we waited for the spot rate without any protection. So Exime Co has a cash inflow of 1,485 rather than 1,480 and this is where the 5 000 of the gain comes into place So the gain is reflected in that income as the difference between the net gain on forward contract and the cumulative discount Which is 20 000 minus 15 recognized over two period. Why recognize over two period? Because we have to amortize the discount over two periods now Hopefully, you know, you were able to follow this the best way to do this if you're not sure create t accounts So create t accounts for every account that you create and see what happened to them as they get as they disappear Or as they increase and they decrease, but this is How you would record or this is how you would account for A forward contract a cash flow hedge forward contract And this is a cash flow hedge and the next example will work the same example However, we're going to look at it from a fair value hedge. What does that mean? It means all the gains and losses that will affect net income and you'll see how it works If you happen to visit my website for additional lectures, please consider donating Good luck on your CPA exam and use all the resources that I provide you to pass and see you on the other side of success