Chapter A, Problem 1P

Derivatives; interest rate swap

On January 1, 2018, Labtech Circuits borrowed $100,000 from First Bank by issuing a three-year, 8% note, payable on December 31, 2020. 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, 2018, 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 $100,000 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 2018, 2019, and 2020, 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:

Required:

1. 1. Calculate the net cash settlement at the end of 2018, 2019, and 2020.
2. 2. Prepare the journal entries during 2018 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.
3. 3. Prepare the journal entries during 2019 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.
4. 4. Prepare the journal entries during 2020 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. 5. Calculate the book values of both the swap account and the note in each of the three years.
6. 6. Calculate the net effect on earnings of the hedging arrangement in each of the three years. (Ignore income taxes.)
7. 7. Suppose the fair value of the note at December 31, 2018, had been $97,000 rather than $98,241, 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?

To determine

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.

To determine: The net cash settlement as at December 31, 2018, 2019, and 2020.

Explanation of Solution

Determine the net cash settlement as at December 31, 2018.

Particulars	Amount ($)
Fixed interest payments	$8,000
Floating interest payments	(9,000)
Net interest receipts (payments)	$(1,000)

Table (1)

Working Notes:

Compute fixed interest receipts.

Computation of Fixed Interest Receipts
Notional Amount ($)	$\times$	Fixed Interest Rate	$\times$	Time Period	=	Fixed Interest Receipts (S)
$100,000	$\times$	8%	$\times$	1 year	=	$8,000

Table (2)

Compute floating interest payments.

Computation of Floating Interest Payments
Notional Amount ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Floating Interest Payments (S)
$100,000	$\times$	9%	$\times$	1 year	=	$9,000

Table (3)

Determine the net cash settlement as at December 31, 2019.

Particulars	Amount ($)
Fixed interest payments	$8,000
Floating interest payments	(7,000)
Net interest receipts (payments)	$1,000

Table (4)

Working Notes:

Refer to Table (2) for value and computation of fixed interest payments.

Compute floating interest payments.

Computation of Floating Interest Payments
Notional Amount ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Floating Interest Payments (S)
$100,000	$\times$	7%	$\times$	1 year	=	$7,000

Table (5)

Determine the net cash settlement as at December 31, 2020.

Particulars	Amount ($)
Fixed interest payments	$8,000
Floating interest payments	(7,000)
Net interest receipts (payments)	$1,000

Table (6)

Working Notes:

Refer to Table (2) for value and computation of fixed interest payments.

Compute floating interest payments.

Computation of Floating Interest Payments
Notional Amount ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Floating Interest Payments (S)
$100,000	$\times$	7%	$\times$	1 year	=	$7,000

Table (7)

To determine

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2018

Explanation of Solution

Entry for issuance of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
January	1	Cash		100,000
		Notes Payable			100,000
		(To record issuance of note)

Table (8)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Notes Payable is a liability account. Since obligation to pay the note increased, liability increased, and an increase in liability is credited.

Entry for interest expense payment:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		8,000
		Cash			8,000
		(To record interest expense payment)

Table (9)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Note: Refer to Table (2) for value and computation of fixed interest payments.

Entry for net cash settlement:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		1,000
		Cash			1,000
		(To record net cash settlement which is the difference between fixed interest and variable interest)

Table (10)

Note: Refer to Table (1) for net cash settlement value.

• Interest Expense is an expense account. Since fixed interest payment is paid as per the agreement, the expense value increased, and an increase in expense is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Entry for changes in fair value of interest swap:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Holding Loss–Interest Rate Swap		1,759
		Interest Rate Swap			1,759
		(To record decrease in fair value from $0 to $(1,759))

Table (11)

• Holding Loss–Interest Rate Swap is a loss account. Since interest rate increased causing holding loss increase, which decrease equity, so equity value is decreased, and a decrease in equity is debited.
• Interest Rate Swap is a liability account because the fair value has decreased from $0 to $(1,759), and a decrease in asset is credited.

Entry for changes in fair value of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Notes Payable		1,759
		Holding Gain–Hedged Note			1,759
		(To record decrease in fair value from $100,000 to $98,241)

Table (12)

• Notes Payable is a liability account. Since fair value of the note decreased, liability decreased, and a decrease in liability is debited.
• Holding Gain–Hedged Note is a revenue account. The fair value of hedged liability has decreased causing a holding gain. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2019.

Explanation of Solution

Entry for interest expense payment:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Interest Expense		8,000
		Cash			8,000
		(To record interest expense payment)

Table (13)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Note: Refer to Table (2) for value and computation of fixed interest payments.

Entry for net cash settlement:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Cash		1,000
		Interest Expense			1,000
		(To record net cash settlement which is the difference between fixed interest and variable interest)

Table (14)

Note: Refer to Table (1) for net cash settlement value.

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Interest Expense is an expense account. Since fixed interest payment is received as per the agreement, the expense value decreased, and a decrease in expense is credited.

Entry for changes in fair value of interest swap:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Interest Rate Swap		2,694
		Holding Gain–Interest Rate Swap			2,694
		(To record increase in fair value from $(1,759) to $935)

Table (15)

• Interest Rate Swap is an asset account because the fair value has increased from $(1,759) to $935 causing an increase of $2,694, and an increase in asset is debited.
• Holding Gain–Interest Rate Swap is a revenue account. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.

Entry for changes in fair value of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Holding Loss–Hedged Note		2,694
		Note Payable			2,694
		(To record increase in fair value from $98,241 to $100,935)

Table (16)

• Holding Loss–Hedged Note is a loss account. The fair value of hedged liability has increased causing a holding loss. Since holding losses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Notes Payable is a liability account. Since fair value of the note increased, liability increased, and an increase in liability is credited.

