 Hello, and welcome to the session. This is Professor Farhad in which we would look at CPA sample exam questions covering the topic of derivatives. This topic is covered heavily on the financial accounting and reporting, not in depth, but it's covered on the exam. In my website, I do cover this topic in details in my intermediate accounting as well as international accounting. And the reason I have it in both courses is because in intermediate accounting we talk about the fair value hedge, we talk about the cash flow hedge. In my international accounting course, we'll talk about foreign currency hedge under fair value and cash flow hedge. So it's very important that you understand both topics. And on my website, if you subscribe, you'll have access to both, to my intermediate as well as my international accounting. So what I do is the difference between my lecture and a typical CPA review course is I dive deep into the topics. I give you examples. I explain it. I teach it. I don't review it. I know it. And I go over two, three sentences about the topic. I show you the material as if this is the first time you're looking at it during your college days. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lessons, please like them, share them, subscribe to the channel. If they benefit you, it means they might benefit other people. Share the wealth connect with me on Instagram. As I was saying on my website, funhatlectures.com, this is where you find more information about topics like derivatives, either in my international accounting course and in my intermediate accounting courses. Again, one subscription gives you access to everything, so you don't have to kind of subscribe for each course separately. And if you're studying for your CPA exam, I have plenty, plenty of resources that's going to help you succeed. You can get those 10 to 15 needed points to pass your exam. So let's take a look at the first question just to get a feeling about this challenging topic of derivatives. The first question, which of the following is among the criteria that need to be met for the derivatives to be designated as a fair value hedge? Now, the first thing we have to understand is, do we know what a fair value hedge is? Speaking of, somebody asked you, do you know what a fair value hedge is and what is it used for? Well, a fair value hedge, it's a hedge. And what is a hedge? What's the word of hedge? Hedge is to offset, to reduce. To reduce what? To reduce the exposure to the changes of the fair value of either an asset or reliability. You might have an investment in stocks. You might have an investment in bonds. You might have an unrecognized commitment, like a purchase, unrecognized commitment, purchase, purchase commitment. So what you have to do, you want to protect yourself against the changes in those, against the changes and the underlying value of that asset or liability. So what you do is you create a hedge, but when is the derivatives considered a fair value hedge? We can call it a fair value hedge. What do we need? Let's take a look at the first statement. There's a formal documentation of the hedging relationship between the derivative and the hedging item. So simply put, the question is, do you need to have a documentation? Simply put, you need to spell out exactly what you are hedging and which instrument you are using the hedge. Let's assume you have inventory of tires. You have inventory of tires and you fear that the prices of the tires might go down. So you are trying to hedge the tire. The hedged item are the tires. Now, can you buy some sort of a policy, some sort of a hedging instrument that's going to protect you? Yes, you might buy put option to sell rubber. So simply put, if the prices of your tires go down, you have a put option right to sell rubber. Like maybe you will buy 2,000 pounds of rubber, put option. So what's going to happen as the tires goes down, the hedged item goes down, your put value goes up. So you are hedged. Do you need to document this policy to be a fair value? And the answer is yes. So the fair value hedge would require documentation. So you have to have an official policy written down to be considered a fair value. Now, why is that important? Because it makes a difference whether it's a fair value of a cash flow and we'll see that shortly. So as soon as you say one is correct, so you can take out B, you can take out D. So all we have to know now is the hedge item is specifically identified and already told you, yes, the hedge item must be specifically identified. So in your documentation, if you said I bought the rubber, the put on the rubber, you have to specify what are you hedging. I'm hedging the tires. That's in my inventory. Therefore the answer is C. So it's very important to know what are we looking at in terms of the hedged item and the policy. If we know the policy, if the policy is documented, you're looking at a fair value hedge. In other words, you're identifying exactly what you are trying to do. Let's take a look at a second question. In a perfect hedge, which of the following would have no possibility of occurrence? So if you have a perfect hedge note, well, the answer is going to tell you what a perfect hedge is. Think about the word perfect hedge. Hedge is hedging is offsetting the risk. So what we are saying here, you have not even a hedge. Hedge is to protect yourself. You have a perfect hedge. So exactly when you have a perfect hedge, what exactly are you eliminating? You're eliminating losses and gains. You don't want to worry about losses and gains. So one, gain on the derivatives instrument, which of the following would not have the possibility of occurring? Yes, that will occur. You will have a gain on the derivatives instrument. That will occur for sure. For example, if we go back to the tires and they put option on the rubber, the derivatives instrument is the put, the cell, the rubber at a certain price. Even the price goes down. You still have to write the solid at 50. Let's assume the price dropped down to 40 for rubber. You make a $10 