On September 30 of the current year, a US company entered into a future contract to hedge the value of its inventory. The inventory was reported on the balance sheet at its cost of $250,000 on September 30. On December 31, the market value of the inventory had decreased to $175,000. The entity had a gain of $74,500 on the futures contract at December 31. What is the proper accounting for this hedging transaction on the December 31 year-end financial statements, adssuming that the hedge is considered to be highly effective?
a. Other comprehensive income will increase by $74,500
b. Other comprehensive income will decrease by $500
c. Net income will increase by $74,500
d. Net income will decrease by $500
Answer:D
Choice “d” is correct. This hedge is classified as a fair value hesge because it is being used to hedge the value the inventory. Therefore, the gain on the fair value hedge must be recognized in earnings, along with the loss on the inventory, for a net decrease in net income of $500:
Gain on derivative= $74,500
Loss on inventory=$175,000FV-$250,000BV=$(75,000)
Net loss on fair value hedge=$(75,000)loss+$74,500gain=$(500)loss