 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 wanna buy something and you log the price now at $100, you lock it. You have a 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, how does firm commitment factor into this whole picture? How does it factor into this whole picture? Well, what's gonna happen now? You're gonna sell goods and services and you are going to have, you're gonna 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 gonna protect this? Okay, so we're gonna be using a put option in this recording. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. 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 recognized 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. In 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 a liability. 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 gonna 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 two 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 gonna deliver on March 1st, they're gonna deliver the goods. But what's gonna happen, they receive the order December 1st, but they will not deliver till March 1st. So what's gonna happen is this, they made the commitment December 1st that they're gonna 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 expose 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 a put option to sell the euro at $1.50. Now the premium for such option we 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 gonna have to come up with, we're gonna have to come up with $9,000. Why do we have come up with $9,000? Well, to have a put option, it's gonna 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 $150, if the price of the euro drops below $150, they can sell the euros at $150. Now if the price of the euro is $155, they're like, okay, we're gonna let the option expire and they will buy the, they will sell the euro at $155. So why $1,491,000? Because if they sell the euro, if they sell the euro for $150, they're gonna receive $1.5 million, they're gonna cost them $9,000. Therefore $1.5 million minus $9,000 is $1,491. And this is the minimum they would receive, okay? So the company elect to measure the fair value through the reference of changes in the US dollar spot rate. So for this example, they're gonna 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 paid 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 3000. So the option itself lost 3000. Now we made the firm commitment. We've said we're gonna be receiving 1 million of euros and when we made that commitment, the rate was 1.51. Now guess what? The rate is 1.51. Oh, 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 did 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 discount it 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 it go down? Yes, the 0.006 really went away but what happened is the spot rate, 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 gonna 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, I remember, by 10,000, but we discounted, it's 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 foreign currency option is six. Why is it six? We started with nine. Then we reduced it by three. 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 gonna have a credit and an asset account. That's okay. Just keep track of it because we're gonna be closing the transaction soon, okay? Then you have to 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 for 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 wanna keep track of your foreign currency option, that's not a bad idea, okay? The foreign currency option, remember, it started at nine, went down by three, now went up by 14, started by nine, started for nine, went down by three 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 gonna take your foreign currency and transfer them into $1.5 million in cash. Why? Because you have a put option that's gonna give you the option of selling them at 1.5 and the rate is 1.48. You're gonna use the option, okay? Then you would remove this foreign currency because you're gonna 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 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 gonna 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 gonna be receiving $1,492,000, which is what we said we're gonna do at the beginning, which is $1,500,000, and 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 euros 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 receive 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.