Question

Based on past experience, Leickner Company expects to purchase raw materials from a foreign supplier at a cost of 1,400,000 marks on March 15, 2018. To hedge this forecasted transaction, the company acquires a three-month call option to purchase 1,400,000 marks on December 15, 2017. Leickner selects a strike price of $0.62 per mark, paying a premium of $0.004 per unit, when the spot rate is $0.62. The spot rate increases to $0.624 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 $0.64, resulting in a fair value for the option of $28,000.

1. 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.

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

Date	journal	debit	credit
	No entry to record the forecasted transaction
15- dec	foreign currency option (1400000 × $0.004)	$5600
	To cash		$5600
	(To record purchase of foreign currency option)
31 dec	foreign currency option ($9000 - $5600)	$3400
	To AOCI		$3400
	(To record the increase in foreign currency option)
31 Dec	option expense[{($0.624-0.620)×1400000} - $3400]	$2200
	To AOCI		$2200
	(To record the decrease in time value of option as an expense)

Date	journal	debit	credit
15 march	foreign currency option($28000-$9000)	$19000
	To AOCI		$19000
	(To record the increase in foreign currency option)
15 march	option expense [{($0.64-$0.624)×1400000} - $19000]	$3400
	To AOCI		$3400
	(to record the decrease in time value of option as an expense)
15 march	foreign currency (1400000 × $0.64)	$896000
	To cash (1400000 × $0.62)		$868000
	To foreign currency plan		$28000
	( To record exercise of foreign currency option at the strike price of $0.62 and close out foreign currency stock account)
15 march	part inventory	$896000
	To foreign currency		$896000
	( To record purchase and payment of 1400000 marks to the supplier)
15 march	AOCI	$28000
	To adjustment to net income		$28000
	(To record the transfer of AOCI amount)

Part b)

Description	amount
2017
Option expense	$2200
Impact on net income (A)	($2200)
2018
Cost of goods sold	($896000)
Option expense	($3400)
Adjustment to net income	$28000
Impact on net income (B)	($871400)
Impact on net income (A + B)	($873600)

Part c)

Net cash outflow = $5600 + $868000 = $873600

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