 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at forward contract as a cash flow hedge. This topic is covered in advanced accounting. This topic is covered in international accounting, and it's also covered on the CPA exam. Now, I would like to really connect with my students, with my followers, with my viewers by all means, please connect with me on LinkedIn if you have a LinkedIn account. Or if you are a Facebook user, I have a Facebook page accounting lectures. Please subscribe to my YouTube to view all the lectures, and this is my Twitter account. You can always go to my website as well. So we need to talk about a cash flow. What is a cash flow hedge? A cash flow hedge deals with forecasted transaction. Now, what is a forecasted transaction? When we say forecast, what does that mean? It means we are planning. We are planning something. We are planning some forecasted transaction in the future. We might be planning to buy something. We might be planning to sell something. And that something is a foreign currency. Now bear in mind we have no commitment here. And this is important, because if we have a commitment, then it becomes a fair value hedge. So here we are dealing with no commitment. So what do we need to know about this cash flow hedge? So cash flow hedge, hedge and cash flow, which means we're gonna be paying or we're gonna be receiving for future transaction that have not yet occurred or for which there is no firm commitment. So it did not happen yet. And we don't have a commitment to do it. How does cash flow differ from fair value? Cash flow may differ from fair value in the sense that the income statement is not involved. So we're gonna defer gains and losses from the income statement when the transaction is forecasted. So simply put, if it's a cash flow hedge and we have a gain or a loss, it's not gonna go on the income statement yet. So what is it gonna go? It's gonna go first into OCI. So amount is accumulated in other comprehensive income. Then they are reclassified into earning in the same period which the hedge transaction affects earning. When does it affect earning? Is when we actually have the transaction happened. Okay, so first it sits in OCI. So if we say this is a cash flow hedge, well, guess what? Any gain or losses, it sits in OCI. How do we know it's a cash flow hedge? It's a forecasted transaction. We have no firm commitment. Once again, the best way to illustrate this is to actually work an example. So we will work this example to show you how this whole thing fits together, okay? On December 1st, a US company, a US firm plans. Notice plans to purchase. We have a plan. We did not make a commitment. We did not sign a contract to purchase a piece of equipment with an asking price of 100 franc in Switzerland. So it's Swiss franc during January of 2019. The transaction is probable. We think we're gonna go through it and the transaction is denominated in euros. Therefore we have to buy it in euros. On December 1st, the company enters into a forward contract to buy 100,000 francs for 101. Guess it's gonna be in franc. It's not denominated in euros. It's a Swiss franc. So we bought a contract to buy 100,000 francs at 101. Let me stop you right there. Well, guess what? I bought 100,000 Swiss francs at 101. What does that mean? It means my commitment for this whole thing is 100 and $1,000. So when I buy this piece of equipment, I guaranteed myself a price of 100 and 1,000. Spot rates and the forward rate for January 31st and December are as follows. So this is when the transaction, this is when we plan to buy it, which is this really doesn't make any sense because we didn't do anything for the spot rate. So this is when we bought the forward contract at this rate. This is the spot rate for the balance sheet. Again, it's meaningless to us. What we care about is the forward rate on December 31st to see what happened. And on January 1st and February 1st, the spot rate is 104 and this is gonna be relevant to us because that's gonna be the settlement date. So what do we do first? The first thing we're gonna do is we are going to put the transaction, put the forward contract on the books. The forward contract is on the books. So what we do is we debit forward contract receivable from an exchange dealer 101, which is an asset. So we put an asset on the books 101 and we credit dollar payables to exchange dealer 101. So this is basically how much we have to pay 101. And this is fixed. In this situation, this is fixed. So the first thing I'm gonna do, I'm gonna go ahead and start to input those accounts and a T account to show you how this is gonna move along the way. Now, remember we did the hedging, we did the fair value hedge and we did the regular currency transaction. In this situation, I'm gonna do the fair values. The fair value, this is the third example. The reason I showed you the other one is to in case you have any questions, you can go to the other one. Now, in