Question

Silverado Inc. buys titanium from a supplier that requires a six-month firm commitment on all purchases. On January 1, 2011, Silverado signs a contract with the supplier to purchase 10,000 pounds of titanium at the current forward rate of $310 per pound with settlement on June 30, 2011. However, Silverado wants to actually pay the June 30 market price for titanium. To achieve this goal, the company enters into a forward contract to sell 10,000 pounds of titanium at the current forward price of $310 per unit. The firm commitment contract and the forward contract both have zero value at inception. Titanium spot prices and the contract fair values are: Contract Fair Value Spot price Forward Price (June 30 Jan 1, 2011 March 31, 2011 June 30, 2011 $300 292 285 $310 297 N.A Forward 0- $128,079 250,000 Firm Commitment 0- 128,079 (250,000) Required 1. Why did Silverado hedge its firm commitment with the supplier? After the fact, was it a good idea to do so? What journal entries were made when the 2 contracts are signed on Jan 1, 2011? Silverado designated the forward contract as a fair value hedge of its future titanium purchase. What journal entries were made on March 31, 2011? What journal entries were made on June 30, 2011, when the contracts are settled and Silverado pays for the titanium? 2. 3. 4.

Answer 1

Hedging a Purchase Commitment Requirement 1: Silverado must give the supplier a six-month advance commitment for titaniunm fixed price, but the company does not want to forego the possibility that titanium prices will decline over the period. So, the company enters into a forward contract to sell titanium in six months at the same $310 price. If titanium prices fall, as Silverado expects, the forward contract will increase in value and this value increase will offset the value decline of Silverado's purchases at a firm commitment contract with the supplier. The net effect is that Siliverado will end up paying the June 30 market price for titanium. Was it a good idea? Yes, in this case, because titanium prices fell to $285 per pound by June 30.

Requirement 2: Both contracts have zero value at inception, as the problem statement indicates. So there is no entry made on January 1 for ether contract

Requirement 3: The following entries are made on March 31: DR Investment in forward contract $128,079 CR Gain on forward contract $128,079 To record the change in fair value on the forward contract) DR Loss on firm commitment $128,079 CR Liability under firm commitment $128,079 To record the change in fair value of the firm commitment) Notice that the gain on the forward contract is offset by the loss on the firm commitment, and that both the gain and the loss flows through income in March.

Requirement 4: The following entries are made on June 30: DR Investment in forward contract $121,921 CR Gain on forward contract $121,921 To record the change in fair value on the forward contract: $250,000 minus $128,079) DR Loss on firm commitment S121,921 CR Liability under firm commitment $121,921 To record the change in fair value of the firm commitment) DR Cash $250,000 CR Investment in forward contract $250,000 (To record the cash receipt upon settlement of the forward contract.)

DR Titanium $3,100,000 CR Cash$3,100,000 To record the purchase of titanium at the contracted price.) DR Firm commitment $250,000 CR Titanium $250,000 To unwind the firm commitment and adjust the carrying amount of the titanium purchase.) Notice that titanium inventory is now on the books at June 30 market price of $285 per pound ($3,100,000 minus $250,000 $2,850,000), the net price paid by the company as a result of its fair value hedge of the firm commitment.