Smith Company predicts a requirement for 200,000 pounds of cotton in May. On April 11, the company obtains 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 are given below:
April 11 April 30 May 3
Spot price per pound $0.37 $0.38 $0.38
Fair value of option 814 1,137 1,689
Smith Company settled an option on May 3 and purchased 200,000 pounds of cotton on May 17 at a spot price of $0.3840 per pound. In the last half of May and 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.
1) Create all journal entries required through June to record above transactions and events.
2) What will the effect on earnings have been if the predicted purchase were not hedged?