Question

Exercise A-7 (Algo) Derivatives; fair value hedge—futures contract [LOA–2] Arlington Steel Company is a producer of raw steel and steel-related products. On January 3, 2022, Arlington enters into a firm commitment to purchase 10,000 tons of iron ore pellets from a supplier to satisfy spring production demands. The purchase is to be at a fixed price of $53 per ton on April 30, 2022. To protect against the risk of changes in the fair value of the commitment contract, Arlington enters into a futures contract to sell 10,000 tons of iron ore on April 30 for $53/ton (the current price). The contract calls for net cash settlement, and the company must report changes in the fair values of its hedging instruments each quarter. Required: On March 31, the price of iron ore fell to $51/ton, and then to $50/ton on April 30. 1. Calculate the net cash settlement at April 30, 2022. 2. Prepare the journal entries for the period January 3 to April 30, 2022, to record the firm commitment, necessary adjustments for changes in fair value, and settlement of the futures contract.

Answer 1

Requirement 1

	January 3	March 31	April 30
Fair value of futures contract	$0	$20,000	$30,000
Fair value of firm commitment	0	20,000	30,000
Receipts—futures contract			$530,000
Payment at spot rate			500,000
Net cash receipts (payments)			$ 30,000

Requirement 2

January 3

Document the firm commitment and the futures contract, but no formal entry. Futures contract is issued at the current/spot price.

March 31

Futures contract [($53 – $51) × 10,000]   20,000

Cost of goods sold 20,000

To record the change in fair value of the futures contract.

Cost of goods sold 20,000

Firm commitment 20,000

To record the change in fair value of the firm commitment.

April 30

Futures contract [($51 – $50) × 10,000]   10,000

Cost of goods sold 10,000

To record the change in fair value of the futures contract.

Cost of goods sold 10,000

Firm commitment 10,000

To record the change in fair value of the firm commitment.

Cash 30,000

Futures contract 30,000

To record the net settlement of the futures contract.

Inventory 500,000

Firm commitment 30,000   

Cash 530,000

To record the purchase of inventory.