Question

On January 1, 2018, LLB Industries borrowed $350,000 from Trust Bank by issuing a two-year, 10% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2018, 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 10% fixed interest rate on a notional amount of $350,000 and to pay 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, 2018. 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.

	January 1			March 31			June 30
Fair value of interest rate swap		0		$	7,972		$	14,394
Fair value of note payable	$	350,000		$	357,972		$	364,394

Required:
1. Calculate the net cash settlement at March 31 and June 30, 2018.
2. Prepare the journal entries through June 30, 2018, to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

Answer 1

1	Net cash settlement:
	Interest to be calculated on notional amount of $ 350000
					Mar 31.	June 30.
	Fixed rate				10%	10%
	Floating rate				8%	6%
	Fixed interest		(Quarterly interest )
	(350000*10%*3/12)				8750	8750
	Less; Floating interest				7000	5250
					(350000*8%*3/12)	(350000*6%*3/12)
	Net cash settlement				1750	3500
2	Date	Account titles and explanation					Debit	Credit
	Jan 1.	Cash					35000
		Notes payable						35000
		(Notes issued)
	Mar 31.	Interest expense		(Fixed interest )			8750
		Cash						8750
		(Interest paid)
		Cash					1750
		Interest expense						1750
		(Net settlement recorded)
		Interest rate swap					7972
		Holding gain-interest rate swap						7972
		(Recorded change in fair value of derivative)
		Holding loss-hedged note			(357972-350000)		7972
		Note payable						7972
		(Recorded change in fair value of note)
	June 30.	Interest expense		(Fixed interest )			8750
		Cash						8750
		(Interest paid)
		Cash					3500
		Interest expense						3500
		(Net settlement recorded)
		Interest rate swap			(14394-7972)		6422
		Holding gain-interest rate swap						6422
		(Recorded change in fair value of derivative)
		Holding loss-hedged note			(364394-357972)		6422
		Note payable						6422
		(Recorded change in fair value of note)