this example, since we are gonna be paying, this amount is fixed. So this is the fixed amount we are committed to 101. So the dealer is gonna give us a 101. They're guaranteeing the price at 101 for us. And this is the hedge. The red is what we are hedging. I'm sorry, the hedge, not what we are. We don't have anything hedged yet. We don't have anything being hedged yet. This is the hedge. The red is the hedge. You know, we just add one zero here. Let's go back and see what happened on December 31st. On December 31st, the forward contract rate was 1.02. Is this bad news or good news for us? Actually, this is good news. Why? Because if we waited till December 31st to buy the contract, we would have to pay 100 times 102. We would have been responsible for 102,000. However, since we already bought the contract, our contract is only worth 101. It means we have a gain. So we credit for an exchange gain. Very important to notice this, OCI 1000. And we debit our forward contract receivable from exchange rate, 1,000. Simply put, we made a good choice by buying the contract December 1st, because by December 31st, the contract, our contract had a gain of $1,000. Once again, go ahead and update your T-account. So debit this 1,000. And we have for an exchange gain, OCI 1000, okay? Let's go back and see what happened next. Yeah, well, what happened next, it's gonna be January 1st. On January, I'm sorry, January 31st. January 31st, the spot rate was 1.04. And remember, on that date, that's the settlement date. That's also considered the forward rate. The forward rate is 1.04, okay? What does that mean? We started at 1.01 when we bought the contract. By December 31st, the contract was 1.02, and we had a gain of a penny. By January 31st, if we waited, it would have been 1.04. So we gained an additional two pennies. And that two pennies, if we multiply it by 100,000, Swiss franc, it's gonna give us a gain of additional gain of 2,000. Therefore, we debit the receivable, the forward contract receivable, $2,000. And we credit foreign exchange OCI 2,000, let me do this. Again, it's all, in this example, we're always having gains. And this was 1,100, and we have an additional 2,000 in OCI. So it's so far so good. I mean, we made the right choice when we bought that contract. Now we are ready to settle. Basically, we are ready to settle. How much cash do we have to pay for this land? We have to pay 1.01. This is how much cash we have to pay. Why 1.01? Because when we started the contract, it was the dollar payable to exchange dealer. When we bought this initial contract, it was 1.01. Therefore, we're only responsible for paying 1.01. If we did not do so, we would have to pay 1.04. If we did not hedge the position. So we credit cash 1.01, debit, dollar, payable, 1.04. Then forward contract receivable exchange dealer is transferred to investment. So therefore, we credit this account and we debit investment. So now we have the investment in foreign contract and the investment will pay for the equipment. So let me update the account before we proceed. So I'm gonna have to pay cash 1.01. And I'm gonna have to debit my payable from the contract 1.01. So what happened is this, my dollar payable is gone. Then the balance right now in this account is 1.04. So I'm gonna credit this account. I'm gonna credit the hedge 1.04. I'm gonna credit the hedge 1.04. As a result, the hedge goes down to zero. And for this credit, I will need to debit this account 1.04. So this account is gone. Okay. Then I'm gonna buy the equipment. And how am I buying the equipment? I'm buying the equipment with paying with the investment. Therefore, I reduce my investment 1.04. And my equipment is recorded at 1.04. Therefore, my investment is zero. Okay. This is gone. My equipment is 1.04. This is how much I buy the equipment for. Hold on a second. I only paid 1.01. Oh yes. I have 3,000 of gain. Good. It was a good transaction. Overall, it was a good transaction. So basically what we did is we hedged the position. We only paid 1.01 for an equipment. We would have to pay 1.04 if we waited without the forward contract. Okay. Notice we debit the equipment, credit the forward contract. All right. And again, this is a fair value hedge. And the reason it's called fair value hedge, it's because what we did is we park everything in OCI. Now again, at the end, what we do is we can move the, we could move this from OCI. Oops, sorry. We could move this from OCI and credit. I mean, my pen doesn't work anymore and credit again to go from, to take it from OCI to let it hit the income statement again, okay? Because OCI eventually is reclassified. So this is basically a fair value hedge. If you have any questions, any comments, by all means email me. If you need additional lectures, please go to my website. If you're studying for your CPA exam, as always, study hard. And if you happen to visit the website, please consider donating. Thank you very much. Good luck.