 Hello and welcome to this session in which we will discuss Fair Value Hedge. This sounds very complicated but let's see what Fair Value Hedge is. What is hedging? So let's first discuss the word hedge then we'll discuss the fair value and look at the big picture because understanding what a fair value hedge is will tremendously help you in the journal entries and the accounting concept. What is the idea of hedging? What are you trying to do? What's hedging? Hedging in accounting means protecting, hedge, protect. So what are you protecting and what are you using to protect? Well first of all you're going to be using something called derivative instrument and if you don't know what derivative instruments are please take a look at the prior recording because we discussed derivative instruments. So the derivative instruments are the tools that's going to help us hedge, protect. So what is hedging? It's protecting your exposure, protecting hedging. Think of protecting people will understand the word protecting more than hedging, protecting your exposure to changes in a fair value of an asset. Recognized asset means an asset that that you have like maybe a commodity, a stock, foreign currency, something that you have on your balance sheet that you are trying to protect, to protect its fair value or it could be a liability. So you could be protecting an asset, you could be protecting a liability like a bond or you could be protecting unrecognized commitment. It means you made a commitment but it's not recognized. It's not recorded on the balance sheet as of yet. What could be an example of unrecognized commitment? You could have what's called a firm or purchase commitment where you entered into a contract to buy orange juice, to buy coffee, to buy cotton, to buy something for your business but you only entered into a contract. What you can do, you can protect yourself from changes in the value of the prices and that contract and don't worry, we'll work an example specifically about unrecognized commitment but the idea is you are trying to protect yourself from fluctuation, from the fluctuation of something that's going to be affecting your asset, your liabilities or that contract unrecognized firm commitment. So to hedge, you have to have two things. You have to hedge item, something to protect. So you need something to protect and you need the tool to protect it which is the hedging instrument which could be an option, forward, swap contract, something to do. So you need two things in the hedging. You are protecting something, you are protecting the castle and you need weapons to protect the castle. You need soldiers to protect that castle. In hedging, you have an asset and you need something else, a cold option, a put option, whatever you need to do, a forward contract, a swap contract to protect that thing. So bear in mind, you have two things. Now, those two things from an accounting perspective, they're going to have a negative correlation. What does that mean? It means if your asset that you are protecting goes up, your hedging instrument will go down and they cancel each other and the opposite is true. If your asset that you are trying to protect go down in value, your hedging instrument will go up. So the point is to increase certainty because if they cancel each other, the net effect is zero. Theoretically, if the net effect is zero, there is no volatility on your balance sheet. It means although your assets went up, well, you have a loss. Your assets went down, you have a gain. So you're trying to actually not even decrease, remove volatility as much as possible. Obviously, if you could remove it, that's going to be a perfect hedge. It means the net effect is zero. Now, when we learn, we assume that we have a perfect hedge where the effect is zero on everything and you will see what I mean when we work an example. But specifically, now we talked about the idea of hedging. What is fair value? Fair value means there is a risk in your fair value. It means the item that you have, it's going to change in value. So there's a fair value uncertainty. The fair value is going to change, go up or down. But the point is if it went up, you would lose on the hedging. If it went down, you would gain on the hedging. So you are protected from volatility. So remember, in the prior session, also, we talked about speculation. Sometimes you enter into a derivative instrument without anything to hedge. And actually, this is what we did in the prior session. In the prior session, let's go back here. What I just said is important because because in the prior session, what I did is I had hedging instrument. I had a hedging instrument. Remember, I work an example with a call option, but I did not have anything to hedge. So I had the derivative instrument for speculation purposes, for gambling purposes. Fair value hedge is different. Fair value hedge, you buy the instrument and you have something to protect. You have something to protect. So hedging is basically in a nutshell, using derivatives to offset negative impact of changes in interest rate, foreign currency, stock value, fluctuation, whatever you want to do, commodity prices, so on and so forth. So you have a tool to protect yourself from the negative impact. You assume there's a