Question

Based on past experience, Maas Corp. (a U.S.-based company) expects to purchase raw materials from a foreign supplier at a cost of 1,000,000 francs on March 15, 2021. To hedge this forecasted transaction, on December 15, 2020, the company acquires a call option to purchase 1,000,000 francs in three months. Maas selects a strike price of $0.58 per franc when the spot rate is $0.58 and pays a premium of $0.005 per franc. The spot rate increases to $0.584 at December 31, 2020, causing the fair value of the option to increase to $7,500. By March 15, 2021, when the raw materials are purchased, the spot rate has climbed to $0.59, resulting in a fair value for the option of $10,000. The raw materials are used in assembling finished products, which are sold by December 31, 2021, when Maas prepares its annual financial statements. Prepare all journal entries for the option hedge of a forecasted transaction and for the purchase of raw materials. What is the overall impact on net income over the two accounting periods

Answer 1

Answer:

A. 15-Dec-20

Dr Foreign Currency Option $5,000

Cr Cash $5,000

2. 15-Dec-20 No Journal Entry Required

3 31-Dec-20 Dr Foreign Currency Option

$4,000

Cr To Accumulated - Other Comrehensive Income $4,000

4 31-Dec-20 Dr Option Expense (AOCI) $1,500

Cr To Foreign currency option $1,500

5 15-Mar-21 Dr Foreign Currency Option $6,000

Cr To Accumulated - Other Comrehensive Income $6,000

6 15-Mar-21 Dr Option Expense (AOCI) $3,500

Cr To Foreign currency option $3,500

7 15-Mar-21 Cash A/c $10,000

Cr To Foreign currency option $10,000

8 15-Mar-21 Dr Raw material inventory $590,000

Cr To Cash $590,000

9 15-Mar-21 Dr Accumulated - Other Comprehensive Income $6,000

Cr To Gain on sale of Option (Income statement) $6,000

b. Impact on net income in 2020= $2,500

Impact on net income in 2021 = $4,500

Explanation:

A. Preparation of all journal entries for the option hedge of a forecasted transaction and for the purchase of raw materials

15-Dec-20

Dr Foreign Currency Option Dr (1,000,000*0.005) $5,000

Cr To Cash $5,000

(Being call option purchased to acquire 1000000 marks at $0.005 per mark)

2 15-Dec-20 No Journal Entry Required

3 31-Dec-20 Dr Foreign Currency Option

[($0.584 - 0.58)*1000000] $4,000

Cr To Accumulated - Other Comrehensive Income $4,000

(Being adjustment of increase in fair value of option)

4 31-Dec-20 Dr Option Expense (AOCI) ($4,000 + $5,000 - $7,500) $1,500

Cr To Foreign currency option $1,500

(Being time value reduction of foreign currency option)

5 15-Mar-21 Dr Foreign Currency Option [(0.59 - 0.584)*1000000] $6,000

Cr To Accumulated - Other Comrehensive Income $6,000

(Being adjustment of increase in fair value of option)

6 15-Mar-21 Dr Option Expense (AOCI) ($7,500 + $6,000 - $10,000) $3,500

Cr To Foreign currency option $3,500

(Being time value reduction of foreign currency option)

7 15-Mar-21 Cash A/c $10,000

Cr To Foreign currency option $10,000

(Being sale of foreign currency option)

8 15-Mar-21 Dr Raw material inventory $590,000

Cr To Cash (1000000*0.59) $590,000

(To record purchase of raw material)

9 15-Mar-21 Dr Accumulated - Other Comprehensive Income $6,000

Cr To Gain on sale of Option (Income statement) $6,000

($4,500+$2,500)

(Being gain on option realzied and transferred to statement of comprehensive income)

b. Calculation for What is the overall impact

Impact on net income in 2020 = $4,000 - 1,500 = $2,500

Impact on net income in 2021 = $6,000 - $1,500 = $4,500