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 notional amount of $ 390000
					June 30.
	Fixed rate				10%
	Floating rate				6%
	Fixed interest		(Quarterly interest )
	(390000*10%*3/12)				9750
	Less; Floating interest				5850
					(390000*6%*3/12)
	Net cash settlement				3900

Journal entries

Date	particulars	Debit ($)	Credit ($)
Jan 1	Cash	390000
	Notes payable		390000
	(To record notes issued)
Mar	Interest expense	9750
	Cash		9750
	(To record interest paid)
	Cash	1950
	Interest expense 9750-(390000*8%*3/12)		1950
	(To record net settlement )
	Interest rate swap	8372
	Holding gain - interest rate swap		8372
	(To record change in fair value of derivative)
	Holding loss -hedged note (398372-390000)	8372
	Notes payable		8372
	(To record change in fair value of note)
	Interest expense	9750
	Cash		9750
	(To record Interest paid)
	Cash	3900
	Interest expense		3900
	(To record net settlement)
	Interest rate sap (15194-8372)	6822
	Holding gain - interest rate swap		6822
	(To record change in fair value of derivative)
	Holding loss- hedged note (410000-398372)	11628
	Note payable		11628
	(To record change in fair value of note)