In: Accounting
On January 1, 2021, Labtech Circuits borrowed $300,000 from
First Bank by issuing a three-year, 6% note, payable on December
31, 2023. Labtech wanted to hedge the risk that general interest
rates will decline, causing the fair value of its debt to increase.
Therefore, Labtech entered into a three-year interest rate swap
agreement on January 1, 2021, and designated the swap as a fair
value hedge. The agreement called for the company to receive
payment based on an 8% fixed interest rate on a notional amount of
$300,000 and to pay interest based on a floating interest rate tied
to LIBOR. The contract called for cash settlement of the net
interest amount on December 31 of each year.
Floating (LIBOR) settlement rates were 8% at inception and 9%, 7%,
and 7% at the end of 2021, 2022, and 2023, respectively. The fair
values of the swap are quotes obtained from a derivatives dealer.
These quotes and the fair values of the note are as follows:
January 1 | December 31 | ||||||||||||
2021 | 2021 | 2022 | 2023 | ||||||||||
Fair value of interest rate swap | 0 | $ | (3,759 | ) | $ | 2,935 | $ | 0 | |||||
Fair value of note payable | $ | 300,000 | $ | 296,241 | $ | 302,935 | $ | 300,000 | |||||
Required:
1. Calculate the net cash settlement at the end of
2021, 2022, and 2023.
2. Prepare the journal entries during 2021 to
record the issuance of the note, interest, and necessary
adjustments for changes in fair value.
3. Prepare the journal entries during 2022 to
record interest, net cash interest settlement for the interest rate
swap, and necessary adjustments for changes in fair value.
4. Prepare the journal entries during 2023 to
record interest, net cash interest settlement for the interest rate
swap, necessary adjustments for changes in fair value, and
repayment of the debt.
5. Calculate the book values of both the swap
account and the note in each of the three years.
6. Calculate the net effect on earnings of the
hedging arrangement in each of the three years. (Ignore income
taxes.)
7. Suppose the fair value of the note at December
31, 2021, had been $287,000 rather than $296,241 with the
additional decline in fair value due to investors’ perceptions that
the creditworthiness of Labtech was worsening. How would that
affect your entries to record changes in the fair values?