Question

On January 1, 2017, Four Brothers Manufacturing borrowed $10 million from Guiffrie Bank by signing a three-year, 8.0% fixed-rate note. The note calls for interest to be paid annually on December 31. The company then entered into an interest rate swap agreement with Herman Bank. The agreement calls for Four Brothers to receive a fixed-rate of 8.0% and pay a variable LIBOR rate based on a $10 million notional amount each December 31 for three years. Four Brothers will receive or pay a net amount on each December 31. The variable LIBOR rate resets every December 31 and establishes the receipt or payment for the following year. The LIBOR rate for the first year is 8.0%. Four Brothers designates the swap as a hedge of its fair value exposure to interest rate risk on its fixed-rate note. The hedge is fully effective because the key terms of the note and swap are identical. The variable rate was reset to 8.25% on December 31, 2017, and to 7.75% on December 31, 2018. Four Brothers uses a December 31 year-end and records interest expense annually.

Required:

How much net cash settlement will Four Brothers pay to (or receive from) Herman Bank on December 31 from 2017 to 2019?

How much cash will Four Brothers pay to Guiffrie Bank on December 31 from 2017 to 2019?

On December 31, 2017, the swap has a fair value of $(45,000), a negative amount, and the fair value of the $10 million note was $9,955,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2017.

On December 31, 2018, the swap has a fair value of $23,000, and the fair value of the $10 million note was $10,023,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2018.

Answer 1

1. How much net cash settlement will Four Brothers pay to (or receive from) Herman Bank on December 31 from 2017 to 2019?

2. How much cash will Four Brothers pay to Guiffrie Bank on December 31 from 2017 to 2019?

3.On December 31, 2017, the swap has a fair value of $(45,000), a negative amount, and the fair value of the $10 million note was $9,955,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2017.

4. On December 31, 2018, the swap has a fair value of $23,000, and the fair value of the $10 million note was $10,023,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2018.

Refer to the below images for more detailed solution with explanation.

cash settlements on Swap: Requirement 2017 2018 2019 & 10 000 000 * (0.08-0.08) 10 000 000 X (0-08-0.0 825) $10 000 000 X 70.08-000775) $ (Q5000) $ 25000 The December 31, 2017 "net cash settlement for four brothers is aero because the fixed-rate and the variable rate are same, I Zooooo on December 31, 2018 Four brothers will pay a $25000 Cash Settlement to Herman because the Variable rate payment is greater than the fixed rate payment En 2019 the patter is reversed and four brothers received $ 25000 -- - ② ③: cash paid to Guittre on bond: peaquirement (0.08 * $ 10000000 Four each Brothers December 3) pays Griffrie from 2017 Bank & 800000 to 2019. int : joomal entries (2014): The Swap in the When the Contract has zero value problem Statement, so contract is signed. at there inception, as is no entry indicated made

I The following entries are made on Dec 31, 2017 : credit Debit $ 800000 particolars Interest expense ale or To cash Al (Being to record the fixed a rate interest the Guitfrie Bank loan 2017) $800000 on * $4560o Guitfrie Bank loan (deht) Alc or & 45000 To Gain (loss) on hedge activity (Being to record the change in fair value of the fixed -rate debt that is attributable. to changes in interest rates at the end of 2017) $45000 Gain $ 45000 Closs) on hedge activity Alc or To swap contract to record the change in tur value of the Swap Contract) (Being for * No entry the is Swap made to record net contract because it cash is settlement zero. to jornal entries (2013) The following Dec 31, 2018: journal entries are made on Revorgement Debit credit particolars 1 800 000 $ 8.000 Interest expense Alc or To cast Atc (Being to record the fixed-rate interest on the Guiffesie Bank loan 2018)

particolars Debit credit $asto 25000 Interest exponse Ate Dr To cast Al (Being to record the net cash settlement" payment to Herman banks $6800* Ale Dr $ 68000 Gain Closs) on hedge activity ale Dr To uittrie Bank lon (debt) Alc (Being to record the change in fair value of the fixed arate debt that is attributable to changes in interest raty at the end of 2018) @ $40023000 - $9955000 $ 68000 (2008 fair valwe) (2017 fair value) 68000 68000 Swap contract Alc or T o Gain Closs) on hedge activity (Being to record the change in dair value of the Swap contract) The $ 68000 is computed by subtracting the corrent balance of $ (45000) from the desired balance of $25000 The calculation is shown visually in the following I - account. Swap contract 45000 12/31/17 journal entry 45000 12/31/17 balance 6 food 23000 Journal entry needed 12/30/18 Fair vake