Chapter 13, Problem 26P

(Appendix 13.1) Derivatives Danburg. Company has a $5 million, 9% bank loan outstanding with its local bank. On January 1, 2019, when the loan has 4 years remaining, Danburg contracts with Bradford Investment Bank to enter into a 4-year interest-rate swap with a $5 million notional amount. Danburg agrees to receive from Bradford a fixed interest rate of 9% and to pay Bradford an interest amount each year that is variable based on the LIBOR interest rate at the beginning of the year. The interest payments are made at year-end. The applicable interest rate on the swap is reset each year after the annual interest payment is made. The LIBOR interest rate is 8.6% and 9.5% at the beginning of 2019 and 2020, respectively. The 3-year fixed interest rate is 10% at December 31, 2019, and the 2 year rate is 8% at December 31, 2020.

Required:

1. 1. Prepare the journal entries of Danburg for the bank loan and derivative for 2019 and 2020. Round calculations to the nearest dollar.
2. 2. Prepare the appropriate disclosures in Danburg’s financial statements for 2019 and 2020.

To determine

Record the journal entries in the books of Company D for 2019 and 2020.

Explanation of Solution

Derivatives: Derivatives are some financial instruments which are meant for managing risk and safeguard the risk created by other financial instruments. These financial instruments derive the values from the future value of underlying security or index. Some examples of derivatives are forward contracts, interest rate swaps, futures, and options.

Interest rate swap: This is a type of derivative used by two parties under a contract to exchange the consequences (net cash difference between interest payments) of fixed interest rate for floating interest rate, or vice versa, without exchanging the principal or notional amounts.

Record the note payable as on January 1, 2019.

Date	Account titles and explanation	Debit ($)	Credit($)
January 1, 2019	Cash	$5,000,000
	Notes Payable		$5,000,000
	(To record the note payable to bank)

Table (1)

Record the interest payment on loan on December 31, 2019.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Interest expenses	$450,000
	Cash		$450,000
	(To record the payment of interest on $5 million bank loan)

Table (2)

Working note (1):

Calculate the amount of interest paid on loan.

$\begin{array}{c}\text{Interest paid on loan = Loan payable }\times \text{Interest rate on bank loan}\\ \text{=\$5,000,000}\times 9\text{\%}\\ \text{=\$450,000}\end{array}$

Record the interest rate swap receipt (payment) on December 31, 2019.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Cash $\left[\left(9\%-8.6\%\right)\times \$5\text{million}\right]$	$20,000
	Interest expenses		$20,000
	(To record the interest rate swap receipt)

Table (3)

Record the fair values and gains and losses on December 31, 2019.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Loss in fair value of derivative (2)	$124,342
	Liability from interest rate swap		$124,342
	(To record the loss on derivative swap)

Table (4)

Working note (2):

Calculate the amount of present value:

$\begin{array}{c}\text{Present value =}\left[\begin{array}{l}\left(\text{Market fixed interest rate}-\text{Interest rate on swap}\right)\\ \times \text{Loan}\times \text{Factor on present value ordinary annuity}\end{array}\right]\\ =\left[\left(10\%-9\%\right)\times \$5,000,000\times {\text{P}}_{\text{on=3,i=10\%}}\right]\\ =\left[1\%\times \$5,000,000\times 2.486852\right]\\ =\$124,342\end{array}$

Note: Factor of present value of ordinary annuity of $1: n = 3, i =10% is taken from the table value (Table 4 at the end of the time value money module).

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Note payable	$124,342
	Gain in value of debt (6)		$124,342
	(To record the decrease in the value of note payable)

Table (5)

Working note (3):

Calculate the amount of present value of principal.

$\begin{array}{c}\text{Present value of principal= Loan}\times \text{Factor on present value}\\ =\$5,000,000\times {\text{P}}_{\text{n=3,i=10\%}}\\ =\$5,000,000\times \text{0}\text{.751315}\\ =\$3,756,575\end{array}$

Note:

Factor of present value of $1: n = 2, i =8% is taken from the table value (Table 3 at the end of the time value money module).

