The Potato Company (Potato) produces frozen french fries and, therefore, uses po

Question

The Potato Company (Potato) produces frozen french fries and, therefore, uses potatoes in its manufacturing process. On January 1, Potato enters into a forward contract to buy 20 bushels of potatoes in 30 days for $1,200. The contract has a net settlement provision.

Part 1 (1 point): Assume that the potatoes are worth $1,100 at the end of 30 days.

What is the underlying?

What is the notional amount?

Explain how the contract might be settled in 30 days.

Part 2 (1 point): Assume that the potatoes are not easily convertible to cash and that Potato has a history of taking delivery of the potatoes under these types of contracts (gross settlement). Potato has decided not to document the instrument as a normal purchase and sales contract. Prepare the journal entries on January 1 and January 31 assuming that the contract meets the requirements for a derivative.

Explanation / Answer

Underlying-

Underlying is a variable whose fluctuation causes the change in fair market value or cash flows of a derivative. In the given example price of potato is the underlying.

Notional Amount-

Notional Amount is a fixed amount or quantity that determines the size of the change caused by the fluctuation in underlying.

Settlement in Net Settlement Provision-

  Contract Price = $ 1200

Market Price on the date of expiry = $1100

Hence drop in the market price of underlying asset is worth $100 to the seller because he will get $ 100 more than the current market price of potato.

Hence in this case The Potato Company will pay $ 100 to forward contract seller instead of physical delivery of potatoes.

Journal Entries in Gross Settlement

Date

Account Title and Explanation

Debit

Credit

Jan 1

Inventory Receivable

1200

Derivative Liability

1200

(To record the forward contract)

Jan 31

Derivative liability

1200

Cash

1200

Inventory

1100

Trading revenue (loss)

100

Inventory Receivable

1200

To record the settlement of physical delivery of contract and loss on contract.

Date

Account Title and Explanation

Debit

Credit

Jan 1

Inventory Receivable

1200

Derivative Liability

1200

(To record the forward contract)

Jan 31

Derivative liability

1200

Cash

1200

Inventory

1100

Trading revenue (loss)

100

Inventory Receivable

1200

To record the settlement of physical delivery of contract and loss on contract.

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