So what are the derivatives and what is the big picture? Here's the big picture. Yummy, yummy, yummy McDonald, okay? So what are derivatives? Well, derivatives are used to manage risk, okay? What brings risk to French fries and the McDonald burger? Well, let's think about the word derivatives first. What is derivatives? Derivatives means it derives from something else. It derives its value from something else. So something derives its value from something else and it's used to manage risk. Well, how does it work? Let's work the example McDonald and French fries. Now, McDonald, let's assume per year, just don't quote me on the numbers I'm just making this up. Let's assume they would need one million ton of potatoes. That's what they need. One million ton of the potatoes every year. And right now the price per ton, again, I'm just making these number up, the price per ton equal to $100. The price per ton now, this is the spot rate and we talked about the spot rate, okay? But McDonald, they need that one million, not today. They need that one million ton, maybe six month from now, okay? And down the road, six month from now, do we know how much the potatoes will be? One million ton of potatoes, we really don't know. The price could be 105, the price could be 80, depending on the season. If you have an abundance, the season having a lot of potatoes in Idaho, the price might drop down to 80. Or if there was a drought, the price might jump to 120, okay? What does that mean? It means for McDonald, if they wait six month later to buy the dirt potatoes that are needed for their business, I'm just giving McDonald as an example, because hopefully you can relate to it. That hopefully it's not something you should be proud of.  But to make the point, it's easier to make the point. So McDonald is not interested in taking the risk. So there's a risk of waiting because the price of potatoes could go up, it could go down, it could stay around $100. But McDonald is not interested in that risk. So what would McDonald do? McDonald will either buy an option contract, and we talked about option contract in the prior session, or they will buy what's called a forward contract, okay? Either option contract or a forward contract. To do what? To lock the prices. Maybe McDonald is willing to pay 102 per ton, okay? And they can buy an option price. The option gives them the right, not the obligation. The forward contract, they would lock them at 102, and they have to buy that 102. Remember, the forward contract is more stringent, okay? So most probably they will buy an option contract if available, but it doesn't matter. Or they will buy a forward contract. They're happy with 102 and they need the fries, okay? So by lock and door price, they mitigate the risk. They manage the risk. They manage the risk. So this is how derivatives is used to manage the risk. Now, once they buy this contract, once they buy the option contract, or the forward contract, once they buy it, we have to understand two new terms. We have to understand what's a hedge item and what's a hedge instrument. So the contract itself is an instrument, hedging instrument. So using this instrument, it's a hedging instrument. And what are they hedging? They are hedging the potatoes. Okay, this is an example. Now, since we are dealing with foreign currency, since this chapter is dealing with foreign currency, let's talk about a little bit more realistic example that can help us understand this. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is 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, I'm not sure if you know this, but McDonald's buy one-third of the sesame seed from Mexico that they put under bonds. You see those sesame seed? They are mostly, if you're eating them, there's a good chance, 95% chance, those sesame seeds are from Mexico. Now, McDonald's would need to buy those sesame seeds from Mexico, and the suppliers in Mexico, they want to be paid in pesos. That's all that they want to be paid with. Let's assume that's the case. McDonald's might be able to force them to accept US dollar, but that's beside the point because McDonald's buy all their supplies, so they have the upper hand, but we're not gonna talk about this now. So what's gonna happen when they buy those sesame seeds in pesos, what could happen is they might buy them now, but the supplier might give them 30, 60, 90 days to pay. Again, what's McDonald's exposed to? McDonald's exposed the price of pesos. The price of pesos could fall down substantially, which will be good for McDonald's because the US dollar will buy them, will buy more pesos, or the pesos could go up in value. What would that do? That will force McDonald's to pay more US dollar per pesos to buy those sesame seeds. Again, there's a risk here, but the risk is foreign currency fluctuation. Now, we could also say the risk of sesame seed price could go up on them, but we don't wanna double risk it here, so keep it simple. So here we have a foreign currency exposure. Okay, we bought them, we bought the sesame, and we have to pay in Mexican pesos, and here's the risk. All right, so this is what we mean. So we buy a contract, and that contract, that instrument, whether it's the forward contract or the option contract, derive its price. What do we mean? Let's go back to the word derive. Derive its