 This is Professor Farhad. In this session, we would look at forward contract as a hedging instrument. This topic is covered in advanced accounting, it's covered in international accounting, and it's covered on the CPA exam, the FAR section. If you want additional lectures, please visit my website or visit my YouTube channel. I would like to always connect with my viewers. I'd like to know them even on a personal level. You could subscribe to my channel on YouTube. You can connect with me on LinkedIn. I'm very, very active on LinkedIn. You can like my Facebook page, Accounting Lectures, or you can connect with me on Twitter. So let's go ahead and get started about the hedging foreign exchange rate. As we saw in the prior session, if you viewed the prior session, what we established, we established the fact that if you are involved in foreign currency transaction, if you buy or sell in a foreign currency, as a result, what's going to happen is this, you're going to have a risk. And what is that risk? The risk is the currency could work against you. The foreign currency position could work against you and you could have a substantial loss. But also you could have a reward where the currency works to your favor and you could have a gain. Well, guess what? You're not in the business of playing the foreign exchange rate risk. You're not interested in the risk. You're not interested in the rewards. Specifically, you're not interested in the risk. And you don't care about the reward because you're not in the business of trading foreign currency. So what you do, you're going to use hedging techniques. You're going to be hedging foreign exchange risk. Now, how do you hedge foreign exchange risk? You will use something called derivative instrument. Now, what is a derivative instrument? Well, basically a derivative instrument is a financial instrument. Basically, it's a contract that provides the holder or the right or if you can buy it or you can write it with the right or the obligation to participate in some or all of the price changes of another underlying value of measures that does not require the holder to own or deliver the underlying value of measure. This is a long statement for what? Well, for one thing that I need to tell you that you could have derivative instrument not only for foreign currency transaction. This is only one thing. You could have derivative instrument for many other financial assets such as stocks, bonds, gold, real estate. So you could have derivative instrument. And what are they really? What's going to happen is this, if the prices go up, you can participate in those prices increases. So that's what it gives you that option. Or if the prices goes down, you can protect yourself depending on what position you are on. Okay, and we will see how it works. But that's basically what it is. So you are basically taking a position to either participate in the reward, if the price goes up or protect yourself if the prices went down. Now, we have two types of derivatives instruments. We have forward based contract and option based. Basically, in a sense, they work the same in terms of production, but they have a different purpose. The forward contract in a forward contract, what's going to happen is this, you are looking to either buy a specific amount of foreign currency if we're dealing with foreign currency or sell a specific amount of foreign currency at a specific date. So forward base is when you will have a specific transaction and you would like to protect. Option based, it gives you the option within a period to either buy or sell the option. So basically, but option basis, I'm not going to say it's speculative, but it's more speculative. We're going to be interested in actually it is more speculative than forward based. Forward based, you're looking to protect a certain position. And this is what we're going to be working with in this chapter. Now, also, you could have a forward base for stocks, for bonds, for gold, and you could have options for stocks, bonds or gold, but we are dealing with foreign currency in this situation. So derivatives are recognized in the balance sheet. So once you buy a derivative, it's recognized at the balance sheet at fair value, resulting in a payable position for one party and the receivable position for another party. So when you buy a forward or when you buy an option, you could have a payable, you could have a receivable depending on what position you are on. And we would look at an example today. So what is a forward exchange contract or a forward contract? Because this is going to be the heart of this session, we're dealing with forward contract. The forward contract is an agreement to exchange currencies for two different countries at a specified rate, the forward rate on a stipulated future date. So basically, you know, you need a certain amount of money in the future in a foreign currency. Why? Because you purchased from another country, you purchased goods and services from Germany and you need to pay them. Therefore, and you need to know, you're going to know when you need to pay them, the time, therefore you buy a forward contract to make sure you can pay them. Or you sold something, you sold goods to another company, to a German company, and they're going to pay you in euros. And you want to convert those euros into US dollar, but you want that amount to be guaranteed. You don't want to play the exchange rate risk. So basically, an example