Question

Mega Company believes the price of oil will increase in the coming months. Therefore, it decides to purchase call options on oil as a price-risk-hedging device to hedge the expected increase in prices on an anticipated purchase of oil.

On November 30, 20X1, Mega purchases call options for 10,000 barrels of oil at $31 per barrel at a premium of $2 per barrel with a March 1, 20X2, call date. The following is the pricing information for the term of the call:

Date	Spot Price				Futures Price (for March 1, 20X2, delivery)
November 30, 20X1		$	31			$	32
December 31, 20X1			32				33
March 1, 20X2			34

The information for the change in the fair value of the options follows:

Date	Time Value				Intrinsic Value				Total Value
November 30, 20X1		$	20,000			$	–0–			$	20,000
December 31, 20X1			6,000				10,000				16,000
March 1, 20X2							30,000				30,000

On March 1, 20X2, Mega sells the options at their value on that date and acquires 10,000 barrels of oil at the spot price. On June 1, 20X2, Mega sells the oil for $35 per barrel.

Required:
a. Prepare the journal entry required on November 30, 20X1, to record the purchase of the call options. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)
  

b. Prepare the adjusting journal entry required on December 31, 20X1, to record the change in time and intrinsic value of the options. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

c. Prepare the entries required on March 1, 20X2, to record the expiration of the time value of the options, the sale of the options, and the purchase of the 10,000 barrels of oil. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

d. Prepare the entries required on June 1, 20X2, to record the sale of the oil and any other entries required as a result of the option. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

Answer 1

Part a)

The journal entry required on November 30, 20X1, to record the purchase of the call options is provided as below:

Date	Account Titles	Debit	Credit
November 30, 20X1	Purchased Call Options (10,000*2)	$20,000
	Cash		$20,000
	(Tp record purchase of call options at a premium of $2 per barrel)

_____

Part b)

The adjusting journal entry required on December 31, 20X1, to record the change in time and intrinsic value of the options is given as follows:

Date	Account Titles	Debit	Credit
December 31, 20X1	Loss on Hedge Activity (20,000 - 6,000)	$14,000
	Purchased Call Options		$14,000
	(To record decrease in time value)
December 31, 20X1	Purchased Call Options (10,000 - 0)	$10,000
	Other Comprehensive Income		$10,000
	(To record increase in intrinsic value)

_____

Part c)

The journal entries to record each event are prepared as below:

Date	Account Titles	Debit	Credit
March 1, 20X2	Loss on Hedge Activity (6,000 - 0)	$6,000
	Purchased Call Options		$6,000
	(To record decrease in time value)
March 1, 20X2	Purchased Call Options (30,000 - 10,000)	$20,000
	Other Comprehensive Income		$20,000
	(To record increase in intrinsic value)
March 1, 20X2	Cash (20,000 - 14,000 + 10,000 - 6,000 + 20,000)	$30,000
	Purchased Call Options		$30,000
	(To record sale of call options at fair value)
March 1, 20X2	Oil Barrel Inventory (10,000*34)	$340,000
	Cash		$340,000
	(To record purchase of oil barrels at spot rate)

_____

Part d)

The journal entries to record different events are given as follows:

Date	Account Titles	Debit	Credit
June 1, 20X2	Cash (10,000*35)	$350,000
	Sales		$350,000
	(To record sale of oil barrels at $35 per barrel)
June 1, 20X2	Cost of Goods Sold	$340,000
	Oil Barrel Inventory		$340,000
	(To record cost of oil barrel inventory sold)
June 1, 20X2	Other Comprehensive Income (10,000 + 20,000)	$30,000
	Cost of Goods Sold		$30,000
	(To adjust cost of goods sold with the amount of other comprehensive income recorded previously)