Question

Fair Value Hedge: Short in Commodity Futures

American Italian Pasta Company (AIPC) manufactures several varieties of pasta. On January 1, 2020, AIPC had excess commodity inventories carried at acquisition cost of $1,000,000. These commodities could be sold or manufactured into pasta later in the year. To hedge against possible declines in the value of its commodities inventory, on January 6 AIPC sold commodity futures, obligating the company to deliver the commodities in February for $1,100,000. The futures exchange requires a $20,000 margin deposit. On February 19, the futures price increased to $1,150,000 and the company closed out its futures contract. Spot prices continued to rise and AIPC sold its inventory for $1,175,000 in cash on March 2.

Required

a. Prepare the journal entries related to AIPC’s futures contract and sale of commodities inventory. Assume a perpetual inventory system, that spot and futures prices move in tandem, and the futures position qualifies for hedge accounting. All income effects for the inventories and related hedges are reported in cost of goods sold.

Date	Description		Debit	Credit
1/6/20	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	To record the initial margin deposit on the sale of commodity.
2/19/20	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	Cash		Answer	Answer
	To settle the contract.
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	To adjust the carrying value of the hedged inventory for the change in fair value.
3/2/20	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	To record sale of commodities.
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	AnswerCashCost of goods soldInventoryInvestment in futuresSales revenue		Answer	Answer
	To recognize the cost of sales.

b. By how much would AIPC’s profit increase if the hedge was not undertaken?

$Answer

Answer 1

Part A

Date	Description	Debit	Credit
1/6/20	Investment in futures	20000
	cash		20000
	To record the initial margin deposit on the sale of the commodity.
2/19/20	Loss on hedging (1150000-1100000)	50000
	Investment in futures		20000
	Cash		30000
	To settle the contract.
	Inventory	50000
	Gain on hedging		50000
	To adjust the carrying value of the hedged inventory for the change in fair value.
3/2/20	Cash	1175000
	Sales revenue		1175000
	To record sale of commodities.
	Cost of goods sold (1000000+50000)	1050000
	inventory		1050000
	To recognize the cost of sales.

Part B

$50000

AIPC’s profit after hedge = 1175000-1050000 = $125000

If there has been no hedge by selling futures short, then it would have been possible to avoid the loss of $50000

Thus,

AIPC’s profit would have increased by $50000 to $175000