Question

American Italian Pasta Company (AIPC) manufactures several varieties of pasta. On January 1, 2020, AIPC had excess commodity inventories carried at acquisition cost of $1,000,000. These commodities could be sold or manufactured into pasta later in the year. To hedge against possible declines in the value of its commodities inventory, on January 6 AIPC sold commodity futures, obligating the company to deliver the commodities in February for $1,100,000. The futures exchange requires a $20,000 margin deposit. On February 19, the futures price increased to $1,150,000 and the company closed out its futures contract. Spot prices continued to rise and AIPC sold its inventory for $1,175,000 in cash on March 2.
Required:
a. Prepare the journal entries related to AIPC’s futures contract and sale of commodities inventory. Assume a perpetual inventory system, that spot and futures prices move in tandem, and the futures position qualifies for hedge accounting. All income effects for the inventories and related hedges are reported in cost of goods sold.b. By how much would AIPC’s profit increase if the hedge was not undertaken?

Answer 1

Answer:

A. The Journal entry with their narrations is shown below:-

B. $50,000

Explanation:

a. The Journal entry is shown below:-

Investment in futures  Dr, $20,000

       To Cash  $20,000

(Being the initial margin deposit on the sale of the commodity is recorded)

b. Loss on hedging $50,000

 ($1,150,000 - $1,100,000)

       To Investment in futures  $20,000

       To Cash  $30,000

(Being to settle the contract is recorded)

c. Inventory  Dr, $50,000

      To Gain on hedging  $50,000

(Being To adjust the carrying value of the hedged inventory for the change in fair value is recorded)

d. Cash  Dr, $1,175,000

     To Sales revenue  $1,175,000

(Being the sale of commodities is recorded)

e. Cost of goods sold $1,050,000

($1,000,000 + $50,000)

       To Inventory  $1,050,000

(Being to recognize the cost of sales is recorded)

B. The computation of AIPC’s profit is shown below:-

AIPC’s profit after hedge = Sold inventory - (Acquisition cost + (Future price - Commodities in February))

= $1,175,000 - ($1,000,000 + ($1,150,000 - $1,100,000) )

= $1,175,000 - ($1,000,000 + $50,000)

= $1,175,000 - $1,050,000

= $125,000

So,  If there is no hedge by selling futures short, it would be possible to avoid the loss of $50,000 .

Therefore the AIPC’s profit would have increased by $50,000 to $175,000