price from the underlying item. So let's assume McDonald did buy a contract for French for the potatoes. And let's assume the potato, and remember the contract price was 102. They can buy it at 102. And let's assume the prices of the potatoes in Idaho, because we had a drought, they jumped to 125. Guess what? The contract that McDonald buy went up in value. Why? Because if you have a contract to buy the potatoes at 102 and the actual price of the potatoes is 125, your contract is worth more. Your contract derive its value from the price of potatoes, and the same is true. If you have a contract to buy them at 102 and the price dropped to $80 per ton, then guess what? Then your contract is worth less. So your hedging instrument drive its price from the underlying item, which is we are using the potatoes. Okay, so this is the big picture. Very important to understand the big picture. And I hope I was able to give you that background. Now, here's some information we need to know in respect to accounting for derivatives. So let's get down to accounting work now. All derivatives should be reported on the balance sheet at fair value. And hopefully we all know what fair value is. If not, it means if the value of something goes up, you have to write it up. If the value of it goes down, you have to write it down. There is no off-balance sheet treatment. So you cannot keep it off-balance sheet. Hedge accounting is acceptable for those derivatives used for hedging purposes provided for hedging relationship is clearly defined, measurable, and actually effective. So we can use hedge accounting. Now, what's that term? We're gonna have to define it when it comes to derivatives. We don't have to, it's optional, but if we have to happen to use it, we have to follow hedge accounting. It's acceptable for derivatives if the derivatives is used for hedging relationship and it's clearly defined, measurable, and effective. And we're gonna talk about all of those. Okay, we're gonna talk about one and we'll talk about two. Let's start with one. Remember, with the first number we said, all derivatives has to be reported at fair value. What does that mean? It means we might have a profit or a loss unrealized profit and loss. So first I have to explain to you a concept. You can buy derivatives, which is, this is new information for gambling purposes for speculator or as an arbitrage. So basically to gamble, okay? That's one way to buy derivatives. Some people, some traders, they buy derivatives. They buy options forward contract for the purpose of gambling, making a quick profit on that value of the derivatives going up or down, value of the contract going up or down based on the value of the item. If that's the case, if that's the case since you are speculating or all fair value adjustment goes into the income statement or you could be buying a derivative to protect your asset or protecting your cash flow. Now we're not gonna define those terms yet but could be two other reasons. One, two, protecting your asset or protecting your cash flow. So here what you're doing is you are looking into the future, you are looking into the future and you're trying to protect your company. You're trying to protect your position. If you are trying to protect an existing asset or liability this is called a fair value hedge. If it's a fair value hedge and you will see later, don't worry about it, adjustment of fair value goes under the income statement. We're gonna talk a little bit more about this. If you are considered protecting a cash flow then it's called the cash flow hedge and the adjustment goes into OCI. So the fair value goes into the income statement, the cash flow hedge goes into OCI. So this is the big picture. Now let's talk about, we talked about also we said so we took care of fair value, not really, but we're starting to map it out. Now we need to talk about hedge accounting. Well, let's talk about hedge accounting. Hedge accounting for foreign currency derivatives might be used if three conditions are satisfied. So when can we use hedge accounting? Well, there's three conditions has to be in existence. One, the derivatives is used to hedge either a fair value exposure or a cash flow exposure to foreign exchange rate. So there's the nature of the hedge risk. What does that mean? We're gonna discuss this in a moment. So first we have to define what's the nature of the hedge risk? What are we hedging? Are we hedging an existing asset or are we hedging a cash flow? Don't worry, we'll talk about this in a moment. So that's the first condition. The second condition is the derivatives is highly effective in offsetting changes in the fair value or cash flow related to the hedged item. We have to have hedge effectiveness. Remember, when we bought that contract, when we bought that forward contract or option contract to buy the potatoes, our purpose is to hedge, is to protect ourselves from fluctuation in the prices. So our strategy should be effective. Now, how do we define effective? We're gonna talk about this in a moment as well. And the derivatives is properly documented as a hedge. We have to have hedge documentation. We're gonna discuss those three points one after the other. So now we talk about hedge accounting. The first thing about hedge accounting is the nature of the hedge risk. So once we buy