Question

On January 1, 2021, S&S Corporation invested in LLB Industries’ negotiable two-year, 10% notes, with interest receivable quarterly. The company classified the investment as available-for-sale. S&S 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 investment to increase. The agreement called for the company to make payment based on a 10% fixed interest rate on a notional amount of $360,000 and to receive interest based on a floating interest rate. The contract called for cash settlement of the net interest amount quarterly.

Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the investment in notes are as follows:

	January 1			March 31			June 30
Fair value of interest rate swap		0		$	8,072		$	14,594
Fair value of the investment in notes	$	360,000		$	368,072		$	374,594

Required:
1. Calculate the net cash settlement at March 31 and June 30, 2021.
2. Prepare the journal entries through June 30, 2021, to record the investment in notes, interest, and necessary adjustments for changes in fair value.

There are 9 journal entries.

Answer 1

1

Net cash settlement = [(Fair value at Fixed interest rate) - (Fair value X Floating rate on the date)] X (months)
March 31 = [($360000 X 10%) - ($360000 X 8%)] X (3/12 months)
=> ($36000 - 28800) X (1/4)
=> $1800

June 30 = [($360000 X 10%) - ($360000 X 6%)] X (3/12 months)
=> ($36000 - $21600) X (1/4)
=> $3600

2

Date	Particulars	Debit ($)	Credit ($)
Jan 1, 2021	Investment in notes- LLB Industries	360000
	To Cash		360000
	(Being investment made in LLB industries Notes)
March 31	Cash	9000
	To interest Revenue [$360000 X 10% X (3/12 months)]		9000
	(Being interest on fixed rate recorded)
	Interest revenue	1800
	To Cash (Calculated in '1' above)		1800
	(Being Net cash settlement recorded)
	Holding loss- interest rate swap	8072
	To interest rate swap		8072
	(Being change in fair value of derivative recorded)
	Investment in Notes- LLB Industries	8072
	To Holding gain- Hedged note ($368072 - $360000)		8072
	(Being change in fair value of investment recorded)
June 30	Cash	9000
	To interest Revenue [$360000 X 10% X (3/12 months)]		9000
	(Being interest on fixed rate recorded)
	Interest revenue	3600
	To Cash (Calculated in '1' above)		3600
	(Being Net cash settlement recorded)
	Holding loss- interest rate swap	6522
	To interest rate swap ($14594 - $8072)		6522
	(Being change in fair value of derivative recorded)
	Investment in Notes- LLB Industries	6522
	To Holding gain- Hedged note ($374594 - $368072)		6522
	(Being change in fair value of investment recorded)