Question

LLB Industries borrowed $230,000 from Trust Bank by issuing a two-year, 12% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 8% fixed interest rate on a notional amount of $230,000 and to pay interest based on a floating interest rate.

Floating (LIBOR) settlement rates were 8% at January 1, 6% at March 31, and 4% at June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors’ perceptions that the creditworthiness of LLB was improving.

	January 1			March 31			June 30
Fair value of interest rate swap		0		$	6,772		$	11,994
Fair value of note payable	$	230,000		$	236,772		$	250,000

Required:
1. Calculate the net cash settlement at June 30, 2021.
2. Prepare the journal entries on June 30, 2021, to record the interest and necessary adjustments for changes in fair value.

Answer 1

LLB Industries borrowed $230,000 from Trust Bank by issuing a two-year, 12% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 8% fixed interest rate on a notional amount of $230,000 and to pay interest based on a floating interest rate.

1. Calculating net cash settlement at June 30, 2021.

Net cash settlement:June 30, 2021.
Interest to be calculated on a notional amount of $ 230,000
	Mar 31.	June 30.
Fixed-rate	12%	8%
Floating rate	6%	4%
Fixed interest
(230,000 *12%*3/12) 27,600 x 3 /12 =6900	$6900	$6900
Less; Floating interest	$3,450	$2,330
(230,000 *6%*3/12) = 3450 (230,000 *4%*3/12) = 2,330
Net cash settlement	$3,450	$4,570

2. Preparing the journal entries on June 30, 2021, to record the interest and necessary adjustments for changes in fair value.

Date	Account titles and explanation	Debit	Credit
Jan 1.	Cash	$230,000
	Notes payable		$2,330
	(To record Notes issued)
Mar 31.	Interest expense	$    6900
	Cash		$    6900
	(To record Interest paid)
	Cash	$    3,450
	Interest expense		$    3,450
	(To record Net settlement)
	Interest rate swap	$    6,772
	Holding gain-interest rate swap		$    6,772
	(To record change in fair value of derivative)
	Holding loss-hedged note	$ 6,772
	Note payable (236,772-230,000 ) =6,772		$ 6,772
	(To record change in fair value of note)
June 30.	Interest expense	$    6900
	Cash		$    6900
	(To record Interest paid)
	Cash	$    2,300
	Interest expense		$    2,300
	(To record Net settlement)
	Interest rate swap	$ 5,222
	Holding gain-interest rate swap (11,994-6,772)		$ 5,222
	(To record change in fair value of derivative)
	Holding loss-hedged note	$ 13,228
	Note payable ( 250,000 - 236,772)		$ 13,228
	(To record change in fair value of note)

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