will be something like this today, you either bought bought or sold something and the spot rate, which is the exchange rate today is 0.168. Okay, now what you would do, you would say, you know what, the spot rate is 1.68, but I'm not interested in what's going to happen 90 days from today. Why don't I buy a future forward rate at 0.75, where I can exchange my currency at 1.75, or I can exchange my currency if I want to depending if it's available forward rate at 0.162. If the forward rate is lower than the spot rate, we say that there is a discount. If the forward rate is above the spot rate, so it's a premium depending on what you what you think is going to happen to the currency. Okay, but basically the forward rate is different than the spot rate, but you are guaranteed that rate. Okay, because let's assume this is a 90-day contract. Okay, so what's going to happen on that date, the spot rate could be 0.2 or the spot rate could be 0.1. It doesn't matter to you. You are locked at that rate, and that's what you want to do. You want to lock yourself, whether you are buying or what you are selling. So what type of a forward contract to choose from? You have forward contract used as a hedge. In under hedging, you could have four different options. For example, you could hedge a foreign currency transaction, which we'll see an example in this session. You could have unrecognized firm commitment. And what is unrecognized firm commitment? This is when you enter into a contract to buy something in the future. So you have a firm commitment. Firm commitment means you enter into a contract and that's it. You're going to have to buy the item. We call this a fair value hedge and we'll work an example later about fair value hedge. And we have something called foreign currency denominated, which is forecasted transaction. Here is you planned to buy something in the future. So what you want to do is you want to protect your position. This is called a cash flow hedge. Now, why do we differentiate between B and C? We're going to see that in B, any gains and losses goes into the income statement, which is the it goes to earning. While in C, first it's going to go into OCI, then from OCI, it's going to go into the income statement. So where do we have the gains and losses? Then net investment in foreign operation. We don't really cover this, but if you have an investment in a foreign operation, you made an investment, you could also hedge your position for that investment. Also, you could use forward contract for speculation. Speculation means gambling. Forward contract used to speculate changes in foreign currency. Here you're interested in the gain and the loss of the of the contract itself. Not you are not protecting anything. You may not have something to protect. You're just interested in basically you're going to the casino in a sense. And the best way to illustrate this is to work an example to show you how this whole thing works. So we have Crystal Exporting Company is a US wholesaler engaged in a foreign trade. The following transaction is representative of its business dealing. The company uses a periodic inventory system as an is on a calendar year basis. So December 31st is year end. All exchange rate are direct quotation. That's fine. December 1st. So here's what happened December 1st. Crystal Exporting purchased merchandise from Chang Limited, a Hong Kong manufacturer. So the first thing is we're going to have an accounts payable. Okay, why? Because we bought something from a Hong Kong manufacturer. The invoice was for $210,000 Hong Kong dollars. So we have to pay $210,000 on April 1st. Notice the transaction took place. We did not make a commitment. So notice here, we did not make a firm commitment. You're going to see what a firm commitment later here what we did is we have a transaction a transaction took place. Okay. On this date, Crystal Exporting acquired a forward contract to buy $210,000 Hong Kong dollar on April 1st for .1314. So we know we're going to need the money on April 1st. So what we did is we said, okay, let's just make sure we cover all our basis. What does that mean? It means let's go ahead and buy a forward contract at 1.1314. So let me show you what happened here. $210,000 times .1314, $27,594. You basically you basically log yourself into paying this amount and you're going to see how later we're going to see the transaction that this is basically what you are going to be paying for those goods and services. Why? Because you bought a contract and you are guaranteed the price. Now, here's some additional information we need to work through this. Okay. To record the transaction. Okay. On April 1st, Crystal Exporting submitted full payment and we already know how much the payment it's going to be after obtaining the $210,000 Hong Kong dollar on its forward contract. So it basically cashed out the investment. So here's the additional information spot and forward rate for the Hong Kong dollar worth as follow. December 1st, this is the spot rate. And this is the forward rate that they purchased. Remember, they purchased the forward rate on that date. So what happened on December 1st, we technically have two transactions on December 1st. First, the transaction for the purchase and the transaction for the hedge. Basically, what you have to think about this is you have two transactions. What do I mean by you have two transactions? Let me show you the two transactions. One is you have to record