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hello and welcome to the session this is Professor Farhad in this session would look at hedges of unrecognized foreign currency firm commitment using option specifically we're going to be using a put option to illustrate this concept this topic has covered an international accounting could be covered on the CPA exam and the only ACCA exam as well if you haven't connected with me only then please do so YouTube is really would need to subscribe i have 1500 plus accounting auditing and tax lecture if you like my lectures please like them click on the like button that helps me a lot share them put them in playlists let the world know about them if they're benefiting you it means they might benefit other people so share the wealth this is my Instagram account this is my Facebook account and this is my website if you're studying for your CPA exam or for your CFA exam I suggest you check out study pal that Co it's an artificial intelligence driven study buddy platform that match you with a study buddy study pal dat CEO has users in 85 countries in two thousand eight hundred cities from New York to LA so what is unrecognized foreign currency firm commitments now if you'd watch and if you watch my prior lecture you're gonna see what I'm gonna be talking about it's basically the same thing as in this lecture except we're gonna be using a put option so unrecognized foreign currency ferb commitment is very similar to something called purchase commitment under US GAAP now what is a purchase commitment so does this way maybe it will be easier for you to understand this concept it's when you make a commitment it could be signed it could be oral whatever it is but you make some sort of a commitment and that commitment is firm you cannot basically back out to acquire goods or services from a supplier or to sell goods or for other services for a fixed price so basically you logged in your prices and what happened when you lock in a price to buy or sell something in the future well the price could change in that price when that price change it could harm you so let's assume you want to buy something and you log the price now at $100 you lock it you have a firm commitment let's assume your textbook but a time the semester start the textbook are selling for 120 you did good you lock your price at 80 but let's assume the textbook are selling at $80 well you didn't really do well good because now you have to buy it at 100 and the current price is 80 so how does firm commitment how does firm commitment factor into this whole picture how does it factor into this whole picture well what's gonna happen now you're gonna sell goods and services and you are going to have you're gonna have a foreign currency future commitment so you might sell goods and you may be receiving foreign currency or you might buy goods and you need to pay in foreign currency but what's happening here you did not really buy or sell you just made the commitment so it's unrecognized means and recognized means you did you don't you don't hedge the item you don't have any asset or any liability on the books so you don't have a receivable what an asset exposure or you don't have a liability or a payable exposure you just have you made a commitment so what you're doing here is you're hedging your commitment you're you're trying to protect the commitment that you make how are you gonna protect this okay so we're gonna be using a put option in this in this recording so I just wanna let you know hedge accounting you could have many combinations we talked about forward hedge and a prior recording and how can we use forward hatch and treat it as a cash flow hedge we looked at forward hedge and how we treat it as fear value hedge we look at foreign currency option how can we use foreign currency option to protect an existing act recognized well hold on this is recognized foreign currency option recognized currency okay when we have a recognized asset here what we're talking about is unrecognized foreign currency that commitment so here we talked about recognized and we talked about both fair value and cash flow and in the prior session we looked at unrecognized foreign currency firm commitment however we use the forward contract so in this session can be like the first session but then I remove the forward and we're gonna be using a put option so this is gonna be another recording showing you the same example that they've been working through but now using a put option so the best way to illustrate this is to just go through an example but before we go over the example it's one make sure we all understand how fair value hedging work the gain or the loss of the hedging instrument is recognized in that income the gain or the loss of the firm commitment also recognized and net income so everything is recognized in that income and the accounting treatment requires measuring the fair value of the firm commitment so we have to know how much is the firm commitment and recognizing the change in the fair value in net income that's fine we already said this and reporting the firm commitment on the balance sheet as either an asset or a liability some time you might have it as an asset some time you might have it a liabilities and how do you measure the fair value of the firm commitment well you could use either the spot rate spot exchange rate or you could use the forward rate now on the prior example we use the forward rate and this example we're gonna be using I believe the spot rate if I remember how I set up this problem okay so let's assume X emo purchase a put option to sell 1 million euros on march 1st year 2 at a strike price of the other 50 so this company what they did they they receive an order and they accepted the order and they're gonna deliver on March 1st they're gonna deliver the goods now what's gonna happen they receive the order December 1st but they will not deliver till March 1st so what's gonna happen is this they made the commitment December 1st that they're gonna have they will be receiving the