Question

On January 2, 2017, Thompson Corp. issued a $100,000, four-year note at prime plus 1% variable interest, with interest payable semi-annually. On the same date, Thompson entered into an interest rate swap where it agreed to pay 6% fixed and receive prime plus 1% for the first six months on $100,000. At each six-month period, the variable rate will be reset. The prime interest rate is 5.7% on January 2, 2017, and is reset to 6.7% on June 30, 2017. On December 31, 2017, the fair value of the swap has increased by $25,000. Thompson follows ASPE and uses hedge accounting. Assume that the swap qualifies for hedge accounting under ASPE.

Instructions

(a) For this transaction: 1. Identify the hedged item.

2. Identify the hedging item.

3. Identify how the hedged item is being accounted for without hedge accounting.

4. Identify how the hedging item is accounted for.

5. Indicate how the gains and losses for the hedged and hedging items are recognized

(b) Calculate the net interest expense to be reported for this note and the related swap transaction as at June 30 and December 31, 2017.

(c) Prepare the journal entries relating to the interest for the year ended December 31, 2017.

(d) Explain why this is a cash flow hedge.

(e) Assume, instead, that Thompson follows IFRS. Prepare the journal entries for this cash flow hedge.

Answer 1

ANSWER:

(a)     

1)          The hedged item is the risk of cash flow uncertainty from the variable interest note.

2)          The hedging item is the interest rate swap.

3)          Under ASPE, the note is recognized at amortized cost, with interest payments accrued as interest expense.

4)          The swap is not recognized under ASPE; any interest received from the swap is accrued as a credit to interest expense.

5)          The changes in the fair value of the swap are not recognized under ASPE.

(b)

June 30, 2017	Note	Rate	Amount
Interest paid	$  100,000	3.35%*	$  3,350
Cash received on swap			(350)**
Interest expense	$  100,000	3%	$  3,000
* [(5.7 % + 1%) X 6/12]
** [(5.7 % + 1%) – 6%] X $100,000 X 6/12
December 31, 2017	Note	Rate	Amount
Interest paid	$  100,000	3.85%***	$  3,850
Cash received on swap			(850)****
Interest expense	$  100,000	3%	$3,000

*** [(6.7 % + 1%) X 6/12]

**** [(6.7 % + 1%) – 6%] X $100,000 X 6/12

(c)

June 30, 2017

Interest Expense...................................................................................	3,350
Cash.............................................................................................		3,350
Cash .....................................................................................................	350
Interest Expense..........................................................................		350

December 31, 2017

Interest Expense...................................................................................	3,850
Cash.............................................................................................		3,850
Cash .....................................................................................................	850
Interest Expense..........................................................................		850

(d)      The interest rate swap is a cash flow hedge because the hedge is entered into to protect Thompson against variations in future cash flows caused by the changes in the prime interest rate. At the time of entering into the contract, Thompson had not yet incurred the interest charges for the note. The cash flows are therefore related to future interest payments. Consequently, the hedge cannot be a fair value hedge.

(e)      Under IFRS, the journal entries related to interest would be identical to those under ASPE as recorded as in part (c). In addition, the gain in the swap must be recorded in Other Comprehensive Income.

December 31, 2017

Derivatives – Financial Assets/Liabilities	25,000
Unrealized Gain or Loss............................................		25,000