 Hello and welcome to this session. This is Professor Farhad and this session will look at hedges of unrecognized foreign currency firm commitment using option. Specifically, we're going to be using a put option to illustrate this concept. This topic is covered in international accounting, could be covered on the CPA exam and the on the ACCA exam as well. If you haven't connected with me on LinkedIn, please do so. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lecture. If you like my lectures, please like them. Click on the like button that helps me a lot. Share them, put them in playlists, let the world know about them. If they're benefiting you, it means they might benefit other people. So share the wealth. This is my Instagram account. This is my Facebook account and this is my website. If you're studying for your CPA exam or for your CFA exam, I suggest you check out studypal.co. It's an artificial intelligence driven study body platform that match you with the study body. Studypal.co has users in 85 countries and 2800 cities from New York to LA. So what is unrecognized foreign currency firm commitments? Now if you watch my prior lecture, you're going to see what I'm going to be talking about. It's basically the same thing as in this lecture except we're going to be using a put option. So unrecognized foreign currency firm commitment is very similar to something called purchase commitment under US GAAP. Now what is a purchase commitment? So this way maybe it will be easier for you to understand this concept. It's when you make a commitment, it could be signed, it could be oral, whatever it is, but you make some sort of a commitment and that commitment is firm. You cannot basically back out to acquire goods or services from a supplier or to sell goods or services for a fixed price. So basically you logged in your prices. And what happened when you locked in a price to buy or sell something in the future? Well the price could change and that price when that price change, it could harm you. So let's assume you want to buy something and you log the price now at $100. You lock it. You have firm commitment. Let's assume your textbook. But at the time the semester starts, the textbook are selling for $120. You did good. You locked your price at $80. Let's assume the textbook are selling at $80. Well you didn't really do good because now you have to buy it at $100 and the current price is $80. So how does firm commitment factor into this whole picture? How does it factor into this whole picture? Well what's going to happen now? You're going to sell goods and services and you are going to have, you're going to have a foreign currency future commitment. So you might sell goods and you may be receiving foreign currency or you might buy goods and you need to pay in foreign currency. But what's happening here? You did not really buy or sell. You just made a commitment. So it's unrecognized means, unrecognized means you don't hedge the item. You don't have any asset or any liability on the books. So you don't have a receivable or an asset exposure or you don't have a liability or a payable exposure. You just have it and you made a commitment. So what you're doing here is you're hedging your commitment. You're trying to protect the commitment that you make. How are you going to protect this? Okay. So we're going to be using a put option in this, in this recording. So I just want to let you know hedge accounting, you could have many combinations. We talked about forward hedge and a prior recording and how can we use forward hedge and treat it as a cash flow hedge? We looked at forward hedge and how we treated a sphere value hedge. We look at foreign currency option. How can we use foreign currency option to protect an existing act recognized? Well, hold on. This is recognized. Foreign currency option recognized currency. Okay. When we have a recognized asset here, what we're talking about is unrecognized foreign currency commitment. So here we talked about recognized and we talked about both fair value and cash flow. And in the prior session, we looked at unrecognized foreign currency firm commitment. However, we use the forward contract. So in this session, we're going to be like the fifth session, we're going to remove the forward and we're going to be using a put option. So this is going to be another recording showing you the same example that they've been working through, but now using a put option. So the best way to illustrate this is to just go through an example. But before we go over the example, it's fun to make sure we all understand how fair value hedging work. The gain or the loss of the hedging instrument is recognized in net income. The gain or the loss of the firm commitment also recognize in net income. So everything is recognized in net income and the accounting treatment requires measuring the fair value of the firm commitment. So we have to know how much is the firm commitment and recognizing the change in the fair value in net income. That's fine. We already said this. And reporting the firm commitment on the balance sheet as either an asset or a liability. Sometimes you might have it as an asset. Sometimes you might have it as liabilities. And how do you measure the fair value of the firm commitment? Well you could use either the spot rate, spot exchange rate or you could use the forward rate. Now on the prior example, we used the forward rate and this example we're going to be using I believe the spot rate. If I remember how I set up this problem. Okay. So let's assume Eximo purchased a put option to sell 1 million euros on March 1st year to at a strike price