 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at forward contracts that are used as a fair value hedge. This topic is covered in advanced accounting, covered in international accounting, and covered on the CPA exam, the FAR section. If you need additional lectures, please visit my website. But I would always like to connect with my subscribers and viewers. So please connect with me on LinkedIn. I'm very active on LinkedIn. I'd like to know my followers. If you are a Facebook user, I have a Facebook page for my accounting lectures. Please like this page. Obviously, all my lectures on YouTube, please subscribe to my YouTube. So this way you can, you'll always have updates. And my Twitter account is Farhad Lectures. So in this session, we'd look at the fair value, a hedge, which is hedging an unrecognized foreign currency commitment. So the first thing is what is that? How do we use a forward contract as a hedge that's considered fair value hedge? Here's what happens sometime. A company, and specifically since we are US centric, a US firm at a date earlier than the transaction. And what's the transaction date? The transaction date is the date that we do the exchange. But sometime what we do is we make a commitment before the exchange, before the exchange transaction takes place, before the transaction takes place to a foreign company to buy or sell goods or services at an established price and a foreign currency. Simply put, today, today is November the 18th. Today, we might make a commitment to buy goods and services. So this is November the 18th. And we might make a commitment to buy goods and services May 1st. And this transaction will be denominated in euros. So we made the, we made the commitment today and we assume this is a firm commitment means we cannot change it, but the transaction will take place earlier. So this is what we mean by unrecognized foreign currency commitment. So the transaction did not take place, but we have a commitment and that commitment is firm changes in the exchange rate between the commitment date, today's date and the transaction date will be reflected in the cost or the sale price of the asset. So between now and the transaction date, any changes will need to be recorded. Okay, the US firm may enter a contract, which is a forward contract to hedge its commitment. So to protect ourselves from the fluctuation, we enter into a contract. Now with the fair value hedge, all the adjustments goes to the income statement. And we assume it's a fair value hedge. It's considered effective. Effective means overall, it's going to give you no gain and no loss. So overall, it's going to be neutral. And you're going to see what I mean by this once we do the transaction. But no, if the, if the hedge is effective, it means in a sense, we are eliminating the fluctuation, the fluctuation changes in terms of gains and losses. And we will see how this work in a transaction. So the best way to illustrate this is to always work an example. Because I just told you, but you don't see it until we work an example. Consider the following information on December 1st, the US firm contract to sell equipment with an asking price of 10,000 pesos in Mexico, the firm will take delivery and will pay for the equipment in March. So today we're making the equipment, I'm sorry, today we are making the commitment to sell the equipment for 10,000 pesos. And the transaction doesn't take, actually takes place until March 1st. So this is what this is an unhedging for an unrecognized, this is unrecognized foreign currency commitment. And we're going to hedge against it. Okay, on December 1st, 2008, the company entered into a forward contract to sell 10,000 pesos for 948 on March 1st. So the US company said, you know what, we don't know what's going to happen March 1st. And we're not interested in taking our chances. Therefore, we want to find someone that's willing to buy from us the pesos at 948. And we would receive 94,800. We are happy to receive this. Now on March 1st, we might be able to sell the pesos for $10 and get 100,000 or the pesos could be for $8 and we may only get 80,000. We're not interested. We're just, if we can get 94,800, we're happy with this. What happened to the pesos on March 1st, we don't care because this is when we get the money. Okay, so the spot rate and the forward rate for March 1st are as follows. So December 1st, the spot rate is 948. The forward rate is 9, sorry, the spot rate is 954. The spot rate is 948. And this is what we bought. We bought the forward contract for March 1st. On December 31st, we really don't care about the spot rate. I'll tell you why. And the forward rate is 944. On March 1st, the spot rate is 947. Now remember, the spot rate has to do with the transaction. And the transaction doesn't take place until March 1st. That's why I ignored the 954 and the 949. On March 1st, the equipment was sold for 10,000 pesos. As expected, the cost of the equipment is $40,000 to us. First thing we do, since we enter into the contract to sell the 10,000 pesos, we'll need to record that transaction. So we're going to debit a receivable from exchange dealer, 94,800. Remember, this is what we're going to be receiving. This is a receivable. This is a receivable. Okay. And we credit forward contract payable to exchange dealer, 94,800. And what I suggest we do is to go ahead and just like what we did in the prior session, create a T account, one for