Below is a written communication sample extracted from Wiley CPAExcel’s webinar on “Mastering Written Communication on the CPA Exam” on August, 10, 2017. It is a good reference for candidates who want to get an idea on how to develop and write a memo based on instructions given.

 

In the past, XYZ Co. has used forward contracts effectively to offset price volatility for the purchase of raw materials. The CEO is considering extending this practice for the purpose of additional raw materials. Write a memo the CEO describing the factors that should be considered in deciding whether to extend this practice.

 

Type your communication in the response area below the horizontal line using the word processor provided.

 

REMINDER: Your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of table, bullet point list, or other abbreviated presentation.

 

 

To: CEO

Re: Forward contracts

 

Forward contracts hedge price changes by locking in the price of a raw material to be purchased at a future time. If the price of the raw material increases during the period of the contract, the contract will gain in value and that gain in value will offset the increase in the price of the physical purchase of the raw material. While forward contracts can reduce the financial risk associated with increases in the price of raw materials, such contract are not without costs. Therefore, it is important to consider certain factors related to the use of the raw materials before deciding whether or not to enter into a forward contract.

 

First, it is important to determine the likelihood of changes in raw material prices occurring and the effect of such changes on the firm’s operating results. Various sources provide forecasts that can be used to determine expected changes in raw materials prices. By using the hight and low prices forecasted to occur during future periods, alternative budgets can be developed which indicate the expected range of impact on earnings. If the expected impact is negative and significant, then forward contracts or other methods should be used to offset the adverse effects of the expected price increases.

 

Before deciding whether or not to enter into forward contracts, other potentially less costly and complex means of addressing an expected increase in the price of raw materials should be considered. For example, it would be appropriate to determine the extent to which the increase in raw materials prices can be passed on to customers in the form of higher sales prices. It also may be appropriate to determine if fixed-price contracts for future purchases can be negotiated with suppliers of the raw materials. In addition, consideration should be given to whether or not it would be economically feasible to acquire and stockpile large quantities of the raw materials hen prices are low.

 

If other methods are not appropriate to mitigate the financial risk of increased raw material prices, forward contracts or other instruments, including futures contracts and options, should be considered. In considering forward contracts, or other instruments, the benefits, costs and risks of doing so must be analyzed. For a forward contract, the primary benefit will be the extent to which a contract can offset an increase in the price the raw material as determined by the difference between the expected change in price and the price available through a forward contract. A number of costs should be considered, including the cost of implementing and managing the forward contract and related compliance with legal and accounting requirements.

 

Finally, since a forward contract is directly between two parties, not through an organized exchange, the risk of non-compliance by a potential counterparty must be considered. This is the risk that other party to the contract will be unable or unwilling to satisfy its obligation at the date of settlement. To mitigate this risk, information about each potential counterparty should be obtained and considered prior to entering into a contract.

 

Consideration of the factors identified above will enable a correct decision s to whether or not XYZ Co. should extend its use of forward contracts to hedge expected fluctuations in the price of raw materials. If I can provide additional information, please let me know.

 

Future CPA