Chapter 7, Problem 67P

To determine

Prepare journal entries to record the transactions given below:

1. a. Borrowing on June 30 (year of borrowing)
2. b. Interest payment at December 31
3. c. Interest payment at June 30 (following year).

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

• Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.
• It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.
• Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

Foreign currency hedging includes buying hedging instruments to mitigate the risk faced by particular foreign exchange positions.

In principle, a futures contract is equivalent to a forward contract, in that a company may enter into a contract to buy or sell money on a future date at a specific price.

Hedges the risk related to changes in fair value of the engagement. It recognizes firm commitment as Assets or liabilities where hedged. Enterprises may use cash flow hedge treatment for firm pledges. In effect, that would be the same as the cash flow hedge accounting for a forecast operation.

The journal entries are as follows:

	Date	Account title and Explanation	Post Ref	Debit ($)	Credit ($)
a.	June 30 (year of borrowing)	Cash		$\$25,000,000$
		Debt			$\$25,000,000$
		(To record the debt)

b..	Dec 31	Interest expense		$\$937,500$
		Cash			$\$937,500$
		(To record semiannual interest payment: $25 mil. x 7.5%/2 = $937,500)
		Cash		$\$187,500$
		Interest expense			$\$187,500$
		(To record the settlement of the semiannual swap-amount receivable at 7.5%, less the amount payable at LIBOR, 6%, as an adjustment to interest: $25 mil of [7.5% − 6%]/2 = $187,500)
		Interest expense		$\$68,750$
		Debt			$\$68,750$
		(To record the change in the debt’s fair value that is attributable to changes in the benchmark interest rate (given) at the end of the first reporting period)
		Interest expense		$\$68,750$
		Gain on Hedge			$\$68,750$
		(To record the change in the fair value (given) of the swap at the end of the first reporting period)
c.	June	Interest expense		$\$937,500$
	(year of following)	Cash			$\$937,500$
		(To record the semiannual debt interest payment)
		Cash		$\$218,750$
		Interest expense			$\$218,750$
		(To record the receipt of the semiannual swap amount receivable at 7.5%, less the amount payable at LIBOR, 5.75%: $25 mil of [7.5% − 5.75%]/2 = $218,750)
		Interest expense		$\$68,750$
		Debt			$\$68,750$
		(To record the change in the debt’s fair value that is attributable to changes in the benchmark interest rate (given) at the end of the second reporting period)
		Interest expense		$\$68,750$
		Gain on Hedge			$\$68,750$
		(To record the change in the fair value (given) of the swap at the end of the second reporting period)

The hedge of the exposure to interest rates in a recognized fixed-rate asset is considered a fair value hedge. Consequently, the swap is reported as an asset or liability at fair value on the balance sheet, with changes in the fair value reflected in each reporting period in the income statement. The change in the fair value of the debt (i.e., the gain or loss on the hedged item) attributable to changes in the benchmark interest rate ( i.e., six-month US LIBOR) is also reflected in earnings by adjusting the carrying amount of the debt. The debt is presented on the balance sheet at an amount reflecting the impact on its fair value of changes in the benchmark interest rates (e.g., six-month U.S. LIBOR). The swap contract is presented at its fair value on the balance sheet. The changes in the fair value of (1) the debt attributable to the hedged interest rate risk, and (2) the swap contract are recognized in the earnings of the current period. Net interest expenditure for the specific plan the coupon rate of the debt adjusted for the settlement period by the swap.

The effective interest rate paid on the debt for the first two periods is as follows:

	Interest expense (net)	Effective annual interest rate (on $25 million of debt)
December 31	$750,000 ($937,500 – 187,500)	6% ([$750,000/$25 million] x 2)
June 30	$718,750 ($937,500 – 218,750)	5.75% ([$718,750/$25 million] x 2)