negative impact and you protect yourself. If there's a positive impact, what's going to happen? The hedge will offset that positive impact. The point is to reduce volatility, get root of volatility. You want to increase certainty because you're in the business of not buying and selling those instruments. You're not trying to make a profit. You want to reduce your risk. Now, we have to understand to qualify for hedge accounting, because you can hedge and it may not be hedge accounting. You could hedge using different methods. We have to have certain procedures to designate a hedge. As hedge accounting, we need formal documentation. So when you have a hedge, when you're trying to hedge something from an accounting perspective, you have to show this is hedge accounting. You need to tell us why are you entering this contract? See, the company will have to have a formal documentation. This is basically those are formal things you have to do. Are you hedging the fair value of the asset or the liability or the unfirm commitment? Or are you hedging cash flow? We have a hedge called cash flow we'll talk about later. You need to tell us, describe the effectiveness of the hedge. How is this hedge helping your business? So you need to show all of this for the hedge to qualify as hedge accounting. Why? Why do you want to qualify as hedge accounting? Because it's going to make a difference to your journal entries. So you have to tell us what are the hedging instrument? What are you using? Coal, option, future contract? Tell us what are you are doing? What's the hedge item? What are you trying to protect? The point is, the management should have a documentation documenting their strategy. And those are the things that they will spell out in that strategy. So what are some of the risk eligible for hedging? For example, if you are exposed to commodity prices, foreign currency risk, interest rate risk, you have inventory like or investments risk, you can hedge those. You are not eligible to do hedge accounting if the performance risk, political risk, so on and so forth. Now you can hedge them if you want to, but they don't qualify for hedge accounting. In other words, hedge accounting will allow you to book the gains and the losses certain way on the income statement. And we have two types of hedge accounting. We have fair value hedge, which we will discuss in this session. Again, the fair value hedge is trying to protect the value of the things that you are trying to protect. So what you want to do, your risk is you have a variable fair value. It means the fair value could go up, the fair value could go down. You want to convert this variable fair value into a fixed fair value. You want to keep it the same. Don't worry, you'll see an example shortly. And the fair value goes to the income statement. So when we have the changes, it's going to go to the income statement. Then we have the other type of hedge, which is called cash flow hedge. Here we have uncertain cash flow. Okay. So they do have a cash flow risk. What we're trying to do, we're going to convert the floating, the variable into a fixed. We'll talk about this in the next session. We'll have a separate recording for cash flow. In this session, we're focusing on protecting the fair value of something, the fair value of an asset, the fair value of a liability or unfair commitment. Now, the best way to illustrate the fair value hedge is to take a look at an example. But before we look at an example, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course. I don't replace your accounting course. My motto is saving CPA candidate and accounting students one at a time. How? By providing new resources, lectures, multiple choice, through false. This is a partial list of my accounting courses that's going to help you do better, learn the information better. My CPA resources are aligned with your better, Roger, Gleam, Wiley. So it's very easy to go back and forth between my material and your CPA review course. In addition to thousands of multiple choice questions, I provide you with the previously released AICPA questions, almost 1500 questions that appeared on the actual exam in the past. And I provide you detailed solution. Those are in the, I kept them in their original format. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other. It helps me a lot. Connect with me on Instagram, Facebook, Twitter and Reddit. I'm growing, I'm trying to grow my followers on Instagram. Look at this example on March 1st, 20 X3 Adam purchases 1000 bonds of Apple at $120 per bond. The investment is classified as available for sale. Therefore we debit that investment, 120,000 available for sale, credit cash, 120,000. By the end of the year, since this is an available for sale, we have to market to market and Apple bond happens to be 150 per bond. So what happened? The bond went up in 30, $30 in price. Therefore we debit fair value adjustment, 30,000. We increase the investment by 30,000. And we credit unrealized holding gain or loss, which is a gain of 30,000. This is what the balance sheet would look like. Basically the net investment is 150. And we have on the stockholders equity, unrealized holding gain and other comprehensive income 30,000. Now what's going to happen is this. Adam's now is a little