Ins makes sophisticated medical equipment. A key component of the equipment is G
ID: 2518550 • Letter: I
Question
Ins makes sophisticated medical equipment. A key component of the equipment is Grade A silver. On May 1, 2016, Ins enters into a firm purchase agreement to buy 1,200,000 troy ounces (equal to 100,000 pounds) of Grade A silver from Sil, for delivery on February 1, 2017, at the market price on that date. To hedge against volatility in price, Ins also enters into an option contract with Cur to buy 1,200,000 troy ounces on February 1, 2017, for $14 per troy ounce, the market price on May 1, 2016. If the market price of silver is above $14 per troy ounce on May 1, then Ins will exercise the option. If it is below $14 per troy ounce, then Ins will let the option expire. The option is to be settled net. Cur will pay Ins the differ- ence between the market price and the exercise price. The option costs Ins $1,000 initially. Assume that a 6 percent annual incremental borrowing rate is reasonable.
1. Assume that the market price for Grade A silver is $15 per troy ounce on December 31, 2016. What are the required entries?
2. Assume that the market price of Grade A silver is $13.8 per troy ounce on February 1, 2017, when Ins receives the silver from Sil. Prepare the appropriate journal entries on February 1, 2017.
Explanation / Answer
journal entries:
Date particulars Debit Credit May1,2016 call option $1,000 Bank $1,000 Dec 31 ,2016 call option $1,200,000 unrealised gain/loss $1,200,000 ($15-$14)x 1.200,000 troy ounces Dec 31 ,2016 interest expense $40 bank $40 ($1,000 x 8/12 x 6%) feburary 1,2017 purchases-grade a silver $16,560,000 To Bank $16,560,000 (1,200,000 x $ 13.80 per troy ounce) feburary 1,2017 unrealised gain/loss $1,201,000 to call option $1,201,000 (call option lapses since silver price is below $14 per troy ounce, then Ins will let the option expire