bryris
Major Contributor
Joined: 07 Dec 2008
Location: United States
Online Status: Offline
Posts: 624
|
| Posted: 06 Sep 2009 at 19:26 | IP Logged
|
|
|
This is based on a Gleim publisher question. I am going to just paraphrase the "jist" of the question:
Company X deals in selling copper and currently has 5,000,000 lbs of it purchased at .58/lb. Therefore, cost of the inventory to the company is 2,900,000. The company decides to implement a fair value hedge on this inventory and sells copper futures contracts to be delivered in 3 months at .83/lb. Therefore, the value of the (now locked in) contracts are $4,150,000.
The value of the hedge is zero at the time of implementation (as always).
1 month after the creation of the hedge, it is the company's fiscal year end. It is stated in the problem that the futures rate for the date 2 months out (from b/s date) is .85/lb. Therefore, on that date, the company could have gotten $4,250,000 for the copper, but will only get $4,150,000. Thus on the balance sheet date, there is a loss of $100,000 (income statement, recognized in earnings, FV hedge) and a $100,000 liability on the contract.
Here is where I derail:
It is stated in the problem that the company determined that the hedge was 100% effective. Therefore, all gains and losses must offset to zero at all times. Thus, it makes sense that since we've got a $100,000 loss on the fair value hedge, we must have an offsetting gain on the actual item being hedged (the copper). What I cannot reconcile is that with inventory, unless issuing current cost statements for supplementary information, inventory is not written up (unless I've lost my mind), it is only written down if impaired. It is given that historical cost of the inventory is .58/lb, $2,900,000. The solution to this problem states that the inventory would be revalued at original cost (2,900,000) + 100,000 gain = $3,000,000.
I just cannot wrap my head around this. I can get the answer, but it runs right against some other concepts that I thought were true - namely that inventory is carried at cost (in some form) and never marked up from cost to a higher amount (in GAAP statements). Furthermore, due to the gap between .58 and .83 and considering the short 3 month period, we can infer that inventory is actually worth significantly more than the 3,000,000 that it is revalued at.
Furthermore, profit on the hedge implementation date was $4,150,000 - 2,900,000 = 1,250,000 profit. On the sale date, the profit will be $4,150,000 - $3,000,000 = 1,150,000. Therefore, we've earned less profit AND we've already recognized a loss on the hedge value decrease. Seems like we're being hit twice.
Edit: I guess on the gain on the inventory "writeup" we've offset the loss (hence the perfect hedge), so we haven't been hit twice. But, we've still lost the profit.
__________________
REG - 97
FAR - 97
BEC - 90
AUD - 97
|
Active Topics 
Memberlist 
Search 
Help
Register 
Login
Topic: Hedging question
Topic Closed)
