 What is unrecognized foreign currency firm commitments? So a lot of words, let's go ahead and break it down. First of all, if you're familiar with purchase commitment under US GAB, basically it's the same thing. It's a purchase commitment. So what is a purchase commitment? So if you understand what a purchase commitment is, you'll be able to understand where a firm commitment is. A purchase commitment is when the firm, when the company has a commitment to acquire, to buy goods or services from a supplier, all sells goods or services for a specific fixed price. So basically what you did, you signed the contract and you cannot get out of this contract. You are boxed in, okay? Either you are buying something at a fixed price or you are selling something at a fixed price. This is what a commitment is. Now for our, for this purpose, for the purpose of this lecture, we are dealing with foreign currency commitment. Now you sold something, you're gonna be receiving that money, that money in a foreign currency. You sold something or you bought something and you have to pay money in a foreign currency. So you have unrecognized foreign currency. Why is it unrecognized? What do you mean by it's unrecognized? It means there's no assets or liability on the books. All what you did is you sign the contract. That's all what you did. And now you have to protect that signature because that signature would require you to either pay in a foreign currency or receive a foreign currency which you have to translate. So you are hedging your commitment. You're hedging your signature because you cannot technically, in theory, you cannot get out of this contract. Therefore, protect your exposure. But you don't have an asset and you don't have a liability. You don't have a receivable and you don't have a payable. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. It's 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 as always with all the other hedging example or with the other hedging concepts is to work an example. Assume now it's December 1st, year one and XCIM Co. received and accepted an order from a Spanish customer to deliver goods on March 1st at a price of 1 million euros. So we signed a contract and we said, we commit to deliver goods to that company and they're gonna pay us $1 million March 1st. We signed the contract December 1st. We don't have to deliver anything till March. In March, this is when we receive the money. Assume further under the terms of the agreement, we will ship the goods on March 1st and we will receive the payment immediately. So nothing happened December 1st except that we agreed to deliver the goods but at the same time, we know once we deliver the goods, we're gonna have, money will be waiting for us in a foreign currency. What are we gonna do with that money? Now notice the sale will not take place till March but we made a firm commitment. We signed, we put our name on the line. Now we have to protect that. Assume in here we cannot get out of it. This scenario creates a euro asset exposure to foreign currency exchange risk as of December 1st. As of December 1st, the company now is exposed, exposed to the fluctuation in the euros, okay? So on this date, we want to hedge. On December 1st, XSEAM Co wants to hedge against an adverse change in the value of the euro over the next three months. This is known as hedge of a foreign currency firm commitment. So notice, we did not make a sale. We did not buy anything. We just made a commitment and that commitment created an exposure. And that exposure is basically called the firm commitment and we need to protect that firm commitment. That's what we're doing here. So for the sake of illustration, we're gonna be using the fair value hedge to illustrate this scenario. So under the fair value hedge, hopefully you would remember from the prior recording if you did watch them, the gain or the loss of the hedging instrument is recognized in that income and the gain or the loss and the change in the fair value of the firm commitment is also recognized in that income. So everything goes into net income. So this accounting treatment would require that you measure the fair value of the firm commitment. So you have a firm commitment and you're gonna keep in track of that firm commitment. Track means up or down. Recognizing the change in the fair value in net income as always fair value goes into net income. That's another thing that hopefully now it's drilled into your head and reporting firm commitment on the balance sheet as an asset or a liability, depending on the firm commitment is an asset or whether it's an asset or whether it's a liability depending on what happened to the currency. This raises the conceptual question of how we are tracking the fair value of the firm commitment because think about it. We have a firm commitment. Well, we have to look at the foreign currency. Which foreign currency are we looking at? Do we look at the spot rate or do we look at the forward rate? And guess what? Both of them, they're acceptable. So you could