of $1.50. So this company, what they did, they received an order and they accepted the order and they're going to deliver on March 1st, they're going to deliver the goods. But what's going to happen? They received the order December 1st, but they will not deliver till March 1st. So what's going to happen is this. They made the commitment December 1st that they're going to have, they will be receiving the money, they would receive the 1 million euros, euros actually it's not dollar, they would receive the 1 million euros March 1st. Okay. This is when they deliver and they would receive the euros immediately. What happened here is they made a firm commitment and they exposed themselves to foreign currency. But this is unrecognized foreign currency commitment. Why it's unrecognized? Because they did not deliver. They don't have a receivable. So therefore to protect their position they bought it a put option to sell the euro at $1.50. Now the premium for such option you have to pay a premium. If you want to buy a put option there's a premium is 0.009 per euro. We have 1 million euros times 0.009. We're going to have to come up with, we're going to have to come up with $9,000. Why do we have come up with $9,000? Well to have a put option it's going to cost you money and that money is $9,000. Therefore you have come up to $9,000. Okay. With this option, now just listen to this statement, listen to me carefully with this option the company is guaranteed a minimum cash flow of $1,491,000. Why? Because if the price of the euro is below $1.50, if the price of the euro drops below $1.50 they can sell the euros at $1.50. Now if the price of the euro is $1.55 they're like okay we're going to let the option expire and they will buy the, they will sell the euro at $1.55. So why $1,491,000 because if they sell the euro, if they sell the euro for $1.50 they're going to receive $1.5 million, they're going to cost them $9,000. Therefore $1.5 million minus $9,000 is $1,491, and this is the minimum they would receive. So the company elect to measure the fair value through the reference of changes in the U.S. dollar spot rate. So for this example they're going to be referencing the spot rate rather than the forward rate and you have to document this. You could use either the spot rate or the forward rate but the company will have to determine which one they want to use and that's part of their documentation for the transaction to be considered hedged accounting. And this is what we talked about at the beginning of this chapter. In this case the fair value commitment must be discounted to its present value and the fair value and changes in the fair value of the firm commitment and the foreign currency option are summarized as below. So let's take a look at the changes and make sure we understand what we are giving here. So on December 1st when we made the sale, on December 1st when we made the sale, the option premium would pay 0.009 and obviously that same day if we paid that much the value is that much. The foreign currency option is valued that much. And the spot rate this is what we're using is $1.50. This is what we'll be using to measure our firm commitment and to measure the hedging instrument. By the end of the year, the premium is 0.006 so the premium went down 0.003. And this has to do with the time because as time passes, the always the option goes down in value. Therefore the change in the fair value of the option is negative 3,000. So the option itself lost 3,000. Now we made the firm commitment. We said we're gonna be receiving 1 million of euros and when we made the commitment, the rate was 1.51. Now guess what? The rate is 1.51, sorry when we made the commitment it's 1.50, when we made the commitment, now it's 1.51. What happened to our commitment? If we receive the money today, we receive an additional $10,000. So our firm commitment in other words went up in value. How much it went up? It went up 10,000 because then we would receive 1 million 510 if today we are closing the position and receiving the money. Then we have to discounted at the present value. Therefore the fair value of the firm commitment is $9,883. Okay, then on March 1st when we actually got the money, the premium actually went up. The option premium went up. Now your premium is worth more. Now we might say why? Didn't time expire shouldn't go down? Yes, the 0.006 really went away. But what happened is the spot rate of the euro fell below what you can sell the euro for. Now the spot rate is 1.48 and you can sell your euro at 1.5 because of this option. Well guess what? The option premium is worth 0.02. It went up in value. So the option went up in value, went from 0.006 to 0.002. That's going from 6,000 to 20,000. So that's a plus 14,000. So on the option we made the profit up 14,000. And the reason I'm going all of this in detail because I'm going to show you the journal entries in a moment. But the firm commitment went down. Why did the firm commitment went down? Because if you did not have the option, you would only receive 1,480,000. If you did not have the option, therefore you would receive $20,000 less than $1.50 when you actually enter into the contract. So your commitment went down in value. And notice the option and the firm commitment work the opposite way. If one have a loss, the other one will have a gain. Now the best way to do this, as I go through the journal entries, I show you the big picture here. Just copy this information down and create a T account to keep track of what's going on, especially with the balance sheet account. So let's start with the transactions step by step. First we bought