Cash flow hedge of a forecasted purchase of wheat. Custom Brand Bakeries, Inc. (CBBI), located in Erie, Pennsylvania, bakes a variety of products for various parties on a contract basis. For example, a food company may contract with CBBI to make energy bars that are then sold under the food company’s private label. Contracts are typically signed several months in advance of actual production and set forth a fixed sales price. Because sales prices are fixed by contact, CBBI is concerned that materials costs do not increase and further reduce profits. However, CBBI does not want to guard against increasing costs by purchasing materials in advance of their scheduled production. Corn and wheat flour are two major ingredients used in the production process where increasing costs are of concern. CBBI wants to hedge against these costs increasing but cannot buy flour futures. However, buying corn and wheat futures can provide an effective hedge against changing flour prices. Changes in the price of corn flour and wheat flour often correlate highly with changes in the price of corn and wheat.
On September 1, 2015, the company purchased, on the Chicago Board of Trade, futures for delivery of the commodities in November. The CBTrequired a deposit of $70,000 toward a margin account.
CBBI properly documents the hedging relationship, and all criteria for special accounting as a hedge are satisfied. The hedging instruments are determined to be highly effective as a hedge against changing flour prices. The changes in the time value of the futures contracts are to be excluded from the assessment of hedge effectiveness.
In early November, CBBI actually purchased both corn flour and wheat flour used in products sold to contracting parties on November 21. The futures contracts are settled net on November 5.
1. Prepare all monthly entries to record hedging activity.
2. Identify and discuss several factors that might cause the futures contracts to not be perfectly effective as a hedge against changes in the price of flour used by CBBI.