Question

On January 1, 2018, Labtech Circuits borrowed $190,000 from First Bank by issuing a three-year, 8% note, payable on December 31, 2020. Labtech wanted to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. Therefore, Labtech entered into a three-year interest rate swap agreement on January 1, 2018, and designated the swap as a fair value hedge. The agreement called for the company to receive payment based on an 8% fixed interest rate on a notional amount of $190,000 and to pay interest based on a floating interest rate tied to LIBOR. The contract called for cash settlement of the net interest amount on December 31 of each year. Floating (LIBOR) settlement rates were 8% at inception and 9%, 7%, and 7% at the end of 2018, 2019, and 2020, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. These quotes and the fair values of the note are as follows: January 1 December 31 2018 2018 2019 2020 Fair value of interest rate swap 0 $ (2,659 ) $ 1,835 $ 0 Fair value of note payable $ 190,000 $ 187,341 $ 191,835 $ 190,000 Required: 1. Calculate the net cash settlement at the end of 2018, 2019, and 2020. 2. Prepare the journal entries during 2018 to record the issuance of the note, interest, and necessary adjustments for changes in fair value. 3. Prepare the journal entries during 2019 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value. 4. Prepare the journal entries during 2020 to record interest, net cash interest settlement for the interest rate swap, necessary adjustments for changes in fair value, and repayment of the debt. 5. Calculate the book values of both the swap account and the note in each of the three years. 6. Calculate the net effect on earnings of the hedging arrangement in each of the three years. (Ignore income taxes.) 7. Suppose the fair value of the note at December 31, 2018, had been $187,000 rather than $187,341 with the additional decline in fair value due to investors’ perceptions that the credit worthiness of Labtech was worsening. How would that affect your entries to record changes in the fair values?

Answer 1

Answer 1

Net Settlement(Since we have to recieve fix and pay floating,the difference between these two rates will be net settlement on basis of notional amount)

2018 Pay 1% of 190000 =1900$

2019 Recieve 1% of 190000 =1900$

2020 Recieve1% of 190000 =1900$

Answer 2

For issuance of Note
1.1..2018

Bank A/c Dr $190000

To 8% Note $190000

(Being note issued)

For interest settlement

31.12.2018

Interest Payable Dr $17100

To Interst Recievable $15200

To loss on Hedge $1900

Loss on Hedge $1900

To Bank $1900

For Fair value adjustment

31.12.2018

Decrease in Fair Value (Trf to p&l)Dr $2659

To 8% Note $2659

Answer 3

For interest settlement

31.12.2019

Interest Payable Dr $13300

Bank a/c (Profit) Dr $1900

To Interst Recievable $15200

For Fair value adjustment

31.12.2019

8% Note Dr     $4494 (1835+2659)

To Increase in Fair Value (Trf to p&l) $4494

Answer 4

For interest settlement

31.12.2020

Interest Payable Dr $13300

Bank a/c (Profit) Dr $1900

To Interest Recievable $15200

For Fair value adjustment

31.12.2019

Decrease in Fair Value (Trf to p&l) $4494

To 8% Note $4494

(Since Fair Value is 0(2659-1835) to bring the Book Value to Par value)

For Final Payment

8% Note Dr $190000

To Bank $190000

Answer 5

Book value Swap Note

2018 0 192659 (190000+2659)

2019 0 188165 (190000-1835)

2020 0   190000

Book value of Swap is Zero since all profit or losses are passed through p&l

Answer6

Profit/Loss With Hedge Without Hedge net profit/(loss)

2018 8%of 190000+ 1900+2659 9% of 190000 (2659)

2019 8%of 190000-1900-4494 7% of 190000 4494

2020 8% of 19000-1900+4494 7% of 190000 (4494)