the purchase. And what's the purchase? The purchase is $210,000 worth of goods from a Hong Kong company. The spot rate, you record that at the spot rate and the spot rate is 0.1265. Therefore, you have an accounts payable of $26,565. So this is one transaction. So what you do now is you put your, you debited your purchases and you credited your accounts payable and you credit your accounts payable based on the spot rate because this is what the spot rate, you need to record the transaction today. On that same day, you're going to enter into another transaction. Now you're going to be hedging your position. Hedging means you want to guarantee the price you're going to, you are going to pay for those Hong Kong dollars. What you do is you purchase a forward contract and as I told you the forward contract, the forward rate is 1.314 and someone told you, I will sell you the Hong Kong dollar at 1.1314. So your commitment is $27,594. So what you do is you debit a forward contract receivable from exchange dealer, which is basically this is an asset at $27,594 and you credit dollar payables to exchange dealer and you have a payable to the dealer. You're going to have to pay the dealer $27,594 because they promise they will sell you that currency at that date. So you have an asset and you have a liability. Now let me tell you this and I want you to write this number down. Remember you are committed for $27,594, but today your payable is worth $26,565. So if you find the difference between those two, basically you are willing to pay $1,029 more than what you would pay today. Now why are you paying this extra? Because you want to have a peace of mind. You want to wake up a pro first and not knowing that the Hong Kong dollar is went to 0.2 or 0.4, 0.2 or 0.4 where you have to pay a lot. You're saying, you know what, I'm going to just lock in my gain. So remember this number here, $1,029 and you're going to see it later. So this is what you did. You protected yourself by entering into this contract. Now what I suggest you do is this. So here's what we're going to do. What I want you to do is create T accounts and I want you to create those T accounts and start to plug in some numbers because I want you to follow this in a T account transaction because T account should help students. So we have an accounts payable of $26,565. We have a forward contract receivable of $27,594 and we have a payable of $27,594. Now here's what I want you to know. Basically we are hedging something. What are we hedging? We are hedging our accounts payable. So this is the item that's being hedged. The payable is the item that's being hedged and the forward contract receivable is the hedge itself. This is the hedging. We hedge the position with the forward contract. So the accounts payable is what's being hedged. Now what's going to happen is we're going to have to keep track, keep track in a sense of a market value. We have to keep track of the fluctuation in both the payable as well as the forward contract. Okay, now let's forward fast forward till December 31st. December 31st, the spot rate, if you go back and look at the problem, the spot rate equal to 0.1259. The spot rate equal to 0.1259. The spot rate was, the spot rate was when I entered the transaction was one, on December 1st, it was 0.125. So December 1st was 0.125. Now it's 0.1259. So what does that mean? It means right now when I adjust my payable, if I take 210,000 times 0.1259, 0.1259, I will find out that my payable should be adjusted to 26,439. So let's go ahead and process this transaction, 210 times the spot rate as December 31st. This is my payable. My payable should be 26,439. My payable is 26,565. Well, my payable went down. I have a gain. Therefore, I debit accounts payable, $126. I'm going to reduce my payable and I'm going to have a gain on the item being hatched. This is the item being hatched. I have a gain on the payable. So let me go ahead and update my books. Let me show you what's going to happen. So for my payable, I debit the payable, $126. Now my payable equal to $126,565 minus the debit. My payable equal to $26,439 and I credit again, $126. So that's good news. Basically, the spot rate worked to my favor. Why? Because the rate went down as a result. I have less of a liability. I have a less of a liability of $126. Now, I have another adjustment to make. Remember, I have to adjust the item being hatched and I have to also adjust my hedge, which is the foreign currency contract. Let's go back to the rates. So just in case you're wondering where I came up with all these rates, this is where I came up with all these rates. So this is the 0.159. So I figure I'm done with my spot rate. Now I have to adjust my forward contract. When I enter into this contract, I bought the forward contract at 0.1314. Well, guess what? Too bad. If I waited till December, I could have bought the contract at 0.1308. I could have bought the contract at 0.1308. Therefore, my contract went down in value. How much did it go down in value? Well, now I can buy it for that much. So it's 0.1314 minus 0.1308. If I waited, I could have saved 0.006 if I bought that contract on December 31st. I have $210,000. Oh, $126. Interesting. So I have a loss of $126. Well, as this number sounds familiar, yes, I had the gain on the payable of $126. If you remember, I had the gain on the payable of $126. But what's going to happen since I have the opposite position because I bought the forward contract, if I