a contract, once we have a derivatives, we have to determine is this a fair value hedge or is this a cash flow hedge? Remember, for speculating purposes, it's easy. It goes on to the income statement. Now, we need to know what is a fair value hedge? What's a fair value hedge? A fair value hedge exists if changes in the exchange rate can affect the fair value of an asset or a liability reported on the balance sheet. So you are trying to protect the fair value of an asset or the fair value of a liability. How does that happen in the foreign currency? Let's assume McDonald is buying, is buying the sesame seed from Mexico. They have a liability, they have to pay them. Now, if they buy a fair value hedge to make sure their liability is protected, then that's considered a fair value hedge, their exposure to the Mexican pesos. And the Mexican pesos do fluctuate substantially, especially recently, with every tweet that Trump makes, the president, the pesos fluctuate tremendously. So if you are McDonald or any company that buys from Mexico, yes, you better have some protection for your currency, but that's beside the point. So this is when we have a fair value hedge. It's to protect the asset, to protect the value of the asset or the liability for that matter, okay? So when do we have a fair value hedge? We have a fair value hedge when we have a recognized foreign currency payable or receivable, I'll just explain it to you, like for a payable. Or we have a foreign currency firm commitment. What is a firm commitment? We entered into a contract to buy good in foreign currency at a future rate. So simply put, we sign a contract saying, we're gonna buy the sesame seed, okay? And it's gonna be in a foreign currency at a future date. It's a commitment. It's a commitment. We don't have the asset yet, but we made a commitment. So under those two circumstances, we could have a fair value hedge. What does that mean? It means the gains and the losses of the fair value hedge goes into the income statement. Now, when do we have a cash flow hedge or a cash flow exposure? Well, exist if changes in exchange rate can affect the amount of cash flow to be realized from a transaction with changes in cash reflected in net income. Here, what we're doing, we're not protecting the asset. We're saying we're protecting our cash flow. We want to make sure that when we pay for that asset, okay, our cash flow is protected. What does it mean it's protected? It's what we thought we're gonna pay. We actually paid. We did not overpay, we did not underpay. So the cash flow, the cash that we're gonna have to come up with is kind of basically known. So we manage that risk. Now, when do we have a cash flow hedge? Recognize foreign currency, asset and liability. Hold on a second. This is what it says here. It says recognize foreign currency, doesn't matter asset or liability, payable or receivable, the same thing. So what's the difference between one here and one here? There's no difference, except when we say it's a cash flow hedge, it means the exposure to cash flow is 100% protected. Completely offset the variability in cash flow. It doesn't have to be 100%, 100% but to a great degree, we are fully covered. So when we create a hedge to make sure our cash flow, it means when we end up paying, when we end up writing that check at the end of the day, what we thought we're gonna pay, we're gonna pay. So it's a cash flow hedge because we set up the hedge in a way to completely offset the variability in cash flow. You might be saying how. Once you see a journal entry, you will see how. I will show you a little bit or you will see it in numbers. But the point is the difference between cash flow hedge and the fair value hedge and a cash flow hedge, you completely, let's say 100%, it doesn't have to be 100%. You offset the variability in the cash flow. Either incoming or outgoing, remember, you could have a receivable, you could have a payable or you could have a foreign currency, firm commitment. Same thing as the fair value hedge, except you're hedging here and you're completely offsetting the variability in cash flow. Same thing. So a recognized foreign currency asset or liability, which is a payable or a receivable, could be considered a fair value hedge, could be considered a cash flow hedge. You'll be told in the problem. Okay, or if they said it's completely protected, then it's a fair value. If it's not completely protected, I'm sorry, if it's a completely protected, I'm sorry, it's a cash flow. If it's not a cash flow hedge, it's a fair value hedge. Now we have a third type. It's a forecasted foreign currency transaction. Here, you did not really made a firm commitment, but you enter into a contract to buy a currency. So it's a forecasted foreign currency transaction without an actual contract, an actual contract to buy something with it, okay? So the purpose of the cash flow hedge is to defer the gain or loss on the hedging instrument to a period or periods in which the hedge expected future cash flow affect the profit on loss. Simply put, what does that mean? It means any changes, you're gonna put them in OCI and other comprehensive income, then eventually you'll put them into, you'll put them into the income statement. So park any gains and losses in OCI, then recycle, transfer them eventually to the income