A Company Holds Inventory Carried at Cost, $100,000

Essay

A company holds inventory carried at cost, $100,000. The inventory has a current market value of $105,000. To hedge against possible declines in the value of the inventory, the company pays $200 for put options with a strike price of $105,000. The options qualify as a fair value hedge of the inventory. All income effects of the inventory and the hedge are reported in cost of goods sold. Before the options expire, the company sells the inventory for $104,000, and sells the put options for $1,120.
Required
a. Prepare the journal entries to record the above events.
b. Calculate the change in intrinsic value and the change in time value of the options during the time the company holds the options.
c. Does the change in option value allow the company to maintain the $5,000 gross margin expected at the time the company buys the options? Explain why or why not.