Chapter 13, Problem 27E

(Appendix 13.1) Derivatives Anglar Company has a $3 million, 7% bank loan from Castle Rock Bank. On January 1, 2019, when the $3 million loan has 3 years remaining, Anglar contracts with Susan Investment Bank to enter into a 3-year interest rate swap with a $3 million notional amount. Anglar agrees to receive from Susan a fixed interest rate of 7% and to pay Susan 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 6.6% at the beginning of 2019. The 3-year fixed interest rate is 8% at December 31, 2019.

Required:

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

To determine

Prepare the journal entries in the books of Company A for the bank loan and derivative for 2019.

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	$3,000,000
	Notes Payable		$3,000,000
	(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	$210,000
	Cash		$210,000
	(To record the payment of interest on $3 million bank loan)

Table (2)

Working note (1):

Calculate the amount of interest paid on loan.

$\begin{array}{c}\text{Interest paid on loan = Loan payable }\times \text{Interest rate on bank loan}\\ \text{=\$3,000,000}\times \text{7\%}\\ \text{=\$210,000}\end{array}$

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

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Cash	$12,000
	Interest expenses $\left[\left(7\%-6.6\%\right)\times \$3\text{ million}\right]$		$12,000
	(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	$53,497
	Liability from interest rate swap		$53,497
	(To record the loss on derivative swap)

Table (4)

Working note (2):

Calculate the present value.

$\begin{array}{c}\text{Present value =}\left[\begin{array}{l}\left(\text{Market fixed interest rate}-\text{Interest rate on swap}\right)\\ \times \text{Loan}\times \text{Factor on present value of ordinary annuity}\end{array}\right]\\ =\left[\left(8\%-7\%\right)\times \$3,000,000\times {\text{P}}_{\text{On=2,i=8\%}}\right]\\ =\left[1\%\times \$3,000,000\times \text{1}\text{.783265}\right]\\ =\$53,497\end{array}$

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, 2019	Note payable (6)	$53,497
	Gain in value of debt		$53,497
	(To record the decrease in the value of note payable)

Table (5)

Working note (3):

Calculate the amount of present value of principal.

$\begin{array}{c}\text{Present value of principal= Loan}\times \text{Factor on present value}\\ =\$3,000,000\times {\text{P}}_{\text{n=2,i=8\%}}\\ =\$3,000,000\times \text{0}\text{.857339}\\ =\$2,572,017\end{array}$

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.

$\begin{array}{c}\text{Present value of interest= }\left[\begin{array}{l}\text{Amount of interest paid on December 31, 2019}\times \\ \text{Factor on present value on ordinary annuity}\end{array}\right]\\ =\$210,000\times {\text{P}}_{\text{n=2,i=8\%}}\\ =\$210,000\times \text{1}\text{.783265}\\ =\$374,486\end{array}$

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 (5):

Calculate the amount of total present value.

$\begin{array}{c}\text{Total present value = Present value of principal}+\text{Present value of interest}\\ =\$2,572,017+\$374,486\\ =\$2,946,503\end{array}$

Working note (6):

Calculate the decrease in the value of debt.

$\begin{array}{c}\text{Decrease in value of debt =Loan }-\text{Total present value}\\ =\$3,000,000-\$2,946,503\\ =\$53,497\end{array}$

To determine

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

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 A’s financial statements for 2019.

Income statement:

Company A
Income statement
For The Year Ending December 31, 2019
Particulars	Amount
Other items:
Interest expense (7)	($198,000)
Loss in value of derivative	($53,497)
Gain in value of debt	$53,497

Table (6)

Working note (7):

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

$\begin{array}{c}\text{Interest expenses =}\left[\begin{array}{l}\text{Interest expense debited on December 31, 2019}-\\ \text{Interest expense credited on December 31, 2019}\end{array}\right]\\ \text{=\$210,000}-\$12,000\\ =\$198,000\end{array}$

Balance sheet:

Company A
Balance sheet
As at December 31, 2019
Liabilities	Amount
Long term liabilities:
Notes payable (8)	$2,946,503
Liability from interest-rate swap	$53,497

Table (7)

Working note (8):

Calculate the amount of notes payable:

$\begin{array}{c}\text{Notes payable}=\left(\text{Face value of the note}-\text{Decrease in value of debt}\right)\\ =\left(\$3,000,000-\$53,497\right)\\ =\$2,946,503\end{array}$