Question

Based on past experience, Leickner Company expects to purchase raw materials from a foreign supplier at a cost of 1,100,000 marks on March 15, 2018. To hedge this forecasted transaction, the company acquires a three-month call option to purchase 1,100,000 marks on December 15, 2017. Leickner selects a strike price of $0.81 per mark, paying a premium of $0.002 per unit, when the spot rate is $0.81. The spot rate increases to $0.817 at December 31, 2017, causing the fair value of the option to increase to $9,000. By March 15, 2018, when the raw materials are purchased, the spot rate has climbed to $0.83, resulting in a fair value for the option of $22,000.

a. Prepare all journal entries for the option hedge of a forecasted transaction and for the purchase of raw materials, assuming that December 31 is Leickner's year-end and that the raw materials are included in the cost of goods sold in 2018.

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

c. What is the net cash outflow to acquire the raw materials

Answer 1

Answer:
a:

Date	Particulars	Debit ($)	Credit ($)
Dec 15, 2017	Call option contract	$2,200
	Cash		$2,200
	(To purchase call option)
Dec 31, 2017	Call Options Contract	$2,200
	Other comprehensive income		$2,200
	(To recognise gain in fair value)
Mar 15, 2018	Call option contract	$11,200
	Other comprehensive income		$11,200
	(To recognise gain in fair value)
	Cash	$22,000
	Call option		$22,000
	(To settle call option)
	Raw material	$913,000
	cash		$913,000
	(To purchase raw materials)
	Other comprehensive income	$22,000
	Revenue		$22,000
	(To recognise gain in revenue statement)

b:

Cost of foreign currency option = 1,100,000 * 0.002 =$2,200

Fair value of option at the end of 2017 = $9,000

Fair value of option on Mar 15 2018 = $22,000

Impact on net income in 2017 = $9,000 - $2,200 = $6,800 increase in net income through OCI

Impact on net income in 2018 = $22,000 - $9,000 = $13,000 increase in net income

c:

Net cash outflow for purchase of raw materials = Purchase cost - Gain on foreign currency option

= 1,100,000 * $0.83 - $19,800 = $893,200