American Italian Pasta Company (AIPC) manufactures several varieties of pasta. O
ID: 2403461 • Letter: A
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?
Explanation / Answer
a. Journal Entries
January 6 - Initial Margin Paid to Future Broker
Debit: Initial margin on Selling Future Contract = $20,000
Credit: Cash = $20,000
February 19 - Recognise the Profit on expiration of Contract
Debit: Commodity Inventory = $50,000
Debit: Cash $20,000
Credit: Unrealised gain on Inreacse in Market price = $50,000
Credit: Initial margin on Selling Future Contract = $20,000
March 2 - Cash Sale of Commodity Inventory at Profit
Debit: Cash =$11,75,000
Credit: Commodity Inventory = $10,00,000
Credit: Profit on Sale of Commodity Inventory = $1,25,000
b. As in case of Hedging via Futures, Company needs to pay initial Margin of $20,000 (which is adjustable while settlement. So, in case hedge was not undertaken AIPC's profit would have increase by Brokerage Paid for future contract in addition with the cost of borrowing of $20,000 (or Rate of Return), which has to be deposited as initial margin for 2 months.
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