Question

On September 1, 2021, American Metals Distribution (AMD) has an inventory of 10,000 pounds of copper that it plans to sell on the spot market in two months. The inventory is carried at cost, and was purchased on the spot market at $2.15/lb. To hedge against a decline in market price, AMD invests in put options on 10,000 pounds of copper, expiring November 1, at a strike price of $2.30/lb, which is the current spot price. AMD pays $150 for the options, and designates the change in intrinsic value as the hedge. On November 1, 2021, the spot price is $2.24/lb, AMD sells the options for their intrinsic value of $600, and AMD sells its inventory at the $2.24/lb spot price. AMD records all income effects of the inventory and hedge in cost of goods sold.
Required:

a. Prepare AMD's journal entries to record the events of September 1 and November 1,2021.AMD's accounting year ends December 31.
b. Calculate the gross margin that is locked in with the put options. What is the ctual reported gross margin? Why are the two amounts different?

Answer 1

Answer and Explanation:

a. The Journal entry is shown below:-

1. Hedge charges Dr, $150  

     To Cash Account $150

(Being bank charges is recorded)

2. Hedge Instrument - Financial Asset Dr, $600  

        To Profit and Loss A/c $600

(Being financial assets is recorded)

3. Profit and Loss A/c Dr, $600  

        To Inventory Account - Copper $600

(Being profit and loss account is recorded)

4. Bank A/c Dr, $22,400  

          To Sales $22,400

(Being bank account is recorded)

2. The computation of the gross margin and locked with the put option and actual reported gross margin is shown below:-

Particulars   Rate    Pounds   Amount   Gross Margin    Gross Margin

Cost Price   $2.15   10,000    $21,500

Strike Price   $2.3 10,000     $23,000      $1,500             6.98%

Cost after hedge

loss of           $0.6    2.09        10,000       $20,900

Selling Rate   $2.24 10,000    $22,400       $1,500         7.18%

Gross margin locked with the put option: 6.98%

Actual reported gross margin: 7.18%

The two amounts are different, since the carrying value of the inventory has changed and the same has been reduced. As a result the total gross margin of 1,500 yielded another percentage as the base value (inventory carrying value) was adjusted.