Working note (4):

Calculate the amount of present value of interest.

$\begin{array}{c}\text{Present value of interest= }\left[\begin{array}{l}\text{Amount of interest paid on December 31, 2019}\times \\ \text{Factor on present value ordinary annuity}\end{array}\right]\\ =\$450,000\times {\text{P}}_{\text{On=3,i=10\%}}\\ =\$450,000\times \text{2}\text{.486852}\\ =\$1,119,083\end{array}$

Note:

Factor of present value of ordinary annuity of $1: n = 3, i =10% is taken from the table value (Table 4 at the end of the time value money module).

Working note (5):

Calculate the amount of total present value.

$\begin{array}{c}\text{Total present value = Present value of principal}+\text{Present value of interest}\\ =\$3,756,575\left(3\right)+\$1,119,083\left(4\right)\\ =\$4,875,658\end{array}$

Working note (6):

Calculate the decrease in the value of debt.

$\begin{array}{c}\text{Decrease in value of debt =Loan}-\text{Total present value}\\ =\$5,000,000-\$4,875,658\\ =\$124,342\end{array}$

Record the interest payment on loan on December 31, 2020.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2020	Interest expenses (7)	$450,000
	Cash		$450,000
	(To record the payment of interest on $5 million bank loan)

Table (6)

Working note (7):

Calculate the amount of interest paid on loan.

$\begin{array}{c}\text{Interest paid on loan = Loan payable }\times \text{Interest rate on bank loan}\\ \text{=\$5,000,000}\times 9\text{\%}\\ \text{=\$450,000}\end{array}$

Record the interest rate swap payment on December 31, 2020.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2020	Interest expenses $\left[\left(9.5\%-9\%\right)\times \$5\text{million}\right]$	$25,000
	Cash		$25,000
	(To record the interest rate swap payment)

Table (7)

Record the fair values and gains and losses on December 31, 2020.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2020	Liability from interest rate swap	$124,342
	Asset from interest-rate swap (8)	$89,164
	Gain in value of derivatives		$213,506
	(To record the gain on derivative swap)

Table (8)

Working note (8):

Calculate the present value.

$\begin{array}{c}\text{Present value =}\left[\begin{array}{l}\left(\text{Interest rate on swap}-\text{Market fixed interest rate}\right)\\ \times \text{Loan}\times \text{Factor on present value ordinary annuity}\end{array}\right]\\ =\left[\left(9\%-8\%\right)\times \$5,000,000\times {\text{P}}_{\text{on=2,i=8\%}}\right]\\ =\left[1\%\times \$5,000,000\times 1.783265\right]\\ =\$89,164\end{array}$

Note: Factor of present value of ordinary annuity of $1: n = 2, i =8% is taken from the table value (Table 4 at the end of the time value money module).

Record the decrease in value of debt.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2020	Loss in value of debt	$213,506
	Note payable		$213,506
	(To record the increase in the value of note payable)

Table (9)

Working note (9):

Calculate the amount of present value of principal.

$\begin{array}{c}\text{Present value of principal= Loan}\times \text{Factor on present value}\\ =\$5,000,000\times {\text{P}}_{\text{n=2,i=8\%}}\\ =\$5,000,000\times \text{0}\text{.857339}\\ =\$4,286,695\end{array}$

Note:

Factor of present value of $1: n = 2, i =8% is taken from the table value (Table 3 at the end of the time value money module).

Working note (10):

Calculate the amount of present value of interest.

$\begin{array}{c}\text{Present value of interest= }\left[\begin{array}{l}\text{Amount of interest paid on December 31, 2020}\times \\ \text{Factor on present value ordinary annuity}\end{array}\right]\\ =\$450,000\times {\text{P}}_{\text{On=2,i=8\%}}\\ =\$450,000\times 1.783265\\ =\$802,469\end{array}$

Note:

Factor of present value of ordinary annuity of $1: n = 2, i =8% is taken from the table value (Table 4 at the end of the time value money module).