bit nervous because we're exposed to the bonds and this bond could go down again or it could keep going up. We don't know what's going to happen, but we want to have 150,000. We would like to have that amount. So what we're going to do, we're going to try to hedge our position. So what we're trying to do is to do this. The hedging item, we're trying to hedge the debt investment. Now we need an instrument to hedge this debt investment because on April 1st we need to buy the inventory with this money. So what we do, we're going to enter into a put option. Put option is the right to sell those bond at 150 in the next six months. And as Adam designated the option as fair value hedge. So we enter into a contract and for the sake of simplicity, we did not have to pay anything because the option strike price and the market price are the same. So what we did, someone else thinks on the other side that Apple bond is going to keep on going up. Therefore said, okay, I will enter into a contract with you that I will buy it from you at 150 and say, okay, I will sell it to you for 150. So you think you're protecting yourself in case the bond went down. You can sell it at 150 and the other person thinks the bond is going to go up. So it doesn't matter what's on the other side, but on your side, that's what's going to happen. Here comes April 1st. The value of the bond is 125. Well, that's bad news for you because the value of the bond went down. What do you have to do on April 1st? We're going to have to mark our investment to market. Well, if it was 130, went down to 150, went down to 125, we lost 25,000. Therefore we debit unrealized holding gain or loss and we book it in equity 25,000 and we reduce our investment by 25,000. So this is the bad news. But remember, we were expecting this. That's why we bought the put option. Our put option on the other hand, which is our hedging instrument, remember we are hedging the investment. That's the hedging item. The hedging instrument is the put option. It's the tool that's going to help us offset the decrease. The value of the put option for each one went up by 25 dollars. Why? Because now you can sell the bonds for 150 while everybody else can only sell it for 125. Therefore a new asset is put on the balance sheet by 25,000 and we have an unrealized holding gain of 25,000. So this is an asset went up. So notice what happened. The fair value adjustment reduce our assets by 25,000. The put option increase our asset by 25,000. Simply put, they offset each other. From an equity perspective, our equity went down by 25,000 in OCI. Our net income went up by 25,000, which increases our equity. Therefore, let's look at what happened all in all. All in all, we still have assets of 150,000. Our equity went down by 25. Then our equity went up by 25 because that income ends up in stockholders equity. So what did we do? The hedging item went down in 25,000. That's the hedging item. The bonds went down. The hedging instrument went up by 25,000. And this is what I was telling you earlier. There should be a negative correlation. The investment is the hedging item. The put option is the hedging instrument. Now we're going to go ahead and sell Apple bonds. We're going to go ahead and liquidate. What's going to happen is this. So we're going to first sell the debt investment and the debt investment is now worth 125,000. Let's get rid of this first. We're going to debit cash, credit debt investment 125, this is gone. We are also going to liquidate the put option. We debit cash, credit the put option, the put option is gone. So notice we get rid of the asset, we sold it, and notice what happened. We have $150,000 in cash. Now, can I combine those two entries? Of course I can, but I'm just keeping it simple. So you'll see it step by step. What else? What else is this? By April 1st, I liquidated my position. Therefore, this has to be gone. This 5,000 and accumulated other comprehensive income has to be gone. So I'm going to debit accumulated other comprehensive income. Get rid of this and I'm going to reclassify it to the balance sheet and it's going to turn into a gain of 5,000. So all in all, I have a gain of 30,000 and I have cash of 150. Is this what I wanted to do? Absolutely. I wanted my cash to be 150 as of December 31st because I wanted to lock the 150 and I end up booking a gain of 30,000 because I bought it at 120. I sold it at 150. I sold it for 150. The net gain is 30,000. So the gain that made it all the way to the income statement at the end of the day is 30,000. So notice what happened is my hedged item went down in value. My hedging instrument went up. Now, the opposite could have been true. The opposite means what? If the bond value kept on going up to 160, I would end up with $10,000 more when I sell the bond, but my put option would have been worth less than $10,000. So they will offset each other. And here we're assuming this is a perfect hedge to illustrate the point. I hope this makes sense. What should you do now is go to farhatlectures.com and work additional multiple choice questions. If you're not a subscriber, subscribe. It's worth it. Practice. That's what you need to do to learn the material. Invest in yourself. Don't shortchange yourself. Good luck, study hard and of course stay safe.