statement when the transaction is realized. So if you're a company, which type of exposure you would like to have, well, if you're interested in stability, you want the cash flow hedge. Why? Because the cash flow hedge, the gains and the losses don't occur on the income statement until the transaction is ended, until it's realized, okay? Versus the fair value hedge, the changes goes into the income statement, okay? Now, hedge is a forecasted currency transaction. This one here, notice this one here, will always be a cash flow hedge. So if they said in the transaction, it's a forecasted foreign currency transaction, it's a cash flow hedge. You just have to say it's a cash flow hedge. So accounting procedures will differ between the two hedges. That's why we need to differentiate between them, okay? So let's take a look at how do they differ between the two, but we're not gonna work an example now, we're gonna work an example later.  I know that, but I will go over them before the example. So you could have a fair value hedge or a cash flow hedge. So what do you need to do at the balance sheet date? Well, the hedge asset or liabilities adjust at the fair value according to the changes in the spot exchange rate and a foreign exchange gain or loss is recognized in that income pretty straightforward. You, what's the spot rate on December 31st year end and you'll make the adjustment to net income. Then the derivatives hedging instrument that adjusted the fair value resulting whether it's an asset, whether you have a gain or a liability if you have a loss with counterpart recognizing a gain or a loss in that income. So simply put, you're gonna debit an asset, credit again or debit a loss and credit a liability at the end of the year. You could have a gain or you could have a gain or you have an asset or you could have a loss from that hedge and you could have a liability and you have to put it down based on the spot rate. Okay, that's it for the fair value hedge. For the cash flow hedge, let's see. The hedged asset or liability is adjusted to fair value according to changes in the spot rate exchange and a foreign currency gain or loss is recognized in net income. I think I copied this and I pasted here. So what's the difference? Well, that's that you're gonna have, you still have to do under cash flow hedge, but you have to do another step. So let's assume here you had the gain that just for the sake of illustration, just from a theory perspective, don't worry we'll work in examples in the next session. Okay, then you have to do what? Then you have an amount in step two, an amount equal to the foreign exchange gain or loss. So we said it's a gain here. So an amount equal to the foreign exchange loss, recognized in net income is then transferred to the accumulated other comprehensive income to offset any gain on the hedged asset or liability. So here's what's gonna happen. You have, you hedge something and as a result of that hedging, it worked to your favor. So the potato prices went up, you have a gain because your prices are locked. Now, what's gonna happen, the instrument, the hedging instrument will go down in value. So the gain will offset the loss and you will see later how that works, okay? The derivative hedging instrument is adjusted to fair value resulting in an asset or a liability reported on the balance sheet with a counterpart recognizing an OCI. So basically you're gonna have an asset or a liability and a counterpart, an adjustment, an adjustment recognize an OCI. Remember, recognize an OCI, it means it's a gain or a loss depending on what you have. And any additional amount is removed from OCI and recognized in net income. So also we have to do, and you're gonna see this later on, we're gonna have to take some amounts of OCI and amortize it, okay? To reflect, the current period amortization of the original discount or premium on the forward contract, if the contract is a hedging instrument or the change in time value of the option, if the option is a hedging instrument. Again, this may not make any sense to you, but you will see later that how we do the accounting. But those are the steps that you will see later on. So this is the nature. All that we talked about here is the nature of hedging risk. And the reason I introduced the second slide is to tell you it's important to know whether it's a fair value hedge or a cash flow hedge. Depending on the hedge, this is how the journal entry will go down, okay? Now, remember we said hedge effectiveness when you talk about hedge effectiveness. How do we know if the hedge is effective? It's working as expected. Well, it used to be as long as you are within 80 to 125%, then your hedge is considered effective. Going back to the potato example, remember you had the price as 100, as long as you end up paying 80 or 125, which is 80% of the price or 125, this is considered an effective hedge. So that will pass the hedging. It used to be that way. Now what happened is now they have more, the hedge and contract qualify for hedge accounting if it meet all the effectiveness requirements. So they change it, they don't have percentages. Well, if something is a hedge, there must be a relationship and economic relationship between the eligible hedged item and the hedging instrument. Remember, I'm buying potatoes, that's the hedged