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Topic: Use of Futures Contracts to Hedge Cotton Inventory Fair Value Hedge

LO: 2

1. On July 1, 2014 a cotton wholesaler purchases 2 million pounds of cotton inventory at an average cost of $1.20 per pound. To protect the inventory from a possible decline in cotton prices, the company sells cotton futures contracts for 2 million pounds at $1.10 a pound for delivery on October 31, 2014 to coincide with its expected physical sale of its cotton inventory. The Company designates the hedge as a fair value hedge (i.e., the Company is hedging changes in the inventorys fair value, not changes in cash flows from anticipated sales.).

Following are futures and spot prices for the relevant dates:

Date	Spot	Futures
July 1, 2014	$1.30	$1.20
September 30, 2014	$1.25	$1.10
October 31, 2014	$1.05	n/a

Required: Prepare the journal entries to record the following:

a. Purchase of cotton and sale of futures contract

b. Adjusting entry at September 30

c. Sale of cotton on October 31 at spot price

d. How much cash does the company receive in total on this transaction?

Answer:

a.	7/1/14	Cotton inventory		2,400,000
			Cash		2,400,000
		To record purchase of cotton inventory.

No entry is made to record the fair value of the futures contracts, because at the time of their inception their fair value is zero.

b.	9/30/14	Loss on cotton inventory		100,000
			Cotton inventory		100,000
		To adjust the carrying amount of the inventory for changes in its fair value = 2 million lbs. x [$1.30 - $1.25].
		Futures contract		200,000
			Gain on hedge		200,000
		To record the gain on futures contract = 2 million lbs. x [$1.20 - $1.10].

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c.	10/31/14		Cash				300,000
					Gain on hedge			100,000
					Futures contract			200,000
			To close out futures contract and recognize the gain on the futures contracts from 7/1/2014 to 10/31/2014 = 2 million lbs. x ($1.20 - $1.05).
			Loss on inventory				400,000
				Cotton Inventory				400,000
		To adjust the carrying amount of the inventory that is due to the decrease in spot prices = 2 million lbs. x ($1.25 - $1.05).
			Cash				2,100,000
			Cost of Goods Sold*				1,900,000
				Cotton sales				2,100,000
				Cotton inventory*				1,900,000
		To record the sale of 2,000,000 pounds of cotton inventory at $1.05/lb.
		$2,400,000 (100,000) (400,000) $1,900,000				Orig. cost 9/30/14 adj. 10/31/14 adj *Cotton inv cost

d. Our company receives $2,100,000 from the sale of the cotton and $300,000 from the futures contract for a total of $2,400,000. This is the $1.20 futures price that we locked in at the start of the transaction.