6.1 Derivative Accounting - the Normal Purchases and Normal Sales Scope Exception Facts: Albert, Inc. sells...

6.1 Derivative Accounting - the Normal Purchases and Normal Sales Scope Exception Facts: Albert, Inc. sells office supplies. Albert, Inc. is in the process of signing a contract for the purchase of 10 tons of softwood pulp, a timber product that is used in the production of paper products. Softwood pulp is traded on futures exchanges, such as the Chicago Mercantile Exchange (CME). Albert, Inc. will deliver this raw material to its paper producer in China. All paper produced using this raw material will be purchased by Albert, Inc. Delivery will occur in one year, for a price of $900 per ton, plus an adjustment based on the consumer price index (CPI). Required: Evaluate 1) whether Albert, Inc.'s purchase contract meets the definition of a derivative; and 2) whether the contract qualifies for the normal purchases and normal sales scope exemption to derivative accounting.

Expert Solution

1) A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks.

According to the definition, Albert Inc.'s purcahse contract meets the required conditions of the definition of derivative as the contract is based upon an underlying financial asset which is the Paper from Softwood Pulp.

2) The normal purchase and sales exemption allows companies to ignore the fact that their purchase and sales agreements satisfy the definition of a derivative, as long as certain conditions are meet.

Those conitions are:

The instrument in question has to have at least one underlying reference
The instrument in question is initially traded at a price
The instrument in question requires or allows net settlement

Since Albert Inc.'s contract fulfills all the required conditons. Thus they qualify for the normal purchase and normal sale scope exemption to derivative accounting.

ekkarill92 answered 1 year ago

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