items and the hedging instrument is either a forward contract or an option contract for potatoes. So there's a relationship between the two. Two, the effect of the credit risk does not dominate the value change that result from the economic relationship. What does that mean? It means, let's assume you bought the contract from a bank and that bank is having issues. They're having some serious issues, some serious economic issues. Now as a result, because that bank is issuing the option or the forward contract, what's gonna happen what's gonna happen is that the value will go down, the value of the contract, not because the relationship is not being hedged between the potatoes and the hedging instrument because the counterparty, the bank that issued the hedge is having some credit problems and that might reflect on the value of the hedging instrument. So what we're saying is the credit risk does not dominate the value. So the credit risk, although it exists, it may not dominate the relationship between the hedged item and the hedging instrument. So what we're looking for back to one, we're looking between the price of the potatoes and the hedging instrument, the forward contract. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the quantity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity for hedged item. Simply put, what does that mean? It means you are not too much or too little over hedging or over hedging or under hedging. It means you could hedge something, but let's assume you have a million dollar worth, a million dollar worth of value, you can hedge it for 1.5 million. Well, you're over hedging because you have a million dollar of a commitment. Why are you buying too much, 1.5 million? Now what we're saying is you're not really hedging, you're really starting to speculate because if you're really hedging, you only have one million dollar of exposure. Why are you going 1.5? And the same thing with if you went down and you only had 600,000 of the million dollar exposure. So the ratio has to be equal. This is basically what this mean in simple English. You can, if you're over hedged or under hedged, then it's not effective. So you have to meet those three items for the four, for it to be an effective hedge. And the third criteria is hedge documentation. Basically you have to document your hedging policy. And right from the get go, for hedge accounting to apply, if you want to say this is hedged accounting, you have the hedging relationship must be formally documented at the inception of the hedge. So you have to have some sort of a policy between yourself and the company. Basically written down that this is my policy. I'm trying to, I bought this derivatives because my purpose is to hedge my position and explain the position. For example, if the auditor is asking for this document, they will see it. So the hedging company must prepare a document that identify the hedged item. What are you hedging? Potatoes, the hedging instrument. Is it a forward contract? Is it an option contract? The nature and the risk being hedged. Well, the nature of the risk, it's either could be fair value hedge or cash flow hedge. What are you trying to hedge here? How the hedged instrument effectiveness will be assessed? How are you gonna find out if you are effective or not? Within 95%, 5% plus or minus, 10% plus or minus, how are you assessing? Because remember it used to be 80 as long as you are between 80 to 25. That's no longer the case. How are, state, how are you measuring your effect? How are you assessing your effectiveness? And the risk management objective and strategy for undertaking the hedge. Well, what is your risk? And how are you managing that risk? Write it down, show us in the hedging document. So that's the purpose of the hedging document. So you have to have those three conditions. Let's go back to them. Maybe we forget about what they are or just I went through a lot of material. So all what I did, since I got to the slide, I explained those three positions. When can we use hedge accounting? When can we use hedge accounting? Last but not least, let's talk about the effect of hedging on the statement of cash flow. Well, guess what? Hedging could be operating, investing or financing. So cash flow rising from hedging can be classified, anything. How its basis on the item begin hedge? Because remember, hedging instruments are derivatives instrument. They derive their value from something else. So if they're driving their values from your receivable, that's operating. If they're driving your values from some property, plant, and equipment, or an investment you are making, then it's an investment. If they're driving their values from stocks and bonds you are issuing for your company, then that's a financing activity. So depending on the item is being hedged. And hopefully this makes sense because remember, it's a derivatives. It derives their value from something else. Therefore, it's cash flow. It's like the cash flow is connected to that instrument. Okay, whatever that instrument is, but it's an operating instrument, accounts receivable, accounts payable, whether it's a property, plant, and equipment, or investment, and whether it's a financing, your stocks, and your own bonds.