profit. So gain on the derivative instrument, would you have that? Yes, you would have that if you have a gain. Loss on the hedged item, that will happen too. Because it's a perfect hedge. When the put have a gain, this is the derivatives instrument is the put. The hedged item, which is the inventory, the tires, if you have a gain, the tires will have a loss. And if it's a perfect hedge, you will have a loss exactly of $10. So if you have a gain of $10, you will have a loss of $10. So in a perfect hedge, we have the following, we have no possibility of occurrence. Gain and loss is what happened. So both will happen. But the result is the net effect is zero. Therefore, both will happen, but the net effect is zero. In a perfect hedge, both will happen. That's how it's a perfect hedge. If the instrument goes up, the item that's being hedged goes down. If the item being hedged goes up, the instrument that's being used goes down in value. And if they are perfect, those changes, they don't have to be 100% perfect. In other words, you don't have to have exactly 100%. But close enough that the loss or the gain is in material. So that's what we're looking at. The gain and the loss is in material. Let's take a look at this question. The risk of a significant number of unsecured account receivable with a company in the same industry is referred to as what? So here, you are being asked to determine, do you know what a concentration of a market risk or a concentration of a credit risk is? Does it fit this definition? Significant number of unsecured account receivable or it's neither or both? So what is an account receivable? Account receivable is when you sell on credit. You sell on account for customers. And what happened when you sell on account for customers? When you sell on account, there is a risk. You're selling on credit. There is a risk. In other words, when you sell on credit, there is a risk that you may not get paid. So that's the risk. So you have a credit risk. So the risk is a credit risk. Now, what does it mean concentration and credit risk? Well, concentration means you are selling to different companies. Listen to me, but those companies are in the same industry. I'll give you a case end point. I lived the 2007, 2008 financial crisis. I lived it means I was working at a CPA firm during that time. So I saw how things were evolving. And we had a lot of customers that were involved in real estate. And guess what happened? Because we had a lot of account receivable from these customers. The CPA firm had a credit risk. Why? Because these companies, they were bailing out. They were going out of business. So they could not pay. Or we had to give them a reduction on their bill. Why? Because we had a concentration of credit risk. And this is what concentration and credit risk. You have too many account receivable in the same industry. Now, sometimes you could also have too many account receivable in the same location. For example, if all of your customers are located in one particular geographical area, let's assume the Pocono in Pennsylvania. And in the Pocono, you have two or three major employers. For example, I used to live in that area. So for example, in Pocono, you have a company called Sanofi. That's a major employer. And the second major employer besides Sanofi, I believe the Pocono Medical Center. Pocono Medical Center. So those are the two major employers. And they employ, I would say, 60% to 70% of the people in the area. So if you're selling on credit to businesses in the Pocono, in a particular area, and somehow Sanofi moved out, or the Pocono Medical Center closes out, or they lay off people, you have a concentration of credit risk because you are located in a particular geographical area. It doesn't have to be only industry. Sometime it happens to be in a particular geographical area. But the answer for this is V. Let's move on. Let's take a look at this question. Which of the following cash flow hedge transaction are reported on the income statement? Now, what is a cash flow hedge? Because we looked at the fair value hedge. And those are things that I cover on my website. So what is a cash flow hedge? Cash flow is to hedge your exposure to cash flow risk. That result from the variability of the cash flow changes. So let's assume you are receiving money, okay? Like you have a loan, and you're gonna be receiving money from that loan. Well, guess what? This is a cash inflow. You need to have a cash flow hedge. Why? Because your concern is receiving money, or if you have a loan receiving money, or if you issued a loan, and you're gonna be paying money or vice the opposite, whatever. Once a cash flow hedge is considered, once a hedge is considered a cash flow hedge, okay? Which of the following transactions are reported on the income statement? That is the question. Well, you need to know that it's a fair value hedge. And we talked about the fair value hedge. That's what's reported on the income statement. If it's a cash flow hedge, it's reported an OCI until it's settled, then it goes into the income statement. Therefore, a cash flow hedge, where would it be reported? It would be reported the gains to the extent they are effective on the income statement, the losses on the income statement. Therefore, the answer is C as in Charlie. Once again, I am not going to tell you, from this recording, you're gonna learn everything about the cash flow hedge and the fair value hedge, and the foreign currency hedging. But that's why I'm gonna refer you to farhatlectures.com, where I do cover those topic in details in my intermediate accounting courses and my international accounting course. And I have plenty of resources, 2000 plus CPA questions. Again, once you subscribe, you have access to all my resources, not only a particular course for one subscription. So the value is a lot. Don't shortchange yourself. You're gonna study for your CPA once in your lifetime. It's a lifetime investment that's gonna pay dividend over 20, 30 years. Take it seriously, study hard, and stay safe during those coronavirus days.