[asdf]

On December 1 of the current year, Bann Co. entered into an option contract to purchase 2,000 shares of Norta Co. stock for $40 per share (the same as the current market price) by the end of the next two months. The time value of the option contract is $600. At the end of December, Norta’s stock was selling for $43, and the time value of the option is now $400. If Bann does not exercise its option until January of the subsequent year, which of the following changes would reflect the proper accounting treatment for this transaction on Bann’s December 31 year-end financial statements?

A. Net income will increase by $5,800.

B. Current assets will decrease by $200.

C. The option value will be disclosed in the footnotes only.

D. Other comprehensive income will increase by $6,000.

Answer is a, and I chose d.
If Fair Value Hedge, gain/loss will be recognized in NI
If Cash Flow Hedge, gain/loss from intrinsic value of the option goes to OCI and gain/loss from time value of the option goes to NI.

I thought this question is Cash Flow Hedge since there is no hedge item in their book yet.
So the unrealized holding gain from intrinsic value of 6,000 (2000 x ($43-40)) goes to OCI.
and the loss from time value of 200 (600-400) goes to NI.

This was my reasoning for choosing d, did I miss something big here? So confused!!

[Lauren]

Great question! This is tricky! They do love to trick us, huh?

This IS a derivative, however, it does not appear to be a hedge. It makes no mention of entering into the option contract to hedge against exposure to variability in cash flow or risk of any kind. It appears to be speculative. Derivatives used as speculation should be measured at fair value and gains and losses should be reported to net income. $5,800 increase in NI would be correct.–> (3*2000)-200=$5,800

Remember all hedges are derivatives but not all derivatives are hedges! Happy studying!

[asdf]

Thank you, @Lauren !! It was really helpful!!
I didn't expect this question to be a speculation at all.. oh no..
It seems because of the phrase “If Bann does not exercise its option until”
This is indeed tricky question (Sigh)

[Author]

Replies