Jensen Company forecasts a need for 200,000 pounds of cotton in May. On April 11, the company acquires a call option to buy 200,000 pounds of cotton in May at a strike price of $0.3765 per pound for a premium of $814. Spot prices and options values at selected dates follow:
April 11 April 30 May 3
Spot price per pound $0.3718 $0.3801 $0.3842
Fair value of option 814 1,137 1,689
Jensen Company settled the option on May 3 and purchased 200,000 pounds of cotton on May 17 at a spot price of $0.3840 per pound. During the last half of May and the beginning of June the cotton was used to produce cloth. One third of the cloth was sold in June. The change in the option’s time value is excluded from the assessment of hedge effectiveness.
a. Prepare all journal entries necessary through June to record the above transactions and events.
b. What would the effect on earnings have been if the forecasted purchase were not hedged?