look at the spot rate to find the changes in your firm commitment or you could look at the forward rate to find the changes in your firm commitment. Now if you don't know what the spot rate or the forward rate is, go to this chapter, the first lecture, I explain what's the spot rate versus the forward rate. So to hedge the position Xeemco decided to enter into a forward contract. So we're gonna be using a forward contract. This is the hedging instrument because we can use a contract or we could use an option. In the next session, I'm gonna tell you we're gonna use an option. Okay, so now we're gonna be using a forward contract. Now if you're on a difference between forward and option, you have to go to the prior session and learn the difference. Now on December 1st, the three month forward rate is 1.485. So we bought a forward contract. So once we receive the euros, we can sell them at 1.485. Okay, so we can get $1,485,000 US from this transaction. Doesn't matter what the rate of the euro is on that date. No cash change on December 1st. All we did is we bought this, we made a commitment to buy this contract and there is really no cost for this. Okay, and we elected to use the fair value method of the firm commitment through changes in the forward rate. So we're gonna go with the fair value, not cash flow. And we're gonna be using the forward rate as we go through this example. So we're gonna be using the forward rate to measure the changes in the firm commitment and to measure the changes in our gains and losses. Now, what I suggest you do, copy this information down or take a picture of it because the journal entries will be based on this. And I suggest you also create T accounts for all the accounts we're gonna be using to see how we opened them, how we closed them, what happened to them from year to year. I'm gonna show you the journal entries and explaining the journal entries. But the best way to really learn this is to see how what's happening to the journal entries, what's happening to each account. Okay, what's happening to the gains, what's happening to the losses from year to year, what's happening to the asset, what's happening to the liability from year to year. So here we go, 1231 year one, the forward rate, 1.458, this is where we enter into the commitment. The fair value of the hedge is nothing because it's the same as the spot rate. There's nothing on 12, 1, 2001 or year one. 1231, the forward rate, 1.496. We made a mistake. If we waited to buy this contract on 1231, we could have get 1.496. So notice, we purchased this forward rate a little bit prematurely. What happened to this contract? Well, it worked against us. The fair value went down 10,783. Now, how did they hear? They show you how you came up with that. So really, you would have received 1,496 if you waited to enter into this contract December 1st, but we don't wanna take that chance. We wanted to enter, we wanted to enter this contract as of December 1st. Therefore, we kind of lost $11,000. However, using the time value of money, if we discount the $11,000, our losses are 10,783 based on the present value factor of 12%, it doesn't matter, okay? Now, the amount is the same as the fair value of the forward contract, but with the opposite sign. So every time, now, if the currency worked against us, the commitment would work for us. If the foreign currency, the forward rate work with us, the firm commitment will work against us. So the forward rate and the firm commitment, they work in the opposite way, just like all the other hedges. If your asset goes down, if your receivable goes down, you have a loss on the receivable, you're gonna have gain on the hedge. If the receivable goes up, you're gonna have a loss on the hedge. So they work the opposite way. So notice here, we have a loss, a loss on the hedged instrument, sorry, but yeah, on the hedge instrument on the contract, okay? By December 1st, year one, the spot rate was 1.48, which is good for us because we can get 1.485. It means we're gonna get a $5,000 gain. And what happened to the value of the, the value of the forward contract went from negative, went from negative 10,783 to positive 15,000, 15,783, okay? So the value went from negative to positive. So we have a gain. Why? Because the spot rate was lower than our commitment. So we did good, we did good. Why? Because we locked our price at 1.485. So let's look at the journal entries and see what happened from year to year. What journal entries do we make? So let's take a look at the journal entries. First, on December 1st, there is no entry, no entry to record as either the sale agreement or the forward contract, or both are executory contract, nothing really changed hands at this point, okay? So just we'll have a memorandum saying this is a forward contract. Remember, we have to document if we are doing hedge accounting, we have to explain why it's hedging, what type of hedging, so on and so forth. Then on December 31st, remember what happened on December 31st, we did not wait, we signed the contract a little