Spiralling crude oil prices prompted AMAR Company to purchase call options on oil as a price-risk-hedging device to hedge the expected increase in prices on an anticipated purchase of oil. On November 30, 20X8, AMAR purchases call options for 20,000 barrels of oil at $100 per barrel at a premium of $4 per barrel, with a February 1, 20X9, call date. The following is the pricing information for the term of the call:
The information for the change in the fair value of the options follows:
On February 1, 20X9, AMAR sells the options at their value on that date and acquires 20,000 barrels of oil at the spot price. On April 1, 20X9, AMAR sells the oil for $112 per barrel.
-Based on the preceding information,which of the following adjusting entries would be required on December 31,20X8?

Question

Spiralling crude oil prices prompted AMAR Company to purchase call options on oil as a price-risk-hedging device to hedge the expected increase in prices on an anticipated purchase of oil. On November 30, 20X8, AMAR purchases call options for 20,000 barrels of oil at $100 per barrel at a premium of $4 per barrel, with a February 1, 20X9, call date. The following is the pricing information for the term of the call:
  The information for the change in the fair value of the options follows:
  On February 1, 20X9, AMAR sells the options at their value on that date and acquires 20,000 barrels of oil at the spot price. On April 1, 20X9, AMAR sells the oil for $112 per barrel.
-Based on the preceding information,which of the following adjusting entries would be required on December 31,20X8?

Quizplus · Accepted Answer

The adjusting entry required on December 31, 20X8, will be to record the premium expense for the call options purchased as a hedge against the expected increase in oil prices. The premium expense is calculated as the premium paid per barrel (i.e., $4) multiplied by the number of barrels covered by the options contract (i.e., 20,000). The total premium expense is, therefore, $80,000 ($4 x 20,000). The option contract will expire on February 1, 20X9, so there will be no need to adjust for the change in fair value until that date. Therefore, the correct adjusting entry is to debit "Oil Options Premium Expense" for $80,000 and credit "Cash" for $80,000. Option B is the correct answer.

Spiralling Crude Oil Prices Prompted AMAR Company to Purchase Call