On April 1, 2011, Petey Ltd. paid $150 for a call to buy 500 shares of NorthernTel at a strike price of $25 per share any time during the next six months. The market price of NorthernTel’s shares was $20 per share on April 1, 2011. On June 30, 2011, the market price for NorthernTel’s stock was $35 per share, and the value of the option was $6,700.
(a) Prepare the journal entry to record the purchase of the call option on April 1, 2011.
(b) Prepare the journal entry(ies) to recognize the change in the call option’s fair value as of June 30, 2011.
(c) Prepare the journal entry that would be required if Petey Ltd. exercised the call option and took delivery of the shares as soon as the market opened on July 1, 2011.
(d) Why is there a loss when the option is exercised?