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 30,2008,AMAR purchases call options for 20,000 barrels of oil at $100 per barrel at a premium of $4 per barrel,with a February 1,2009,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 1,2009,AMAR sells the options at their value on that date and acquires 20,000 barrels of oil at the spot price.On April 1,2009,AMAR sells the oil for $112 per barrel.

-Based on the preceding information,which of the following adjusting entries would be required on December 31,2008?
A)Option A
B)Option B
C)Option C
D)Option D

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 30,2008,AMAR purchases call options for 20,000 barrels of oil at $100 per barrel at a premium of $4 per barrel,with a February 1,2009,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 1,2009,AMAR sells the options at their value on that date and acquires 20,000 barrels of oil at the spot price.On April 1,2009,AMAR sells the oil for $112 per barrel.
  
-Based on the preceding information,which of the following adjusting entries would be required on December 31,2008?
A)Option A 
B)Option B 
C)Option C 
D)Option D

Quizplus · Accepted Answer

On December 31, 2008, AMAR should record an adjusting entry to recognize the time value of the options. Since the options have a premium of $4 per barrel and the spot price on that date is $60 per barrel, the intrinsic value is $40 ($100 - $60). Therefore, the remaining $4 is the time value.

Option A is incorrect because it does not consider the time value of the options. Option C and D are incorrect because they record unrealized gains and losses, which should not be recognized until the options are sold.

Option B correctly recognizes the time value of the options by recording a prepaid expense of $80,000 ($4 x 20,000 barrels) and an offsetting credit to cash. This entry represents the cost of the options over their intrinsic value and will be amortized to expense over the life of the options.

Spiralling Crude Oil Prices Prompted AMAR Company to Purchase Call