 Hello, and welcome to the session in which we will discuss cash flow hedge. It's very important to understand the cash flow hedge and the context of hedging. So it's very important that you understand what our hedging instrument, what is a fair value hedge in order to understand a cash flow hedge. Let's review real quick for a fair value hedge. What's hedging? Hedging means protecting the fair value, notice the fair value of an asset, liability or a firm commitment. And this is what we discussed in the prior session. Also we reported the fair value and changes in those fair value in the income statement. So we reported the fair value changes on the income statement for a fair value hedge. So what is a cash flow hedge on the other hand? Cash flow hedge is hedging, protecting the cash flow associated with an asset, liability or a forecasted transaction. So notice the difference. Here we are protecting the cash flow associated with that asset liability or forecasted transaction. Here we are protecting the fair value of that asset liability or firm commitment. Let's illustrate this point. It's worth illustrating. So if you have a bonds payable, which is a liability, you may want to protect the fair value, the value of the bonds payable of the liability itself. Well if that's the case, you have a fair value hedge. This bonds payable would require us to make payments, interest payments, cash payment. The payments that we make is the cash flow associated with the bonds itself, with the fair value of the bond. So if we are protecting the bonds payable itself, it's a fair value hedge. If we are protecting the cash associated with the bond, then it's a cash flow hedge because it's the cash flow associated. Now for a fair value hedge, we talked about firm commitment. For a cash flow hedge, we have what's called forecasted transaction. What is a forecasted transaction? A forecasted transaction is a planned. So you are planning to enter into a transaction with another party with no commitments or obligation or rights. So you plan to buy something. So you plan to buy cotton for your production. You plan to buy oranges for your manufacturing facilities. You plan to buy milk, so on and so forth. It's simply a planned transaction. And a planned transaction, since it did not occur yet, it's going to require cash flow. Well guess what? You can protect that cash flow. So cash flow is hedging the exposure to the cash flow risk. You have an uncertain cash flow, for example, a variable debt with variable interest rate. So you want to convert maybe the floating risk. The floating rate into a fixed rate. Because you are concerned you have a variable cash flow and you want to protect that. Uncertain cash flow. You would report cash flow hedges at fair value, just like fair value hedges. They are reported at fair value as well. They are reported. They're both reported at fair value. The difference is this. Any gains and losses are reported in OCI, eventually they get released. To income, we'll see later on how they get released. But initially they are reported in OCI. Also cash flow hedge will need to qualify for hedge accounting. What is hedge accounting? To designate a transaction as a hedge accounting, you need to have a documentation, especially when you are hedging a forecasted transaction. Remember a forecasted transaction, transaction that's going to happen in the future. And what you are telling FASB is I want to have a hedge accounting for something that not happened yet. If that's what you want to do, make sure you document what you are doing. You need a formal documentation. Why are you entering into this hedging contract? What is the riskiness of this forecasted transaction? Are you hedging the fair value of a liability asset or a cash flow? So you need to determine whether it's a fair value hedge or a cash flow hedge. And you have to spell this out in the documentation. Describe the effectiveness of the hedge. So you don't buy an oil contract if you are trying to protect your orange crop. So you have to have a hedge that makes sense that's going to reduce your risk. And we'll talk about hedge effectiveness in another session. You also want to describe the hedging instrument, the derivative that you are using, coal option future, and it must be effective. Also what is the hedging item? What are you trying to protect? So you have to spell all this out in a document in order to qualify for hedge accounting. Just want to make sure just for the CPA exam that cash flow hedge is not eligible for business combination, parent, subsidiary, equity transaction, or the company its own equity. Just know this just in case you saw a multiple choice questions. Now the best way to illustrate the concept of hedging is to actually work an example. Before we take a 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. I provide additional resources for you to do better on the CPA exam and in your accounting courses. How? By providing you resources, lectures, multiple choice, true or false. This is a list of all my accounting courses. My CPA resources are aligned with your Becker, Roger, Wiley, and Gleam. I also give you access to 1500 previously released AI CPA questions in their original format with detailed solution. If you have not connected with me on LinkedIn, please do so and take a look at my LinkedIn recommendation. Like this recording, share it with other connect with me on Instagram. I'm trying to grow my Instagram following Facebook and Twitter. Bye bye. Now let's work an example. On November 1st, Adam Transportation budgeted the need for one million gallons of gasoline for its fleet of trucks for February 20 X5. So here, Adam Transportation needs one million gallons of gasoline. They know