ul COtion ol June 37.B Use of futures contracts to hedge a forecasted transactio

Question

ul COtion ol June 37.B Use of futures contracts to hedge a forecasted transaction-cash flow hedge As of January, our company plans to purchase 200,000 lbs. of copper on May 31 at the prevailing spot rate. To hedge this forecasted transaction, we purchase May futures contracts in January for 200,000 lbs. of copper at the futures price of $1.58/lb. On May 31, we close out our futures contracts by enter- ing into an offsetting contract in which we agree to buy 200,000 lbs. of May copper futures contracts at $1.84/lb., the spot rate on that date. We also purchase 200,000 lbs. of copper at $1.84/lb. on that date. Finally, we sell the inventory in June for $2.06/lb. Our company operates on a calendar year and issues financial statements quarterly Following are futures and spot prices for the relevant dates: Date Spot Futures May 31 . . . . $1.84 n/a Prepare the journal entries to record the following: a. Purchase of copper futures contract in January b. Adjusting entry at March 31 c. Purchase of copper on May 31 d. Sale of copper on June 1

Explanation / Answer

1. Valuation of Derivative Contract

Loss on Future Contract A/c   Dr.   28000

            To Derivative Liability A/c               28000

                (200000 x (1.58-1.44))

2. a. Reversal of First Entry:

Derivative Liability A/c Dr.                  28000

     To Loss on Future Contract A/c                      28000

b. Revised Valuation of Derivative Contract

Loss on Futures Contract A/c    Dr.             30000

       To Derivative Liability A/c                                  30000

(200000 x (1.67 - 1.52))

3. a. Purchase of Copper:

Purchase A/c                 368,000     

    To Cash / Bank A/c                           368,000

b. Reversal of Future contract Entry:

Derivative Liability A/c                                  30,000

                Loss on Futures Contract A/c    Dr.             30,000

c. Actual Gain from Derivative Contract:

Cash / Bank A/c         60,000

Forex Gain / Loss      60,000

(200000 x (1.84-1.58))

4. Sale

Cash / Bank A/c        412,000

To Sales A/c                             412,000

(200000 x (1.84-1.58)

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