the receivable, 94,800 and one for the payable, 94,800. Now here's what I want you to know. The receivable is the fixed amount in this example versus the prior example. And the prior example, the payable because we had to pay, remember the 27,594, this was the fixed amount. In this example, since we are receiving, the receivable is the fixed amount. We're only interested in receiving that much and we bought the contract to sell the 10,000 pesos to receive the 94,800. Now this is the contract. Now the foreign currency payable to exchange dealer is basically the forward contract. And this is what we need to keep track of if any changes up or down. So the foreign currency payable is what we need to keep track of. Just like in the prior example, we kept track of the foreign currency receivable changes. In this situation, we keep track of the foreign currency payable example. All right, let's go back. So December 1st, we only have one transaction. Basically, we bought the contract. Now we don't have the underlying hedged. We don't have the item that's being hedged on the books yet. So we don't have any currency yet. Okay? So on December 31st, what's going to happen? We have to look at the forward rate and see what happened. On December 31st, the forward rate was 944, but it was 948 when we bought the contract. Is this good for us or bad for us? Actually, since we have a, since we have a receivable, it's good for us. So guess what's going to happen? On December 31st, we are going to have a foreign currency exchange gain. You might be saying, why do we have a foreign currency exchange gain? Once again, because we bought the contract at 948 and now the contract is 944. So if we waited until December 31st, if we waited until December 31st, we would have received only 94,400. Luckily, we did not. We entered into the contract earlier. Therefore, from a hedging perspective, we, because we have to mark our hedging position, we have to mark this account for incurring, foreign, forward contract payable to exchange dealer to market. We have to increase it by 400. I'm sorry, we have to reduce our liability, not increase it, which yeah, increase its value, reduce it by 400 and record again a 400. So let's do, let's update this. Let's stop right here and update our T account. So what's going to happen is we're going to have to debit foreign currency payable, which is basically we did good and credit again. Now remember what I told you earlier? I told you a fair value hedge is considered to be an effective hedge. And what does it mean an effective hedge? Effective hedge means you eliminated the gains and the losses. Hold on a second. I just recorded a gain on my, on my hedge. What do I need to do? Well, remember, when you are using hedges, when you are hedging, when one of your position goes up, when the hedge goes up, the item then being hedged goes down, or when the item being hedged goes up, the hedge goes down. So they work in the opposite direction. But hold on a second. I don't have the item on December 1st. I did not record the item that's being hedged, although I am not recording the item that's being hedged, because this is a fair value hedge. So listen to me carefully. This is a fair value hedge. I told you this from the beginning. We have to eliminate the gain. This gain has to be gone. Why? Because we have to offset it. The hedging, the concept of hedging, when the item being hedged goes up, the hedge goes down. When the hedge goes down, the item being hedge goes up. So now the hedge went up. We had a gain. Well, we have to offset it with a loss. And what we do, the loss is going to be our firm commitment, because we don't have a commitment yet on the books. So we have to do, we have to create a liability called firm commitment. And this is a liability. What we do is we credit this liability $400 and we debit the loss $400. So let's go ahead and update our record on the Excel sheet. We are going to record the loss of $400. And why are we doing so? Because it's an effective hedge. This is, this will not exist when we do the cash flow hedge. Okay. And we create a firm commitment, which is this is a, this account is a liability. And why did we do so? To reflect, we have an effective hedge. To reflect, we have an effective hedge. All right. Now what's going to happen next, we adjusted our December 31st. Let's move to March 1st. On March 1st, this is when we're going to settle the transaction. Again, we have to do two things. We have on March 1st, we have to adjust our position, adjust our foreign contract payable exchange, which is our hedge. We have to market to market. Okay. And what's the rate on March 1st? Well, the rate, as I told you earlier, on the settlement date, the forward rate is the same as the spot rate. So I don't want to put it here. It's misleading. But the forward rate is the same as the spot rate, which is 947. Okay. So by March 1st, the hedge, remember, we had the hedge was, we started at 948. We started at 948 went down to 944, which was again on December 31st, that it went up to 947. So from December till March, the hedge position worked against us. In other words, we have $300 and losses. Why? Because it was 944. Now it's 947. So we lost 0.03 times 10,000 pesos. That's equal to $300. Therefore, we have to debit a loss, debit a loss, we have a loss of 300, and increase our payable, increase our payable by 300. So let's do so. Let's do so immediately before we