have a gain here, I'm going to have a loss on the position. So if I take $210,000 times the forward rate, so I should have a payable now, a US dollar of $27,468. I'm sorry, this should be my forward contract. My forward contract receivable should be $27,468. But my forward contract receivable is recorded at $27,594. So this is a mistake. It's a forward contract receivable that we are adjusting. Therefore, I have a loss of $126. Therefore, what I have to do, I have to reduce my receivable by $126. Therefore, I debit the loss and I credit my receivable. Forward contract receivable is credited $126. And don't be surprised if I have a gain of $26 and a loss of $26. That's the whole purpose of the contract. The whole purpose of the contract is to offset the losses, offset the losses and offset the losses. In this situation I have a gain. Well, the loss will offset the gain. So I'm neutral, basically, all in all, I'm neutral. Now, if I did not buy the contract, I would have had a gain of $126, but I'm not interested in the gain. Okay, I don't want to take that chance. So think about it. As of December 31st, the company was better off not buying the hedging contract because they had a gain. Notice they had a gain. But because they bought the forward contract, they incur a loss. But they're okay with this. Okay, why? Because they're thinking about April 1st. That's what they're thinking about. They don't know what's going to happen on April 1st. Therefore, on that date, I credit my receivable $126. Now, the balance in my receivable is $27,468 and I have, I debit a loss of $126. I debit a loss of $126. Notice I am not going to touch this. I don't touch this till the end because this is basically a fixed figure. So this is basically this dollar payable to exchange dealer. This is how much I have to pay. You don't adjust this when you have a payable. You don't adjust this. Listen to me when you have a payable. Okay, when you have a payable, you don't adjust this because you logged in. The payment of $27,594. Now, let's fast forward till April 1st. On April 1st, the spot rate is 0.1430. That's the spot rate. And you are responsible for $210,000 Hong Kong dollars. So $210,000 times 0.1430. Your payable should be now $30,030. Now it worked against you. The payable worked against you because the rate went up. And you thought, as of December 31st, you are responsible for $26,439. So the first thing you do is you prepare an adjustment to adjust your payable, the item that's being hedged. So you have a loss of $3,591. Bad news. Debit a loss, credit the payable. So let's go ahead and update the transaction on the Excel sheet. On the Excel sheet, what I would do, I will debit a loss. I have a loss of $3,591. And I will credit my payable. I credit my payable $3,591. And this is my final balance. Okay, this is a balance. This was a balance before. And this is my final balance. And my final balance for the payable is $30,030. Now my initial, when I first started this, this was December 1st, when I started this, I thought I'm only responsible for $26,565. But based on the spot rate, I would have been responsible for $30,030. This is the bad news. This is the bad news for me. But what's the good news? I don't care. Why? Because the good news is, I hedged my position. I hedged my position. That's the purpose of the hedge. Now let's take a look to see what happened to the hedging position. My hedge went up in value. Here's what happened. On April 1st, I have a contract. Remember, I have a contract. And the spot rate is 0.1430. Now the spot rate and the forward rate will equal to each other on that date. Therefore, my foreign currency contract should be worth $30,030. So what does that mean? My forward contract rate was worth as of December 31st, $27,468. Therefore, my asset is going to go up by $2,562. I debit my receivable and I credit my game. Once again, the spot rate and the forward rate are equal to each other. Simply put, my forward rate and the spot rate are the same on that date. So now I debit my receivable, $25,062, and I credit the game. And now here is, oh, thank God, I entered into this contract. So now let me update the transaction there. So I'm going to go ahead and update my accounts. Now I have a gain. Let me just put the gain here. I have a gain of $3,591. And my balance should be, if I take those two together, my balance should be, oops, let me one second here. It was $27,468 plus $3,591. $31,000. Now actually my gain is only $2,562. $2,562. There we go. It's $30,000, $30,000 and $30. My payable is $30,000 and $30. Now I also have a gain. I have to book a gain of $2,562 because I debit the receivable, credit the game. Now this is where the hedge played a role in helping me cover my basically cover my risk. Okay, let's take a look at what's going to happen next. Now I have to settle the transaction. Now I did all the updates. Now I have to settle the transaction. How much am I responsible for paying? Well, let's see. I'm only responsible for paying $27,594. Therefore I credit my cash $27,594. Hold on a second. Where did this number came from? $27,594. Well, let's go back to the Excel sheet. I know I'm flipping back and forth but I want to show you this. Remember I told you I'm only responsible. This is in the green button right here. I'm only responsible for that. Therefore I'm only going to pay $27,594 regardless of the payable. Why? Because I enter into this contract that gave me that amount, that gave me this