FMC Co. uses gold in the manufacture of its jewelry products. FMC anticipates it
ID: 2425670 • Letter: F
Question
FMC Co. uses gold in the manufacture of its jewelry products. FMC anticipates it will need to purchase 500 ounces of gold in October 2013 for jewelry it will ship during the holiday season. However, if the price of gold increases, FMC’s cost to produce its products will increase and reduce its profit margins.
In order to hedge the risk of increased gold prices, on April 1, 2013, FMC enters into a gold futures contract and designates it as a cash flow hedge of the anticipated gold purchase (assume no premium paid.) The notional amount of the contract is 500 ounces, and the terms of the contract give FMC the option to purchase gold at $300 per ounce. The contract expires on October 31, 2013.
Assume the following data with respect to the price of the gold:
Required:
1. Prepare the journal entries for the following transactions:
- Increase in the spot price of gold on June 30 and September 30.
- FMC’s purchase of 500 ounces of gold on October 10 at $315 and settlement of the futures contract on that date.
- FMC’s sale of product for $350,000 on December 20. The cost of the finished goods inventory was $200,000.
2. Indicate the amount(s) reported on the balance sheet related to the futures contract on June 30, 2013 and the income statement for December 31, 2013.
Date Spot Price for October Delivery April 1, 2013 $300 per ounce June 30, 2013 $310 per ounce September 30, 2013 $315 per ounceExplanation / Answer
The company entered into a future contract to purchase 500 ounces at $300 per ounce. The contract can be executed any time before October 31st 2013.
As the spot price = $315 on September 30th, the company stands to gain from the future contracts @ $15 (315-300) per ounce i.e. spot rate - future rate as per contract.
Total gain = $15*500 = $7,500
Thus journal entry will be
Receivable from future broker (Debit) $7,500
Profit from future contract (Credit) $7,500
entry for December 20th sales:
Cash (Dr) 350,000
Sales (Cr) 350,000
The inventory will reduce by 200,000 and profit recorded will be 350,000-200,000 = 150,000
On June 30, 2013 the value of the future contract will be recorded as an asset in the balance sheet = 500*300 = 150,000
Assuming that the option was not exercised, no amount will be recorded in income statement. There will be a notional gain of (310-300)*500 = 5,000
On December 31, 2013: the option was exercised in October @300 per ounce, while the spot rate was 315 per ounce. The company made a profit of $15 per ounce. Total profit = 15*500 = $7,500. This amount will be recorded in income statement.
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