Chapter A, Problem 3P

Derivatives; interest rate swap; fixed rate debt; extended method

(Note: This is a variation of P A–1, modified to consider the extended method demonstrated in Illustration A–3.)

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. Those quotes and the fair values of the note are as follows:

Required:

Use the extended method demonstrated in Illustration A–3.

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.

Entry for net interest receipt and accrued interest:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		0
		Holding Loss–Interest Rate Swap		2,759
		Interest Rate Swap			1,759
		Cash			1,000
		(To record net cash settlement, accrued interest, and decrease in fair value)

Table (10)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited. (Since opening balance of fair value of interest rate swap is $0, the expense paid would be $0).
• Holding Loss–Interest Rate Swap is an expense 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 of derivative has increased, and an increase in liability is credited.
• Cash is an asset account. Since cash (net cash settlement) is paid, asset account decreased, 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 (11)

• 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		8,842
		Notes Payable			842
		Cash			8,000
		(To record interest expense payment)

Table (12)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Notes Payable is a liability account. Since part of principal amount of the note has increased, liability increased, and an increase in liability is credited.
• Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Refer to Table (2) for value and computation of interest expense value at fixed interest rate.

Compute notes payable value.

Step 1: Compute floating interest payment.

Computation of Floating Interest Payment
Fair Value of Note ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Floating Interest Payments (S)
$98,241	$\times$	9%	$\times$	1 year	=	$8,842

Table (13)

Step 2: Compute notes payable value.

Particulars	Amount ($)
Interest expense amount	$8,842
Cash paid	(8,000)
Notes payable amount	$842

Table (14)

Note: Refer to Table (2) for value and computation of interest expense value at fixed interest rate, and Table (13) for interest expense amount.

Entry for net interest receipt and accrued interest:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Cash		1,000
		Interest rate Swap		2,694
		Interest Expense		158
		Holding Gain–Interest Rate Swap			3,852
		(To record net cash settlement and increase in fair value of swap from $(1,759) to $935)

Table (15)

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

Working Notes:

Compute interest revenue from interest rate swap.

Computation of Floating Interest Payment
Fair Value of Swap ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Interest Received (S)
$1,759	$\times$	9%	$\times$	1 year	=	$159

Table (16)

Compute holding gain on interest rate swap value.

Particulars	Amount ($)
Cash receipt	$1,000
Interest rate swap value	2,694
Interest revenue	159
Holding gain value	$3,852

Table (17)

Entry for changes in fair value of note:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
December	31	Holding Loss–Hedged Note		1,852
		Note Payable			1,852
		(To record increase in fair value from $98,241 to $100,935)

Table (18)

• 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.

Working Notes:

Compute notes payable value.

Particulars	Amount ($)
Fair value of note in 2019	100,935
Fair value of note in 2018	(98,241)
Interest on note	(842)
Holding gain value	$1,852

Table (19)

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		7,065
		Notes Payable		935
		Cash			8,000
		(To record interest expense payment)

Table (20)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Notes Payable is a liability account. Since part of principal amount of the note is paid, 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.

Working Notes:

Refer to Table (2) for value and computation of interest expense value at fixed interest rate.

Compute notes payable value.

Step 1: Compute floating interest payment.

Computation of Floating Interest Payment
Fair Value of Note ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Floating Interest Payments (S)
$100935	$\times$	7%	$\times$	1 year	=	$7,065

Table (21)

Step 2: Compute notes payable value.

Particulars	Amount ($)
Cash paid (fixed interest)	$8,000
Interest expense amount	(7,065)
Notes payable amount	$935

Table (22)

Note: Refer to Table (2) for value and computation of interest expense value at fixed interest rate, and Table (21) for interest expense amount.

Entry for net interest receipt and accrued interest:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
December	31	Cash		1,000
		Holding Loss–Interest Rate Swap		0
		Interest rate Swap			935
		Interest Revenue			65
		(To record net interest settlement and decrease in fair value of swap from $935 to $0)

Table (23)

• Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
• Holding Loss–Interest Rate Swap is an expense 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 of derivative has increased, and an increase in liability is credited.
• Interest Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Compute interest rate swap value.

Particulars	Amount ($)
Fair value of interest rate swap in 2018	$0
Fair value of interest rate swap in 2017	935
Interest rate swap value	$(935)

Table (24)

Compute interest revenue from interest rate swap.

Computation of Floating Interest Payment
Fair Value of Swap ($)	$\times$	Floating Interest Rate	$\times$	Time Period	=	Interest Received (S)
$935	$\times$	7%	$\times$	1 year	=	$65

Table (25)

Compute holding loss on interest rate swap value.

Particulars	Amount ($)
Cash receipt	$1,000
Interest rate swap value	(935)
Interest revenue	(65)
Holding gain (loss) value	$0

Table (26)

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 (27)

• 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 (28)

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 ($)		Date	Details	Credit ($)
2018				2018
December 31	Holding gain	1,759		January 1	Cash	100,000
	Total	$0			Total	100,000
				December 31	Balance	$98,241
2019				2019
December 31				January 1	Balance	$98,241
					Holding loss	2,694
	Total	0			Total	$100,935
				December 31	Balance	$100,935
2020				2020
December 31	Holding gain	935		January 1	Balance	100,935
	Cash	100,000
	Total	100,935			Total	100,935
				December 31	Balance	$0

Table (29)

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)	(8,842)	(7,065)
Interest revenue (expense)		(158)	65
Holding gain (loss)–Interest rate swap	(2,759)	3,852	(0)
Holding gain (loss)–Hedged note	1,759	(1,852)	0
Net effect on earnings (Floating interest payment on swap)	(9,000)	(7,000)	(7,000)

Table (30)

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 (31)

• 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.

Entry for net interest receipt and accrued interest:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Interest Expense		0
		Holding Loss–Interest Rate Swap		2,759
		Interest Rate Swap			1,759
		Cash			1,000
		(To record net cash settlement, accrued interest, and decrease in fair value)

Table (32)

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited. (Since opening balance of fair value of interest rate swap is $0, the expense paid would be $0).
• Holding Loss–Interest Rate Swap is an expense 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 of derivative has increased, and an increase in liability is credited.
• Cash is an asset account. Since cash (net cash settlement) is paid, asset account decreased, 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 (33)

• 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.