Ins makes sophisticated medical equipment. A key component of the equipment is Grade A silver. On May 1, 2011, 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, 2012, at the market price on that date. To hedge against volatility in price, Ins also enters into an option contract with Cur to put 1,200,000 troy ounces on February 1, 2012, for $10 per troy ounce, the market price on May 1, 2011. If the market price of silver is below $10 per troy ounce on May 1, then Ins will let the option expire. If it is above $10 per troy ounce, then it will exercise the option. The option is to be settled net. Com will pay Instrument Works the difference 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. Why would you expect this situation to qualify for hedge accounting?
2. Why should this hedge be accounted for as a fair value hedge instead of as a cash flow hedge?
3. What entries should be made on May 1, 2011, to account for the firm commitment and the option?
4. Assume that the market price for Grade A silver is $9 per troy ounce on December 31, 2011. What are the required entries?
5. Assume that the market price of Grade A silver is $9.50 per troy ounce on February 1, 2012, when Ins receives the silver from Silver Refiners. Prepare the appropriate journal entries on February 1, 2012.