bit prematurely, we have a loss of 10,783. Remember, it's an $11,000 loss, but we have to discount it. So the loss is 10,783. Now remember, the loss on the contract is offsetted by a firm commitment because a loss on the contract, it means we did good on the firm commitment, okay? So it's offsetted by again. So a loss is offsetted by again. Therefore, we're gonna have a liability and an asset. Nothing really over all, if you really look at things, we have a gain, we have a loss and that income is zero. We have an asset called firm commitment and we have a forward contract, which is a liability. So basically, nothing really happened, everything canceled each other out, but it's very important that you keep track of your assets and your liabilities. The gains and the losses, they're gonna be closed out. But the assets and the liabilities will be with you from year to year. So keep that in mind. So the nature of the asset, nature of the liability. So that income is zero, you have a liability and you have an asset, okay? Now it's we're gonna be looking at the transaction that takes place on March 1st. What happened on March 1st? Remember, March 1st, you deliver the product and they're gonna pay you a million euros on that day, okay? And remember, this is the data. I should keep bringing this data every time I'm working these examples, but that's fine. Remember this? So remember on March 1st, the forward contract works for you. Why? Because the spot rate is $1.48 and you can sell your euro for 1.485. So immediately you have a gain and the change in the fair value of the contract is 15,783. So you went from a loss of 10,783 year one to a gain of 15,783, okay? Let's take a look at what happened. So you debit the forward contract, 15,783 and you book a gain of 15,783. Then this is to adjust the fair value of the contract from the 10,783 to 5,000 because now you are at a gain of 5,000 to go from 10,000 loss, 10,783 loss to 5,000 gain, you have to move 15,783 to the right, basically. Simply put on a timeline, if this is zero, you are standing right here, negative 10,783 and you have to move to positive 5,000. So you have to move 15,783. If you're gonna look at it from a timeline perspective. Now remember, you have a gain that you're gonna have a loss. Now you have a loss on the firm commitment, you have a loss because it works the opposite of the contract and your loss is, the loss is the gain, is the amount of the gain, 15,783 and you credit the firm commitment. Now keep track of the forward contract and the firm commitment. Remember, you're gonna have 5,000 of the firm commitment. It's gonna be a credit of 5,000 and the forward contract, the liabilities, the debit of 5,000. Hopefully you are keeping track of those journal entries. Then you receive the foreign currency. You receive the foreign currency, it's 1,480, that's the rate of it because you have to record it at the spot rate. Remember, when you record the currency, you would record the sale at the spot rate. The cash that you would receive is 1,485. Why 1,485? Because you bought that contract to sell the foreign currency at 1.485. So you debit the cash, give them the foreign currency, then the liability. Remember the liability, you said we have a debit. So forward contract, if you kept track of the balance, you had the liability left of 5,000. Now you credit the liability to close that liability because you had a debit. Okay, the transaction has ended and at the end you have a $5,000 gain. Remember, you had a firm commitment, a credit balance. You debit the firm commitment to remove the firm commitment. I'm sorry, it has a credit balance. Yeah, you debit the credit balance which is an asset credit balance, unusual. So you debit the firm commitment and you transfer the 5,000 to net income. Now, different companies might use different accounts but I'm sure you got the idea. So the overall, you're gonna have a net income. You're gonna add 5,000 to your net income because you hedge your position using this forward contract. So once again, any gain on the forward contract will be offset by the loss on the firm commitment as a result of the last entry, the $5,000. What happened is we received an additional $5,000. So we did receive 1,480 supposed to be the spot rate plus 5,000 adjustment to income from our contract. Okay, this is exactly to the cash receipt, 1,485. So the net gain from the whole forward contract is 5,000. We had a loss in year one of 10,783 because we did not wait because the forward contract went up and we signed early, then in year two, the contract worked and our favor, we had again a 15,783. So the difference between those is that additional $5,000 for hedging our position. So without the hedging contract, without the forward contract, not the hedging contract, without hedging the position, we would have sold the million dollar at $1,488 and get only 1,480. By hedging, we got 1,885. Basically the same, I'm using the same example using different instruments to hedge the position and in this session, I used a forward contract.