Question

LLB Industries borrowed $390,000 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 $390,000 and to pay interest based on a floating interest rate. Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% at 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. 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 $ 8,372 $ 15,194 Fair value of note payable $ 390,000 $ 398,372 $ 410,000 Required: 1. Calculate the net cash settlement at June 30, 2018. 2. Prepare the journal entries on June 30, 2018, to record the interest and necessary adjustments for changes in fair value.

Answer 1

Answer :

1.

Net Cash Settlement
Interest to be calculated on a notional amount if $ 390000
	31-Mar	30-Jun
Fixed Rate	10%	10%
Floating rate	8%	6%
Fixed Interest	$9,750.00	$9,750.00
(390000*10%*3/12)
Less : Floating Interest	$7,800.00	$5,850.00
(390000*8%*3/120
Net Cash Settlement	$1,950.00	$3,900.00

2.

JOURNAL ENTRY
Date	Account Title & Explanation	Debit	Credit
1-Jan	Cash	$390,000
	Notes Payable		$390,000
	( To Record notes issued)
31-Mar	Interest Expenses	$9,750
	Cash		$9,750
	( To Record interest paid)
31-Mar	Cash	$1,950
	Interest Expenses		$1,950
	( To Record Net Settelement )
31-Mar	Interest Rate Swap	$8,372
	Holding Gain Interest rate Swap		$8,372
	(To Record change in fair value of derivative)
31-Mar	Holding Loss -Hedge Note	$8,372
	Note Payable ( 398372-390000)		$8,372
	(To Record change in fair value of notes)
30-Jun	Interest Expenses	$9,750
	Cash		$9,750
	( To Record interest paid)
30-Jun	Cash	$3,900
	Interest Expenses		$3,900
	( To Record Net Settelement )
30-Jun	Interest Rate Swap	$6,822
	Holding Gain Interest rate Swap (15194-8372)		$6,822
	(To Record change in fair value of derivative)
30-Jun	Holding Loss -Hedge Note	$6,822
	Note Payable ( 405194-398372)		$6,822
	(To Record change in fair value of notes)