they need this much. It's they're forecasting into the future. It's a planned transaction. So what happened is this? Adam enters into a future contract to give Adam company the right and obligation to purchase that one million gallons at $2.50 per gallon. The contract will expire at the end of January. Assume the spot rate and the contract rate are the same. Therefore, there is no value at the inception of the contract on November 1st. Therefore, no entry is required for November 1st. Here's some additional information. You are giving the spot rate on December 31st, the future rate on December 31st, the spot rate on January 18th, the future rate on January 18th. What is the spot rate? The spot rate is how much you can buy the gasoline as of December 31st on that date specifically. And the future rate is how much you'll be able to buy the future contract, the future contract, the future rate of the gasoline on December 31st. Now, what's going to happen is this? We're going to go through series of transactions to illustrate the concept for these dates. So on December 31st, what happened is this? On December 31st, you have a contract that you can buy the gasoline at $2.50. That's the contract. But that same contract is worth $2.90. $2.90 per gallon on December 31st. So what happened on December 31st? On December 31st, your contract is worth 40 cent per each gallon. So what does that mean? It means your value of the contract went up 400,000. Now, be careful. Don't compare the 250 to the 270. You have a future contract. You have a future contract. You enter a future contract. Therefore, you market your future contract to market according to the future market, not according to the spot rate. Therefore, what you do is you debit future contract, an asset, 400,000, and you credit unrealized holding gain loss equity, 400,000. And this is on December 31st. And let's keep track of our T-account for the future contract and unrealized gain and loss. Now, on January 15th, you decided to go ahead and execute and buy the gasoline. The first thing you do is you have a future contract. What's going to happen is the future rate went down to 280. So went down. Well, what happened is you lost 100,000 in value because 10 cent per gallon. So you have to reduce your unrealized holding gain and loss by 100,000. Reduce your future contract by 100,000. And this happened on January 15th. So what you do is you reduce your future contract. You reduce your gain and losses. Now, what's going to happen is this, you're going to go ahead and sell the future contract. The future contract, notice it's worth 300,000. You're going to go ahead and sell it. You're going to sell it. You're going to debit cash, credit future contract, 300,000. OK. And notice what happened. The future contract is closed. Now what you're going to do, you're going to go ahead and buy the gasoline. And when you buy the gasoline, you buy the gasoline at the spot rate. And the spot rate is $2.80. Therefore, you are going to debit gasoline, 2.8 million. And you're going to credit cash 2.8 million. So you bought the gasoline at 2.8 million. Hold on a second. So how did this future contract helped you? Remember, on November 1st, you purchased the contract to buy the gasoline at 250. Well, yes. But you sold that future contract. Indeed, I sold the future contract and I got $300,000 in profit. So what I did, I paid for the gasoline, 2.8 million in cash. But I got 300,000 from the future contract. Therefore, my net cost is 2.5 million. And this is exactly how much I wanted to pay when I enter into this contract on November 1st. On November 1st, I enter into the contract to pay $2.5 per gallon for 1 million. And indeed, I end up paying $2.5 million in gallon. $2.5 million for the gasoline that I need. Notice, I still have 300,000 in unrealized holding gain and loss and equity. Now, what do I need to do with this 300,000? Well, we get rid of this 300,000 when we expense the gasoline. When the gasoline, remember, the gasoline is inventory. It's an asset. What's going to happen, maybe sometime in February or March, we're going to be using that gasoline to operate the business. And it's going to turn into cost of goods sold. Let's assume this happens in the February or early March. It doesn't matter. Something in the future, we're going to expense this gasoline. Once we expense this gasoline, we are going to also reduce our cost of goods sold. We're going to take this gain out. We have $300,000 of gains out. We're going to close the gain. We're going to debit the gain, close the gain. And we are going to reduce our cost of goods sold. And guess what? Look at our cost of goods sold, $2.8 million minus $300,000 from the gain on that future contract. Our cost of goods sold, also $2.5 million. The cash outlay, $2.5 million. That's exactly what we wanted to do. We wanted to pay only $2.5 million for the gasoline. We went into this future contract. We had a cash flow hedge and we only paid $2.5 million because we were concerned in this forecasted transaction. We forecasted that we needed gasoline. And we don't know how much the gasoline will be when we need it in February. So what we did is we went into a cash flow hedge, bought a future contract, and locked our price at $2.5 million. And this is how a future contract work, a derivative instrument work, to create a cash flow hedge. What should you do now? Go to farhatlectures.com. Work multiple choice questions. If you're not a subscriber, subscribe. Invest in yourself, invest in your career. I'm going to help you in your accounting courses. Help you pass the CPA exam. Don't shortchange yourself. Your accounting career is important. Take it seriously. Good luck, study hard, and of course, stay safe.