Yeah Let's hurt a little heart and I am fine stuff Weird hey welcome back to our do-it-your-action to the it's up Corbin I'm Rick Amy falls on the Instagram Twitter for more to see content It's so Kamala Harris about the suspension of the visas that they that the Trump administration had done She replied back to me about she too is concerns about the pandemic. Those are our senators Anyways, uh today we are reacting to a new teaser that just dropped I think that's a telugu film It is non-honey non-honey Or nandi nandi. Yeah, okay Nandi teaser with alari nadesh and vj kanakamela I don't know what it's about. I outside of I think it's about the prison system and the judicial system in india. Oh So probably that's relevant probably something pretty intense. Yeah But outside of that I have zero idea. Okay, uh what it is And this is a straight. This is like a cinematic release. Yeah, I believe so I don't know if it's going. I'm assuming you don't go straight to ot t's Um, what is what does ot t stand for? Old testicle time. Weird. Yeah, it happens for people once they reach the age of 90 actually And it keeps them invigorated Yeah, I know ot is streaming, but I don't know what it stands for because we don't call ot here Streaming platforms streaming platforms. Um are on demand. So I'm assuming means on the Anyway, stuff that's on the telly. Uh, let me know down below. All right, here we go Oh Yeah, I didn't know it was your birthday. I didn't get you a gift Interesting Good teaser. Yeah, very good teaser looks like it's gonna be more like a trailer gonna be Pretty intense because the prison system Uh, I'm only speaking from america is Pretty intense thing and obviously it's a different thing in india than it is here very different and they have their own issues Yeah, because we have our own issues here Um, and so like you could do a total a film about the prison system But it would be a completely different film. Mm-hmm. Yeah, um because ours was started Basically after slavery ended, uh, but that's neither here nor there No, and this this has obviously the the I've been learning for the first time about the history and the problems within the prison and policing system and in america No, no, no in india. Oh in india in india through because of the situation with phoenix and his father And the the competing voices in that, um tragedy The suffice it to say It like everything else in india compared to the united states It's much deeper. Mm-hmm. It's much bigger. It has a longer history And reasons for problems are much much different than the reasons we have problems here. Some of them are similar But uh, one of the biggest mistakes. I think that can be made internationally is for us To make presumptions on something just because we get a splash of something on social media And really don't know the full dynamics not just about the event. I'm not talking about the event. I'm talking about Uh, how little that that's my primary reason as we were watching the teaser My thought was I really hope they get this right because When anything's depicting something true in film I I am a big thing about them getting it right and not doing revisionist history or Coming from a particular slant that you so put your own view on it That you twist the story to teach us the history you want us to learn.  Uh, yeah And so they says a story of about a girl who has been kidnapped and tries to play Uh with the kidnappers mind and convince him to fall for her Wait, that's this film. Hold on. It doesn't sound like this film. No, I mean, it could be There's no synopsis on IMDb. Anyways, uh, yeah, because it looked like a man who was Imprisoned while he was awaiting trial and his guilt is yet to be determined But he's being treated as if he's already a guilty criminal. Yeah, that's what it looked like Yeah, and that's that and that was a powerful line. It said it takes a What did it say take it takes nine months for a human being to give birth Why is it taking me nine years right or years however years to get a to get a trial? Yeah, which Seems to be a thing Throughout multiple cultures. We have that here. Oh, yeah If you're rich and they set bail you're fine You know if you're wealthy and they set a two million dollar bail you pay the two million bucks Do you get out and you're free if you don't have two million bucks? You stay in jail for the totality of your trial just because you didn't have the money One of the many issues with our system. Yep, uh, but and you're guilty to approve an innocent. Yeah, yeah Um So and then I think that's what this is also trying to say that guilty until proven innocent correct the fact that he's not treated Even though It's not always done in in America. You're innocent until you're proven guilty, right? It's not always the case the way that people are treated right and prisoner abuse I mean, yeah, there's different reasons for it in different places But it happens in in all countries in different ways shapes and forms, but it looks intense. It looks powerful Um, who's the director of it? Vj. Yeah vj. Uh, god had mentioned his name at the beginning But May have probably completely mispronounced the last name He did the screenplay as well vj Associate director noddy. Okay. What's that first film first film directing? Dang the teaser was great Yeah, looks phenomenal. Uh, let us know what other information we missed Uh, in any information we need down below