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 1,500,000 francs on March 15, 2021. To hedge this forecasted transaction, on December 15, 2020, the company acquires a call option to purchase 1,500,000 francs in three months. Maas selects a strike price of $0.63 per franc when the spot rate is $0.63 and pays a premium of $0.005 per franc. The spot rate increases to $0.634 at December 31, 2020, causing the fair value of the option to increase to $13,000. By March 15, 2021, when the raw materials are purchased, the spot rate has climbed to $0.65, resulting in a fair value for the option of $30,000. The raw materials are used in assembling finished products, which are sold by December 31, 2021, when Maas prepares its annual financial statements.

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

2. What is the overall impact on net income over the two accounting periods?

3. What is the net cash outflow to acquire the raw materials?

Answer 1

(A)

Journal entries for purchasing the Option hedge would be as under :

Date : 15.12.2020

Call Option( Financial Assest) _________________ $ 7500 Dr

To Bank __________________________________ $ 7500 Cr.

( Being $ 0.005 is paid for one Francs and $ 7500 for ( 1500000 * 0.005 ))

Journal entries at the year end reflecting faur value would be as under :

Date : 31.12.2020

Call Option ( Financial Assest) _________________ $ 5500 Dr

To Profit on increase in fair value________________ $ 5500 Cr.

( Being fair value of Call Option is increased to $ 13000 therefore difference of (13000-7500) is recognised as income )

Journal entries on purchase of Raw Material would be as under :

Date : 15.03.2021

Purchase A/C ________________$ 945000 Dr

To Bank A/C _________________$ 945000 Dr

( Being 1500000 Francs purchases for payment @ 0.63 strike price and payment for the same is made )

Date : 15.03.2021

Call Option ( Financial Assest) _________________ $ 17000 Dr

To Profit on increase in fair value________________ $ 17000 Cr.

( Being fair value of Call Option is increased to $ 3000 therefore difference of (30000-13000) is recognised as income )

(B)

In year ending on 31.12.2020, income of $ 5500 would be booked as the fair value of option is increased to $ 13000 from $ 7500.

In year ending on 31.12.2021, income of $ 17000 would be booked the fair value of option is increased to $ 30000 from $ 13000.

(C)

Overall impact can be summarised as below:

Particular	No. of Francs (a)	$ rate per Frans (b)	Net Outflow of $ = (a)*(b)
Payment if Call option is not taken	1500000	0.65	975000

Particular	No. of Francs (a)	$ rate per Frans i.e. Strike Price (b)	Net Outflow of $ = (a)*(b)
Payment made as option is taken	1500000	0.63	945000

Savings in outflow $ 30000 (975000-945000)

$ paid for purchase of Option = 7500

Net Savings = 22500 i.e.(30000-7500)

Therefore, Savings in outflow of $ is 22500.