money they would receive the 1 million euros euros actually it's not dollar they would receive the 1 million euros March 1st ok this is when they deliver and they would receive the euros immediately what happened here is they as they made a firm commitment and they expose themselves to foreign currency but this is unrecognized foreign currency commitment why it's unrecognized because they did not deliver they don't have a receivable so therefore to protect their position they bought it at a put option to sell the euro at dollar fifty now the premium for such option you have to pay a premium if you want to buy a foot option there's a premium is point zero zero nine per euro we have 1 million euros times point zero zero nine we're gonna have to come up with we're gonna have to come up with $9,000 why do we have competent $9,000 well to have a put option it's gonna cost you money and that money is $9,000 therefore you have come up with $9,000 okay with this option now just listen to this statement listen to me carefully with this option the company is guaranteed a minimum cash flow of 1 million four hundred ninety one thousand why because if the price of the euro is below 150 if the price of the euro drops below 150 they can they can sell the euros at 150 now if the price of the euro is 155 they're like okay we're gonna let the option expire and they will buy the they will sell the euro at 155 so why 1 million dollar 1 1 1 million four hundred and ninety one thousand because if they sell the euro if they sell the euro for 150 they're gonna receive 1.5 million they're gonna end cost them $9,000 there for 1.5 million - $9,000 is 1 million four hundred and ninety one and this is the minimum they would receive okay so so the company elect to measure the fair value through the reference of changes in the US dollar spot rate so for this example they're going to be referencing the spot rate rather than the forward rate and you have to document this you could use either the spot rate or the forward rate but the company will have to determine which one they want to use in that spot of the documentation for the transaction to be considered hedged accounting and this is what we talked about at the beginning of this chapter in this case the fair value commitment must be discounted at its present value and the fair value and changes in the fair value of the firm commitment and the foreign currency option are summarised as videos let's take a look at the changes and make sure we understand what we are giving here so on December first when we made the sale on December 1st when we make the sale the option premium will pay point zero zero nine and obviously that same day if we paid that much the value is that much the foreign currency option is valued that much and the spot rate is what we're using is dollar fifty this is what would be using to measure our firm commitment and to measure the hedging and instrument by the end of the year the premium is point zero zero six so the premium went down point zero zero three and this has to do with the time because as time passes the always the option goes down and value therefore the change in the fair value of the of the of the option is negative three thousand so the option itself lost three thousand now we made a firm commitment we make we'd said we're gonna be receiving 1 million of euros and when we made that commitment the rate was one point five one now guess what the rate is one point five one oh sorry wouldn't made the commitment it's one point five zero one made the commitment now it's one point five one what happened to our commitment if we received the money today we receive an additional $10,000 so our food and commitment in other words went up in value how much it went up it went up ten thousand because then we would receive 1 million five hundred and ten if the day we are closing the position and receiving the money then we have to discount it at the present value therefore the fair value of the firm commitment is nine thousand eight hundred and eighty three dollars okay then on March first when we actually cut the money the premium actually went up the option premium went up now your premium is worth more now you might say why then time expires and II shouldn't go down yes the point zero zero six really went away but what happened is the spot rate the spot rate of the euro fell below what you can sell the euro for now the spot rate is one point four eight and you can sell your euro at one point five because of this option well guess what the option premium is worth point zero two that went up in value the so the the option went up in value went from point zero zero six to point zero zero two that's going from six thousand to twenty thousand so that's a plus fourteen thousand so on the option we made a profit of fourteen thousand and the reason I'm gone all of this in detail because I'm gonna show you the journal entries in a moment but the firm commitment the firm commitment went down why did the firm commitment went down because if you did not have the option you would only receive 1 million four hundred and eighty thousand if you'd up have the option therefore you would receive $20,000 less then dollar 51 and when you actually enter into the contract so your commitment went down in value and notice the option and the firm commitment worked the opposite way if one have a loss the other one will have a gate okay now the best way to do this as I go through the journal entries I show you the big picture here just you know copy this information down okay and create a t-account to keep track of what's going on especially with the balance sheet account so let's start with the transaction step by step first we bought the currency we bought the option so we paid $9,000 we created an asset called foreign currency option remember at the end of the first year the the euro went up to dollar 51 therefore our firm commitment went up by remember by 10,000 but we discounted it's nine thousand eight hundred and three if I was writing this book I would not use the present