Working note (11):

Calculate the amount of total present value.

$\begin{array}{c}\text{Total present value = Present value of principal}+\text{Present value of interest}\\ =\$4,286,695\left(9\right)+\$802,469\left(10\right)\\ =\$5,089,164\end{array}$

Working note (12):

Calculate the decrease in the value of debt.

$\begin{array}{c}\text{Decrease in value of debt =Total present value}-\text{Note payable as on December 31, 2020}\\ =\$5,089,164-\$4,875,658\\ =\$213,506\end{array}$

To determine

Prepare the appropriate disclosures in Company D’s financial statements for 2019 and 2020.

Explanation of Solution

Financial statements: Financial statements are condensed summary of transactions communicated in the form of reports for the purpose of decision making.

Income statement: The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Balance sheet: Balance Sheet is one of the financial statements that summarize the assets, the liabilities, and the Shareholder’s equity of a company at a given date. It is also known as the statement of financial status of the business.

Prepare the appropriate disclosures in Company D’s financial statements for 2019.

Income statement:

Company D
Income statement
For The Year Ending December 31, 2019
Particulars	Amount
Other items:
Interest expense (13)	($430,000)
Loss in value of derivative	($124,342)
Gain in value of debt	$124,342

Table (10)

Balance sheet:

Company D
Balance sheet
As at December 31, 2019
Liabilities	Amount
Long term liabilities:
Notes payable (14)	$4,875,658
Liability from interest-rate swap	$124,342

Table (11)

Working note (13):

Calculate the amount of interest expense to be reported in Income statement, 2019.

$\begin{array}{c}\text{Interest expenses =}\left[\begin{array}{l}\text{Interest expense debited on December 31, 2019}-\\ \text{Interest expense credited on December 31, 2019}\end{array}\right]\\ \text{=\$450,000}-\$20,000\\ =\$430,000\end{array}$

Working note (14):

Calculate the amount of note payable as on December 31, 2019.

$\begin{array}{c}\begin{array}{l}\text{Note payable as on}\\ \text{December 31, 2019}\end{array}\}\text{=}\left[\begin{array}{l}\text{Note payable as on January 1, 2019}-\text{Decrease in}\\ \text{note payable due to increase in market interest rate}\end{array}\right]\\ \text{=\$5,000,000}-\$124,342\\ =\$4,875,658\end{array}$

Prepare the appropriate disclosures in Company D’s financial statements for 2020.

Income statement:

Company D
Income statement
For The Year Ending December 31, 2020
Particulars	Amount
Other items:
Interest expense (15)	($475,000)
Gain in value of derivative	$213,506
Loss in value of debt	($213,506)

Table (12)

Balance sheet:

Company D
Balance sheet
As at December 31, 2020
Assets	Amount
Long term assets:
Asset from interest-rate swap	$89,164
Liabilities	Amount
Long term liabilities:
Note payable (16)	$5,089,164

Table (13)

Working note (15):

Calculate the amount of interest expense to be reported in Income statement, 2020.

$\begin{array}{c}\text{Interest expenses =}\left[\begin{array}{l}\text{Interest expense debited on December 31, 2020}+\\ \text{Interest expense debited}\text{on December 31, 2020}\end{array}\right]\\ \text{=\$450,000}+\$25,000\\ =\$475,000\end{array}$

Working note (16):

Calculate the amount of note payable as on December 31, 2020.

$\begin{array}{c}\begin{array}{l}\text{Note payable as on}\\ \text{December 31, 2020}\end{array}\}\text{=}\left[\begin{array}{l}\text{Note payable as on January 1, 2020}+\text{Increase in}\\ \text{note payable due to decrease in market interest rate}\end{array}\right]\\ \text{=\$}4,875,658+\$213,506\\ =\$5,089,164\end{array}$