On January 1, 2021, Labtech Circuits borrowed $252,000 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 foir value hedge. The agreement called for the company to receive payment based on an 6% fixed interest rate on a notional amount of $252,000 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 6% at inception and 7%, 5%, and 5% at the end of 2021, 2022, and 2023, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair volues of the note are as follows: January 1 2021 2021 (5,200) $248, 800 December 31 2022 42.400 4254, 400 2023 Fair value of intereat rate awap Yair value of note payable 4252,000 $252,000 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.
On January 1, 2021, Labtech Circuits borrowed $252,000 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 foir value hedge. The agreement called for the company to receive payment based on an 6% fixed interest rate on a notional amount of $252,000 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 6% at inception and 7%, 5%, and 5% at the end of 2021, 2022, and 2023, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair volues of the note are as follows: January 1 2021 2021 (5,200) $248, 800 December 31 2022 42.400 4254, 400 2023 Fair value of intereat rate awap Yair value of note payable 4252,000 $252,000 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.
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Transcribed Image Text:On January 1, 2021, Labtech Circuits borrowed $252,000 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 recelve payment based on an 6% fixed interest rate on a notional amount of $252,000 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 6% at inception and 7%, 5%, and 5% at the end of 2021, 2022, and 2023, respectively. The fair
values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as follows:
January 1
2021
December 31
2022
(5,200) 4 2,400
4254, 400
2021
2023
Fair value of interest rate swap
Fair value of note payable
4252,000
4248, 800
$252,000
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 $237,000 rather than $248,800 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?
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