Recall the Rombaurer Metals example in the chapter: On October 1, 20X1, Rombaurer has 10 million pounds of copper inventory on hand at an average cost of $0.65 a pound. The spot price for copper is $0.90 a pound. Instead of selling copper now, Rombaurer decides to hold the inventory until February 20X2 when management believes the price will return to a normal level of $0.95 a pound. To hedge its position, Rombaurer sells futures contracts at $0.95 for February delivery. Spot and futures prices over the next several months are as follows:

On February 26, 20X2, Rombaurer sells its copper on the spot market for $0.94 a pound and cancels the futures contracts.

The chapter described how “hedge accounting” rules are used when Rombaurer hedges its entire 10 million pounds of copper inventory.

Required:

1. Suppose that Rombaurer sells futures contracts for only 5 million pounds of copper. (Management had decided that it is prudent to hedge only half of the company’s economic exposure.) Because the futures contracts are now “ineffective” in hedging the company’s entire fair value exposure to copper price fluctuations, Rombaurer cannot use hedge accounting. Prepare all journal entries needed to account for the futures contracts and sale of copper from October 1, 20X1, through February 26, 20X2.

2. Now assume that Rombaurer designates these futures contracts as a “fully effective” hedge of its risk exposure for 5 million pounds of copper inventory. (The remaining 5 million pounds of inventory is not being hedged.) Rombaurer can now use hedge accounting for the futures contracts. Prepare all journal entries needed to account for the futures contracts and sale of copper from October 1, 20X1, through February 26, 20X2.

3. What impact does changing the definition of the hedged item (10 million pounds of copper inventory versus 5 million pounds) have on the company’s financial statements for 20X1 and 20X2?

Transcribed Image Text:

NYMEX Copper Prices Spot Price February 20X2 Futures Price October 1, 20X1 $0.90 $0.95 December 31, 20X I 0.86 0.91 February 26, 20X2 0.94 0.94