V Company purchases approximately 500,000 bushels of oats each month. On December 1, 2019, the entity purchased an option to purchase 500,000 bushels of oats on March 1, 2020 at a price of P100 per bu

Question

V Company purchases approximately 500,000 bushels of oats each month. On December 1, 2019, the entity purchased an option to purchase 500,000 bushels of oats on March 1, 2020 at a price of P100 per bushel which is the market price of bushel on December 1, 2019. The entity had to pay P100,000 to purchase the call option which it designated as a cash flow hedge against price increases for the March 1, 2020 purchase of oats.
On December 31, 2019, the price of oats is P95 per bushel. Because there is still time for the price of oats to potentially rise above P100 per bushel before the option expires, the option has a value of P40,000 on December 31, 2010. On March 1, 2020, the price of oats is P104 per bushel.
What is the gain on call that that should be reported in the statement of comprehensive income for 2020?

VIPSolutions · Accepted Answer

# V Company: Accounting for Call Option as Cash Flow Hedge

## Scenario Summary

- **Hedge Instrument:** Purchased call option for 500,000 bushels of oats.
- **Strike Price:** P100/bushel
- **Option Premium Paid:** P100,000 on Dec 1, 2019
- **Option Value at Dec 31, 2019:** P40,000
- **Spot Price at Dec 31, 2019:** P95/bushel
- **Spot Price at Mar 1, 202:** P104/bushel

## Key Dates and Values

| Date          | Spot Price | Option Value |
|---------------|------------|--------------|
| Dec 1, 2019   | P100       | P100,000 (premium paid) |
| Dec 31, 2019  | P95        | P40,000      |
| Mar 1, 202   | P104       | P2,000,000   |

- **Intrinsic value at Mar 1, 202:**  
  $ (P104 - P100) \times 500,000 = P4 \times 500,000 = P2,000,000 $

## Accounting for the Hedge (Cash Flow Hedge)

- **Change in fair value of the option (effective portion):** Recognized in **Other Comprehensive Income (OCI)**.
- **Ineffective portion (if any):** Recognized in **profit or loss**.

### Step 1: Calculate Total Gain on Option

- **Proceeds from exercising the option (intrinsic value):** P2,000,000
- **Less: Option premium paid:** P100,000
- **Net gain:** P1,900,000

But, in hedge accounting, the gain is recognized as the change in the fair value of the option from acquisition to its exercise.

### Step 2: Record Changes in Fair Value

1. **Dec 1, 2019 to Dec 31, 2019:**
   - **Fair value decrease:** P100,000 (initial) → P40,000 (Dec 31)
   - **Decrease of P60,000:** Recognized in OCI (as effective hedge).

2. **Dec 31, 2019 to Mar 1, 202:**
   - **Fair value increase:** P40,000 → P2,000,000 (intrinsic value at maturity)
   - **Increase of P1,960,000:** Recognized in OCI (as effective hedge).

3. **Total cumulative change in fair value:**
   - P2,000,000 (Mar 1, 202) − P100,000 (initial) = **P1,900,000** gain

### Step 3: Amount to be Reported in Statement of Comprehensive Income (202)

- **OCI (Other Comprehensive Income):**  
  P1,960,000 (increase from Dec 31, 2019 to Mar 1, 202)
- **Profit or Loss:**  
  None, as the hedge is effective and all changes go to OCI until the hedged item affects profit or loss.

**If the question asks for the gain for 202 only** (i.e., Jan 1 to Mar 1, 202):

- **Reported gain in 202:**  
  P2,000,000 (final value Mar 1) − P40,000 (Dec 31 value) = **P1,960,000**

## Summary Table

| Period              | Gain/(Loss) Recognized in OCI |
|---------------------|------------------------------|
| Dec 1 - Dec 31, 2019| (P60,000) (loss)             |
| Jan 1 - Mar 1, 202 | P1,960,000 (gain)            |

## **Final Answer**

### **The gain on the call option to be reported in the statement of comprehensive income (OCI) for 202 is:**

$$
\boxed{P1,960,000}
$$

**This represents the increase in the fair value of the option from P40,000 (Dec 31, 2019) to P2,000,000 (Mar 1, 202).**

VIPSolutions · Answer

# Problem Objective

Determine the gain on the call option that V Company should report in the statement of comprehensive income for 2020, following the purchase and exercise of a call option hedge.

