Question

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Exercise A-2 (Algo) Derivatives; interest rate swap; fixed rate debt [LOA-2] On January 1, 2021. LLB Industries borrowed $210,000 from Trust Bank by issuing a two-year, 12% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 12% fixed interest rate on a notional amount of $210,000 and to pay interest based on a floating interest rate. The contract called for cash settlement of the net interest amount quarterly. Kipped Floating (LIBOR) settlement rates were 12% at January 1, 10% at March 31, and 8% June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. Book Fair value of interest rate swap Fair value of note payable January 1 0 $ 210,000 March 31 $ 6,572 $216,572 June 30 $ 11,594 $ 221,594 Hint Ask Required: 1. Calculate the net cash settlement at March 31 and June 30, 2021. 2. Prepare the journal entries through June 30, 2021, to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

Answer 1

Required 1:
Fixed rate amount: Notional principal x fixed rate %/(semi-annual (2), annual (1) or quarterly (4))
Floating rate amount: Notional principal x floating rate %/(semi-annual (2), annual (1) or quarterly (4))
Net cash settlement: Fixed rate amount - Floating rate amount
	Mar-31	Jun-30
Fixed rate amount	6,300	6,300
Floating rate amount	5,250	4,200
Net cash settlement	1,050	2,100
Required 2:
1. To record the issuance of the note
Date	Journal	Debit	Credit
Jan-01	Cash	210,000
	Notes payable		210,000
2. To record the interest
Date	Journal	Debit	Credit
Mar-31	Interest expense	6,300
	Cash		6,300
3. To record the net cash settlement
Date	Journal	Debit	Credit
Mar-31	Cash	1,050
	Interest expense		1,050
4. To record the change in fair value of the derivative
Date	Journal	Debit	Credit
Mar-31	Interest rate swap (asset)	6,572
	FV gain on Interest rate swap		6,572
5. To record the change in fair value of the note
Date	Journal	Debit	Credit
Mar-31	FV loss on Notes payable	6,572
	Notes payable		6,572
6. To record the interest
Date	Journal	Debit	Credit
Jun-30	Interest expense	6,300
	Cash		6,300
7. To record the net cash settlement
Date	Journal	Debit	Credit
Jun-30	Cash	2,100
	Interest expense		2,100
8. To record the change in fair value of the derivative
Date	Journal	Debit	Credit
Jun-30	Interest rate swap (asset)	5,022
	FV gain on Interest rate swap		5,022
9. To record the change in fair value of the note
Date	Journal	Debit	Credit
Jun-30	FV loss on Notes payable	5,022
	Notes payable		5,022