value because it just had more complication but it's okay so now we have an asset we put an asset on the books and we have a gain that goes into net income now remember we had the gain on the firm commitment the option lost three thousand because of the time value of money therefore we debit a loss and we credit the foreign currency option we reduce this asset by three thousand so simply put here's that summarize what we have from an income statement and balance sheet perspective at the end of the year on the income statement on the firm commitment we made nine thousand eight hundred and three we book that much of again on the option itself we booked three thousand dollar loss so overall copy this number down for year one we have a profit of six thousand eighty three dollars now our balance sheet our cash went down by nine thousand our fear foreign currency option is six why is it six we started with nine then we reduced it by three that's why it's six thousand that's the options value the third of commitment is nine thousand nine thousand eight hundred and three dollars and net income goes into retained earning to balance the other the other side of the balance sheet now here comes the here comes we did December 31st he comes March first here comes March first well guess what remember our commitment we have a loss on our commitment and we have a gain on the option let's go ahead and book those so on the commitment we debit a loss on the third commitment and we credit the asset the acid firm commitment so again keep track of the firm commitment now here's what happened firm commitment you had nine thousand eight eight eight hundred and three dollar debit now you credited you credited twenty nine thousand now you're gonna have a credit in an asset account that's okay just keep track of it because we're gonna be closing the transaction soon okay then you have to book at you book the game you book the loss on the firm commitment now you have to book the gain on the option itself the option have a gain of fourteen thousand well you debit foreign currency option your option went up and you credit for it gain on foreign currency option which is again notice this is the loss and this is the gain okay you you and you you book the gain on the option itself now again if you also want to keep track of your foreign currency option that's not a bad idea okay the foreign currency option remember it started at nine went down by three now went up by fourteen started by nine started for nine went down by three at the end of year one and now it increased by 14 why because the value of it went up okay so now you're looking at $20,000 in foreign currency option okay then you receive the money when you receive the money the exchange rate is one point four eight you debit foreign currency 1 million four hundred and eighty thousand you received a million you booked yourself as March 1st when you actually when you actually make the same then you're gonna take your foreign currency and transfer them into 1.5 million in cash why because you have a put option that's gonna give you the option of selling them at 1.5 and Drake is one point four eight you're gonna use the IRR option okay then you would remove this foreign currency because you're gonna give up your foreign currency and now you remove the foreign currency option of twenty thousand you have to remove the foreign currency option of twenty thousand and let's take a look over all what happened throughout year two just to kind of see what happened and you'd one and year two then again before we just the last transaction you remember we had a firm commitment a credit balance of twenty thousand if you kept track of your teeth third commitment you had you the credit balance of 20,000 you debited and you transfer it to net income therefore your net income will go up by that much so let's see what happened over a period of two years four years - let's talk about you have - here - you have sales of 1 million four hundred and eighty you had a loss on the firm commitment four years - twenty-nine thousand eight hundred and three dollars gained on the third in currency option fourteen thousand and adjustment to income when you closed your a firm commitment you have a gain of twenty thousand so impact on that income in year two is 1 million four hundred eighty four thousand 197 remember the income the impact of income in year one let's go back and get that number it's right here six thousand eight hundred and three dollars six thousand eight hundred and three dollars if I take my year to income plus six thousand eight hundred and three dollars if I add that to them I'm gonna come up with 1 million four hundred ninety one thousand and do you remember this number I said the minimum we'll get is 1 million four hundred and ninety one thousand why because because the euro fell below our dollar fifty what we do is we exercise the option and sell the euros at dollar fifty and as a result when we book all the gain and the losses were going to be receiving 1 million four hundred and ninety two thousand which is what we said we're gonna do at the beginning which is 1 million five hundred thousand then we paid nine thousand and by paying that nine thousand we did we guaranteed ourselves this 1 million four hundred and ninety one thousand now what if the rate was higher than the strike price again if the euros was down at fifty three dollar 55 the other 60 anything above dollar fifty we would have not used the option would have just sold the euros at this rate and received more than 1 million four hundred and ninety one thousand that's why we said that's the minimum cash you would receive it means you could receive more but the minimum is you are guaranteed one million four hundred ninety one by buying this put option if you have any questions about this topic please email me if you're studying for your CPA or ACCA exam make sure you study hard if you happen to visit my website or my youtube please consider donating to support the channel good luck and see you on the other side of success