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2020.

Explanation of Solution

Entry for interest expense payment:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Interest Expense		8,000
		Cash			8,000
		(To record interest expense payment)

Table (17)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Note: Refer to Table (2) for value and computation of fixed interest payments.

Entry for net cash settlement:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Cash		1,000
		Interest Expense			1,000
		(To record net cash settlement which is the difference between fixed interest and variable interest)

Table (18)

Note: Refer to Table (1) for net cash settlement value.

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Interest Expense is an expense account. Since fixed interest payment is received as per the agreement, the expense value decreased, and a decrease in expense is credited.

Entry for changes in fair value of interest swap:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Holding Loss–Interest Rate Swap		935
		Interest Rate Swap			935
		(To record change in fair value from $935 to $0)

Table (19)

• Holding Loss–Interest Rate Swap is a loss account. Since holding losses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Interest Rate Swap is a liability account because the fair value has increased causing an increase in the obligation, and an increase in liability is credited.

Entry for changes in fair value of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Notes Payable		935
		Holding Gain–Hedged Note			935
		(To record decrease in fair value of note from $100,935 to $100,000)

Table (20)

• Notes Payable is a liability account. Since fair value of the note decreased, liability decreased, and a decrease in liability is debited.
• Holding Gain–Hedged Note is a revenue account. The fair value of hedged liability has decreased causing a holding gain. Since holding gains increase equity, so equity value is increased, and an increase in equity is credited.

Entry for repayment of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Notes Payable		100,000
		Cash			100,000
		(To record note being paid)

Table (21)

• Notes Payable is a liability account. Since obligation to pay the note is decreased, liability decreased, and a decrease in liability is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

To determine

The book values of interest rate swap and note in 208, 2019, and 2020.

Explanation of Solution

Determine the book value of swap in the years 2018, 2019, and 2020.

Interest Rate Swap
Date	Details	Debit ($)		Date	Details	Credit ($)
2018				2018
January 1				December 31	Holding loss	1,759
	Total	$0			Total	$1,759
				December 31	Balance	$1,759
2019				2019
December 31	Holding gain	2,694		January 1	Balance	$1,759
	Total	2,694			Total	$1,759
December 31	Balance	$935
2020				2020
January 1	Balance	935		December 31	Holding loss	935
	Total	935			Total	935
December 31	Balance	$0

Table (22)

Note: Refer to Requirements 2, 3, and 4 for values and computation of all values.

Determine the book value of note in the years 2018, 2019, and 2020.

Note Payable
Date	Details	Debit ($)		Date	Details	Credit ($)
2016				2016
December 31	Holding gain	1,759		January 1	Cash	100,000
	Total	$0			Total	100,000
				December 31	Balance	$98,241
2017				2017
December 31				January 1	Balance	$98,241
					Holding loss	2,694
	Total	0			Total	$100,935
				December 31	Balance	$100,935
2018				2018
December 31	Holding gain	935		January 1	Balance	100,935
	Cash	100,000
	Total	100,935			Total	100,935
				December 31	Balance	$0

Table (23)

Note: Refer to Requirements 2, 3, and 4 for values and computation of all values.

To determine

The net effect of fair value hedge on earnings for the years 2018, 2019, and 2020.

Explanation of Solution

Determine the net effect of fair value hedge on earnings for the years 2018, 2019, and 2020.

L Circuits
Income Statement
For the Years Ended December 31, 2018, 2019, and 2020
	2018	2019	2020
Interest expense (Fixed receipts)	(8,000)	(8,000)	(8,00)
Interest expense (Net cash settlement)	(1,000)	1,000	1,000
Holding gain (loss)–Interest rate swap	(1,759)	2,694	(935)
Holding gain (loss)–Hedged note	1,759	(2,694)	935
Net effect on earnings (Floating interest payment on swap)	(9,000)	(7,000)	(7,000)

Table (24)

Note: Refer to requirements 1, 2, 3, and 4 for values and computation of all values.

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2018, if fair value would have been $97,000 rather than $98,241.

Explanation of Solution

The additional decline in fair value from $98,241 to $97,000 would not make any difference in the entries because the reason for decline is not related to interest rate.

Entry for interest expense payment:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		8,000
		Cash			8,000
		(To record interest expense payment)

Table (25)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Note: Refer to Table (2) for value and computation of fixed interest payments.

Entry for net cash settlement:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		1,000
		Cash			1,000
		(To record net cash settlement which is the difference between fixed interest and variable interest)

Table (26)

Note: Refer to Table (1) for net cash settlement value.

• Interest Expense is an expense account. Since fixed interest payment is paid as per the agreement, the expense value increased, and an increase in expense is debited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Entry for changes in fair value of interest swap:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Holding Loss–Interest Rate Swap		1,759
		Interest Rate Swap			1,759
		(To record decrease in fair value from $0 to $(1,759))

Table (27)

• Holding Loss–Interest Rate Swap is a loss account. Since interest rate increased causing holding loss increase, which decrease equity, so equity value is decreased, and a decrease in equity is debited.
• Interest Rate Swap is a liability account because the fair value has decreased from $0 to $(1,759), and a decrease in asset is credited.

Entry for changes in fair value of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Notes Payable		1,759
		Holding Gain–Hedged Note			1,759
		(To record decrease in fair value from $100,000 to $98,241)

Table (28)

• Notes Payable is a liability account. Since fair value of the note decreased, liability decreased, and a decrease in liability is debited.
• Holding Gain–Hedged Note is a revenue account. The fair value of hedged liability has decreased causing a holding gain. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.