## Given Data

- **Monthly Oats Purchase:** 500,000 bushels
- **Call Option Strike Price:** P100/bushel
- **Option Premium Paid (Dec 1, 2019):** P100,000
- **Option Value (Dec 31, 2019):** P40,000
- **Spot Price (Dec 31, 2019):** P95/bushel
- **Spot Price (Mar 1, 2020):** P104/bushel

## Key Calculations

### Step 1: Calculate the Intrinsic Value at Exercise (Mar 1, 2020)

$$
\text{Intrinsic Value} = (\text{Spot Price} - \text{Strike Price}) \times \text{Quantity}
$$

$$
\text{Intrinsic Value} = (P104 - P100) \times 500,000 = P4 \times 500,000 = P2,000,000
$$

### Step 2: Calculate Total Gain on the Option

1. **Total proceeds from exercising the option:**
   - P2,000,000 (intrinsic value)
  
2. **Less the option premium paid:**
   - P2,000,000 - P100,000 = P1,900,000 (net gain)

### Step 3: Record Changes in Fair Value (Cash Flow Hedge)

1. **From Dec 1, 2019, to Dec 31, 2019:**
   - Initial Fair Value: P100,000
   - Fair Value on Dec 31, 2019: P40,000
   - **Change:** P40,000 - P100,000 = -P60,000 (recognized in OCI)

2. **From Dec 31, 2019, to Mar 1, 2020:**
   - Fair Value on Mar 1, 2020: P2,000,000
   - **Change:** P2,000,000 - P40,000 = P1,960,000 (recognized in OCI)

### Step 4: Total Gain for 2020

- **Total gain recognized in OCI for 2020:**
  - From Dec 31, 2019 to Mar 1, 2020: P1,960,000

## Summary Table

| Period              | Gain/(Loss) Recognized in OCI |
|---------------------|------------------------------|
| Dec 1 - Dec 31, 2019| (P60,000) (loss)             |
| Jan 1 - Mar 1, 2020 | P1,960,000 (gain)            |

## Final Answer

The gain on the call option to be reported in the statement of comprehensive income (OCI) for 2020 is:

$$
\boxed{P1,960,000}
$$

This amount reflects the increase in the fair value of the option from P40,000 (Dec 31, 2019) to P2,000,000 (Mar 1, 2020).

VIPSolutions · Answer

# Explanation of Each Step

## Step 1: Calculate the Intrinsic Value at Exercise
To assess the value of the call option when exercised, the intrinsic value formula is applied, which accounts for the difference between the market price of oats and the strike price. By multiplying this difference by the number of bushels, we determine the total value that the option provides at the time of exercise.

## Step 2: Calculate Total Gain on the Option
This step involves evaluating the financial benefit from exercising the option. The total proceeds from the intrinsic value are calculated, and the original premium paid for the option is deducted to find the net gain that V Company would realize from exercising the option.

## Step 3: Record Changes in Fair Value (Cash Flow Hedge)
In hedge accounting, the changes in the fair value of the call option are recognized differently. Losses and gains are recorded in Other Comprehensive Income (OCI) based on the fair value of the option at different points in time, indicating the effectiveness of the hedge.

## Step 4: Total Gain for 2020
Finally, the total gain recognized in OCI for the year 2020 is summarized. This amount reflects the increase in the fair value of the option from the end of December 2019 to the date of exercise, providing insight into the impact of the hedge on V Company's financial performance.

### Final Summary
The final answer presents the total gain from the call option in a clear manner, specifically highlighting the amount to be reported in the statement of comprehensive income for 2020.

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