proceed. This way, I want you to keep track of this. So basically, what's going to happen, the gain that we had earlier on December 31st, we lost some of it, we lost 300 of it. Why? Because the foreign currency was 947. The pesos was 947. Okay. And 300 here. Okay. Now, remember, this is an effective hedge. What does that mean? It means when we have a loss, the item that's being hedge, which we don't have on the books yet, we'll have to take a gain. But since we don't have it on the books, what we do is we give a gain to the firm commitment. We reduce our firm commitment by 300. Therefore, we credit foreign currency exchange 300 and debit firm commitment 300. Because we don't have the item on the books yet. That's why we do so. So now, firm commitment is 300. The balance is 100. So this is the balance. Let me compute the balances. And the balance for the payable is I started with 94,800. I reduced it by 400. I reduced it by 400 December 31st, and I increased it by 300 March 1st. So my balance right now is 94,700. And this is my balance here, 94,800. Now, remember on March 1st. This is when I deliver my product. And when I deliver my product, I record my sale. And how much is my sale? My sale is 94,800. How so? Well, remember, I'm receiving 10,000 pesos, and I'm going to receive for them 948. How did I know I'm going to receive 948? I entered into a contract. Somebody guaranteed that price to me. Therefore, I'm going to credit my sales 94,800. Now, what am I going to receive in return to that sale? I'm going to receive an investment in foreign contract. Now, I can also debit my foreign currency payable now. But first, we're going to debit an investment in foreign contract, 94,700. And I need to eliminate because now I have the commitment on the books. I have the sale on the books. I need to eliminate my firm commitment. I had a $100 in firm commitment. I eliminate my firm commitment. So this transaction, this transaction to record the sale and remove the commitment. And this is what I just did. Now, remember, I put the investment on foreign currency on the books because I don't want to debit my foreign currency payable from exchange yet. I will do it on the next slide. So the next slide, what I would do is the cash I would receive is 94,800. This is the cash that I would receive. Now, remember, I put investment in foreign contract and foreign and forward contract on the books. I'm going to credit this account and debit forward contract payable to exchange dealer. I could have did this in the prior session. Then once I debit the cash, I credit this. So here's what I did. Let me go back and show you what I did at the end. So on March 1st, here's what happened. March 1st, I let me just create a sales account here because I don't have a sales account. Okay. On March 1st, I credit my sales. I credit my sales 94,800. I remove my commitment 100. So this is, I remove this account. Okay. Then what I do is I debit my investment in forward contract because this is what I really am going to receive. I'm going to receive my contract. Now it mature 94,700. Okay. That's that. Then the next thing I'm going to do is I'm going to receive the cash. How much cash am I going to receive? 94,800. I debit my cash and I credit this account here 94,800. Okay. And this is what I always was looking for. We're looking for this. So now this is zero. This is gone. So I debited my cash. I credited my sales. And this is basically what I did. This is basically what it boils down to. Debit cash credit sales. We'll do all of this to end up with debit cash credit sales. Then I'm going to remove my investment. So I'm going to credit my investment 94,700. This is gone. And I'm going to offset it against the payable 94,700 94,000 94,700. And this is gone. So this is gone. This is gone. This is gone. This will be this was close at the end of the year. This was close end of the year. This will be close at the end of the year. And basically what I end up with is what I thought I will end up with is debit cash to 94,800 from my sale and credit my sale 94,800. And I knew this was going to happen from the get go because I entered into that forward contract. I entered into that forward contract. I also I debit my cost of goods sold credit inventory 440,440,000. Now if you're asked what is the total gain on the gross profit on the sale, whether it's the cash minus cost of goods sold, it's my what's my which is my gross profit on this transaction, my gross profit on this transaction. So this is a fair value hedge. What's what's interesting about the fair value hedge and what's like what student kind of they get stuck on is the firm commitment. Remember, you have to have a firm commitment because this is a fair value hedge. A fair value hedge means it's an effective hedge. Effective means gains and losses goes to the income statement that they kind of cancel each other. If you have a gain on the hedge, you have a loss on the item being hedged. If you have a loss on the item being hedged, you have a gain on the hedge. But here we don't have the item being hedged as of December 1st. Therefore, we create this firm commitment to keep track of this. If you have any questions, any comments by all means email me. Study hard for the CPA exam. If you have any questions, email me and if you happen to visit my website for additional lecture, please consider donating. Good luck. As always, study hard for your CPA exam. It's worth it.