QUESTION 3 Not changed since last attempt Marked out of 45.00 F Flag quest Use o

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QUESTION 3 Not changed since last attempt Marked out of 45.00 F Flag quest Use of futures contracts to hedge cotton inventory-fair value hedge On December 1, 2014, a cotton wholesaler purchases 7 million pounds of cotton inventory at an average cost of 75 cents per pound. To protect the inventory from a possible decline in cotton prices, the company sells cotton futures contracts for 7 million pounds at 66 cents a pound for delivery on June 1, 2015, to coincide with its expected physical sale of its cotton inventory. The company designates the hedge as a fair value hedge (i.e., the company is hedging changes in the inventory's fair value, not changes in cash flows from anticipated sales). The cotton spot price on December 1 is 74 cents per pound. On December 31, 2014, the company's fiscal year-end, the June cotton futures price has fallen to 56 cents a pound, and the spot price has fallen to 65 cents a pound, On June 1, 2015, the company closes out its futures contracts by entering into an offsetting contract in which it agrees to buy June 2015 cotton futures contracts at 47 cents a pound, the spot rate on that date. Finally, the company sells its cotton for $0.47 per pound on June 1, 2015. Following are futures and spot prices for the relevant dates: Spot Futures 660 56C Date December 1, 2014 December 31, 2014 June 1, 2015 740 650 47C Required Prepare the journal entries to record the following: (If no entry is required, select "No entry required" for both the debit and credit account titles.) a. Purchase of cotton General Journal Date Description Debit Credit 12/01/2014

Explanation / Answer

NOTES:1) SINCE IT IS DELIVERY BASED HEDGE CONTRACT IT IS SETTLED THROUGH DELIVERY OF COTTON . IF IT WAS CASH SETTLED THE ENTRY OF GAIN WOULD HAVE BEEN PASSED THROUGH CASH/BANK IF

2) there was $1,330,000 LOSS on the change in Fair Valueof Inventory of Commodity-A ($5,250,000-$3,290,000)

3)there was an exact offsetting Gain of $1,330,000 on the future’s contract(.65-.47)*7million.SINCE WE HAVE SOLD FUTURES WE WILL GAIN WHEN PRICES OF COTTON GO DOWN

JOURNAL DATE DESCRIPTION DEBIT(POUND) CREDIT(POUND) a.Purchase of Cotton 12/01/2014 COMMODITY-COTTON 5,250,000 CASH 5,250,000 (BEING COTTON PURCHASED 7 MILLION POUNDS @.75 PER POUND) b.SALE OF FUTURE CONTRACT THE FAIR VALUE OF FUTURE CONTRACT IS ZERO AT INCEPTION DATE 12/01/2014 NO ENTRY c.ADJUSTMENT ENTRY CHANGE IN FAIR VALUE OF INVENTORY FROM 12/1 TO 12/31 12/31/2014 PROFIT & LOSS ACCOUNT 700,000 COMMODITY-COTTON 700,000 (.75-.65)*7 MILLION POUNDS OF COTTON BEING LOSS IN FAIR VALUE AT YEAR END PROFIT ON HEDGE AS ON 12/31/2014 RECEIVABLE/LIABILTY TO BROKER A/C 700,000 GAIN ON HEDGE 700,000 (.66-.56)*7 MILLION POUND COTTON d.SALE OF COTTON 06/01/2015 CHANGE IN FAIR VALUE OF INVENTORY FROM 12/31/14 TO 06/01/2015 PROFIT & LOSS A/C 126,000 COMMODITY-COTTON 126,000 (BEING LOSS ON COTTON (.47-.65)*7 MILLION POUNDS OF COTTON FAIR VALUE OF HEDGE 12/31/2014 TO 06/01/2015 RECEIVABLE/LIABILTY TO BROKER A/C 630,000 GAIN ON HEDGE 630,000 (.56-.47)*7 MILLION POUND COTTON SALE OF COTTON FUTURE WITH DELIVERY SALES(7 MILLION POUND COTTON * 47 CENTS PER POUND) 3,290,000 RECEIVABLE/LIABILTY TO BROKER A/C(700000+630000) 1,330,000 COMMODITY-COTTON 1,960,000

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