Question

Exercise A-2 (Algo) Derivatives; interest rate swap; fixed rate debt [LOA–2] On January 1, 2021, LLB Industries borrowed $320,000 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, 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 10% fixed interest rate on a notional amount of $320,000 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, 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. January 1 March 31 June 30 Fair value of interest rate swap 0 $ 7,672 $ 13,794 Fair value of note payable $ 320,000 $ 327,672 $ 333,794 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 issuance of the note, interest, and necessary adjustments for changes in fair value.

Answer 1

Answer:

Requirement 1

January 1          March 31            June 30

Fair value of interest rate swap                                     0                $7672 $13794

Fair value of note payable                                $320000 $327672 $333794   

Fixed rate                                                             10%                    10%                    10%

Floating rate                                                         10%                      8%                      6%

Fixed interest receipts                                                                     $8000 $8000 (refer below entries for calculations)

Floating payments                                                                             6400                  4800

Net interest receipts (payments)                                                      $1600             $3200

Requirement 2

January 1

Cash                                                                                                        320000

     Notes payable                                                                                                      320000

To record the issuance of the note

March 31

Interest expense ([10% x ¼] x $320000)                                                  8000

     Cash                                                                                                                         8000

To record interest

Cash ($8000 – ([8% x ¼] x $320000))                                                     1600

     Interest expense                                                                                                       1600

To record the net cash settlement

Interest rate swap [asset] ($7672 – 0)                                                       7672

     Holding gain—interest rate swap                                                                            7672

To record change in fair value of the derivative

Holding loss—hedged note                                                           7672

     Note payable ($327672 – 320000)                                                                        7672

To record change in fair value of the note

June 30

Interest expense ([10% x ¼] x $320000)                                                  8000

     Cash                                                                                                                         8000

To record interest

Cash ($8000 – ([6% x ¼] x $320000))                                                     3200

     Interest expense                                                                                                       3200

To record the net cash settlement

Interest rate swap [asset] ($13794 – 7672)                                              6122

     Holding gain—interest rate swap                                                                            6122

To record change in fair value of the derivative

Holding loss—hedged note                                                                        6122

     Note payable ($333794 – 327672)                                                                        6122

To record change in fair value of the note