the currency. We bought the option. So we paid $9,000. We created an asset called foreign currency option. Remember at the end of the first year, the euro went up to $1.51. Therefore our firm commitment went up by remember by $10,000, but we discounted at $9,803. If I was writing this book, I would not use the present value because it just had more complication, but it's okay. So now we have an asset. We put an asset on the books and we have a gain that goes into net income. Now remember, we had the gain on the firm commitment. The option lost $3,000 because of the time value of money. Therefore we debit a loss and we credit the foreign currency option. We reduce this asset by $3,000. So simply put, here's let's summarize what we have from an income statement and balance sheet perspective at the end of the year. On the income statement on the firm commitment, we made $9,803. We booked that much of a gain on the option itself. We booked $3,000 loss overall. Copy this number down for year one. We have a profit of $6,083. Now our balance sheet, our cash went down by $9,000. Our fair foreign currency option is $6,000. Why is it $6,000? We started with $9,000. Then we reduced it by $3,000. That's why it's $6,000. That's the options value. The firm commitment is $9,803 and net income goes into retained earning to balance the other side of the balance sheet. Now, here comes the, here comes, we did December 31st. Here comes March 1st. Now here comes March 1st. Well, guess what? Remember our commitment. We have a loss on our commitment and we have a gain on the option. Let's go ahead and book those. So on the commitment, we debit a loss on the firm commitment and we credit the asset. We credit the asset firm commitment. So again, keep track of the firm commitment. Now here's what happened. Firm commitment, you had $9,803 debit. Now you credited, you credited $29,000. Now you're going to have a credit and an asset account. That's okay. Just keep track of it because we're going to be closing the transaction soon, okay? Then you have to book, you book the loss on the firm commitment. Now you have to book the gain on the option itself. The option have a gain of $14,000. Well, you debit foreign currency option. Your option went up and you credit foreign gain on foreign currency option, which is a gain. Notice this is the loss and this is the gain, okay? And you book the gain on the option itself. Now again, if you also want to keep track of your foreign currency option, that's not a bad idea, okay? The foreign currency option, remember, it started at $9, went down by $3, now went up by $14, started by $9, started for $9, went down by $3 at the end of year one and now it increased by $14. Why? Because the value of it went up, okay? So now you're looking at $20,000 in foreign currency option, okay? Then you receive the money. When you receive the money, the exchange rate is 1.48. You debit foreign currency, $1,480,000. You receive the million. You book your sale this is March 1st when you actually made the sale. Then you're going to take your foreign currency and transfer them into $1.5 million in cash. Why? Because you have a put option that's going to give you the option of selling them at 1.5 and rate is 1.48. You're going to use the option, okay? Then you would remove this foreign currency because you're going to give up your foreign currency and now you remove the foreign currency option of $20,000. You have to remove the foreign currency option of $20,000. And let's take a look overall what happened throughout year two, just to kind of see what happened in year one and year two. Then again, before we just the last transaction, you remember we had a firm commitment, a credit balance of $20,000. If you kept track of your firm commitment, you had a credit balance of $20,000 you debited and you transfer it to net income. Therefore, your net income will go up by that much. So let's see what happened over a period of two years. For year two, let's talk about year two. Year two, you have sales of $1,480,000. You had a loss on the firm commitment for year two, $29,803, gain on the foreign currency option, $14,000, and adjustment to income when you close your firm commitment. You have a gain of $20,000. So impact on that income in year two is $1,484,197. Remember the income, the impact of income in year one, let's go back and get that number. It's right here, $6,803. $6,803. If I take my year two income plus $6,803, if I add that to them, I'm going to come up with $1,491,000. And do you remember this number? I said the minimum we'll get is $1,491,000. Why? Because the euro fell below $1.50. What we do is we exercise the option and sell the euros at $1.50. And as a result, when we book all the gain and the losses, we're going to be receiving $1,492,000, which is what we said we're going to do at the beginning, which is $1,500,000. Then we paid $9,000. And by paying that $9,000, we guaranteed ourselves this $1,491,000. Now, what if the rate was higher than the strike price? Again, if the euro was $1.53, $1.55, $1.60, anything above $1.50, we would have not used the option. We would have just sold the euros at this rate and received more than $1,491,000. That's why we said that's the minimum cash you would receive. It means you could receive more, but the minimum is you are guaranteed $1,491,000 by buying this put option. If you have any questions about this topic, please email me. If you're studying for your CPA or ACCA exam, make sure you study hard. If you happen to visit my website or my YouTube, please consider donating to support the channel. Good luck and see you on the other side of success.