Question

Alternative (but as similar as possible) scenario with Fair Value Hedge

Jan. 1: Northwest Borrows $50,000,000 from Bank at a 7% Annual Interest Rate

Jan. 1: Northwest enters swap agreement with a variable interest rate pay leg and a receive leg that is 7% with a notional amount of $50,000,000

Applicable Variable Rates:

March 31^st: 6.5%

June 30^th: 6.85%

Sep. 30^th: 7.25%

Dec. 31^st: 7.1%.

Fair Value of Swap on Each Date:

March 31^st: 150,000

June 30^th: (225,000)

Sep 30^th: (175,000)

Dec. 31^st: (210,000)

Fair Value of the Note on Each Date:

March 31^st: 50,150,000 = 50,000,000 + 150,000

June 30^th: 49,775,000

Sep. 30^th: 49,825,000

Dec. 31^st: 49,790,000

Calculate and record the entries for the given quarters using a Fair Value Hedge. Please show work.

Answer 1

Quarterly Payment	Difference between Fixed rates	Variable interest rate on swap	Sum of rates	Debt's principal amount	Quarterly interest	Fixed Interest	Gain / loss
Mar-31	0%	6.50%	6.50%	50000000	812500	875000	62500
Jun-30	0%	6.85%	6.85%	50000000	856250	875000	18750
Sep-30	0%	7.25%	7.25%	50000000	906250	875000	-31250
Dec-31	0%	7.10%	7.10%	50000000	887500	875000	-12500
Date	Variable Rate	Fair Value of Swap	Debt Fair Value
Mar-31	6.50%	150000	50150000
Jun-30	6.85%	-225000	49775000
Sep-30	7.25%	-175000	49825000
Dec-31	7.10%	-210000	49790000

Journal Entries
Jan-01	Cash	Debit	50000000
	Bank Debt	Credit	50000000
Mar-31	Interest Expense	Debit	875000
	Accrued Interest Expense	Credit	875000
	(50000000 * 7% * 1/4)
Mar-31	Accrued Interest	Debit	875000
	Cash	Credit	875000
	(Payment entry)
	Since the variable rate is less on Mar-31, Northwest will gain from this swap arrangement.
Mar-31	Cash	Debit	62500
	Interest Expense	Credit	62500
	(Settlement entry for the swap)
Mar-31	Loss on Hedge activity	Debit	150000
	Bank Debt	Credit	150000
	(Recording of Debt at the fair value)
Mar-31	Swap Contract	Debit	150000
	Gain on Hedge activity	Credit	150000
	(Recording of swap at fair value)
Jun-30	Interest Expense	Debit	875000
	Accrued Interest Expense	Credit	875000
	(50000000 * 7% * 1/4)
Jun-30	Accrued Interest	Debit	875000
	Cash	Credit	875000
	(Payment entry)
	Since the variable rate is less on June 30, Northwest will gain from this swap arrangement.
Jun-30	Cash	Debit	18750
	Interest Expense	Credit	18750
	(Settlement entry for the swap)
Jun-30	Bank Debt	Debit	225000
	Gain on the hedge activity	Credit	225000
	(Recording of Debt at the fair value)
Jun-30	Loss on hedge	Debit	225000
	Swap Contract	Credit	225000
	(Recording of swap at fair value)
Sep-30	Interest Expense	Debit	875000
	Accrued Interest Expense	Credit	875000
	(50000000 * 7% * 1/4)
Sep-30	Accrued Interest	Debit	875000
	Cash	Credit	875000
	(Payment entry)
	Since the variable rate is more on Sep 30, Northwest will have loss from this swap arrangement.
Sep-30	Interest Expense	Debit	31250
	Cash	Credit	31250
	(Settlement entry for the swap)
Sep-30	Bank Debt	Debit	175000
	Gain on the hedge activity	Credit	175000
	(Recording of Debt at the fair value)
Sep-30	Loss on hedge	Debit	175000
	Swap Contract	Credit	175000
	(Recording of swap at fair value)
Dec-31	Interest Expense	Debit	875000
	Accrued Interest Expense	Credit	875000
	(50000000 * 7% * 1/4)
Dec-31	Accrued Interest	Debit	875000
	Cash	Credit	875000
	(Payment entry)
	Since the variable rate is more on Sep 30, Northwest will have loss from this swap arrangement.
Dec-31	Interest Expense	Debit	12500
	Cash	Credit	12500
	(Settlement entry for the swap)
Dec-31	Bank Debt	Debit	210000
	Gain on the hedge activity	Credit	210000
	(Recording of Debt at the fair value)
Dec-31	Loss on hedge	Debit	210000
	Swap Contract	Credit	210000
	(Recording of swap at fair value)

A swap is basically an exchange of cash flows arising from the interest rate changes. So this question has two components. 1) recording of interest expense 2) recording debt and the swap at fair value

Since, the company has agreed to pay the variable interest rate, its cash flow will depend on the variable interest expense and we need to pass journal entries to show that net cash flow from variable stream.

Description of journal enteries is given below each entry and the table is self-explanatory.