payable amount, that fixed amount. Let's go back to the... So let me... I'm going to debit this now because I'm going to pay it $27,594. I'm going to pay it. Now my balance is zero. So let me just kind of take this account out. So once I make the payment, once I make the payment, basically this account is basically gone. This account is basically gone. Okay? This account is gone. This account is gone. Let me go back. So I want you to follow here. So I debited. I credited my cash, debited my payable. Now also what I have to do, I am going to replace my forward contract receivable with an investment because this is what I actually bought. I bought an investment. So I'm going to exchange. I'm going to remove my forward contract receivable, this amount and place it into an investment account. Then I'm going to take the investment account and remove it against my payable. Now you might be saying, why don't we just instead of the second entry, debit the account's payable, that's fine too, as long as your professor is okay with it. So simply put, this entry is not needed. What you do is you remove the payable and the receivable against each other. But we want you to see... I want you to see how the transaction proceeded from the cat go. So what we did, we transfer first. I transferred the foreign currency. I transferred this amount to the investment. Basically I cashed my $30,000 and $30. I cashed out my investment $30,000 and $30. And what happened? This account is gone. Then I closed my account's payable with my investment. So I credit this and I debit the payable. Now this is zero gone and the investment is zero gone. So basically all these accounts are gone. And this is how I settled my transaction. So all in all, all in all, all in all what happened is this. Let me go back and review this. First let me show you what happened if I did not, if I did not hedge this position. So I'll show you the value of the hedging. So if I did not value this position my accounts payable started at $26,565. By December 31st the currency moved into my favor and I had a gain. I had a gain of $26,000. Therefore my payable became $26,439. By April 1st the currency moved against me and I had a big loss of $3,591. My payable would have been $30,030. Overall my loss would have been $3,465 comparing the beginning balance and the ending balance. Those two. The beginning balance I'm going to highlight the beginning balance and the ending balance. My loss would have been $3,465. That's without the hedging. Now this is the value of the hedge. I went, I entered this into this contract and I said I am going to pay $27,594 and I bought a forward contract and that forward contract goes up and goes down in value and as it goes up and it goes down I gain. On December 31st the forward contract moved against me and moved exactly against me the amount that the payable moved in favor. So basically the gain that I had on the payable was canceled by a loss. Well that's not good but hey I chose that route because I want to protect my position. I don't know what's going to happen on April 1st. On April 1st the forward contract, the forward contract is inverse to the payable. It may not be 100% inverse here. It's not 100% but I know from the beginning I am going to have a loss of $1,029. I told you that but let's keep going. So my forward contract went up in value by $2,562. So this $2,562. So the net increase is $2,436. I had a loss $126 again of $25,62. So the net increase I had a gain on the forward contract of $24,36. I had a loss of the payable of $34,65. Remember what I told you? I'm going to pay $1,029 more than the initial contract. Remember when I started this position I said I am responsible for $26,565 based on the spot rate and I told you I'm willing to pay $1,029 more to make sure I am protected. To make sure I am protected and this is exactly what I did. $1,029 more as a result I end up paying $27,000. This is $4,926. $25,94. $27,594. And this is the amount. What is this amount? $27,594. This is the amount. If you remember from that green right here, this is the amount that I said I will pay $27,594 and my original balance was $26,565. So I was willing to accept to pay a little bit more rather than having a surprise on a pro first. So this is the value of the hedge. So simply put basically we had two things to keep track of. We had the accounts payable to keep track of of changes in the accounts payable up and down and we had to keep track of the forward contract receivable, keeping changes of it up and down. Now this one's a liability example. If we have an asset, so rather than a liability, here we were hedging a liability. We could have an asset. We could have an account receivable instead of a liability. The concept is the same. The concept is the same. However, when we have a receivable, we enter into a contract to sell the foreign currency, not the buy because when we receive the money, when we receive the foreign currency, we want to sell it. So we are selling the foreign currency, not buy the foreign currency. So simply put what's going to happen if we go back to the Excel sheet, this will be the fixed amount and this is the amount that we change the value for. This is the amount that change value. If you have any questions, any comments by all means, email me. If you're studying for your CPA exam study hard, if you want additional lectures, please visit my website and if you happen to visit the website, please consider donating.