On January 1, 2016, LLB Industries borrowed $370,000 from Trust Bank by issuing

Question

On January 1, 2016, LLB Industries borrowed $370,000 from Trust Bank by issuing a two-year, 8% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2016, 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 8% fixed interest rate on a notional amount of $370,000 and to pay interest based on a floating interest rate. The contract called for cash settlement of the net interest amount quarterly.

Floating (LIBOR) settlement rates were 8% at January 1, 6% at March 31, and 4% June 30, 2016. 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.

January 1 March 31 June 30   Fair value of interest rate swap 0    $ 8,172    $ 14,794      Fair value of note payable

A.Calculate the net cash settlement at March 31 and June 30, 2016

B. Prepare the journal entries through June 30, 2016, to record the issuance of the note, interest, and necessary adjustments for changes in fair value. $ 370,000    $ 378,172    $ 384,794   

Explanation / Answer

1) Net cash settelment at 31st march 2016

Fixed Rate receivable = $ 370000*8%*4/12 = $ 7400

Floting Rate = $ 370000*6%*4/12 = $ 5550

Net Cash receivable = $ 1850

2) Net cash settelment at 30 June 2016

Fixed Rate receivable = $ 370000*8%*4/12 = $ 7400

Floting Rate = $ 370000*4%*4/12 = $ 3700

Net Cash receivable = $ 3700

Journal Entries

Jan 1, 2016

1) Cash A/c $ 370000

To Note payable $370000

March 31, 2016

2) Cash A/c $ 1850

Profit on swap $ 1850

3) Loss on revaluation of note payable $ 8172 (WN-1)

To Note Payable $ 8172

30 June 2016

4) Cash A/c $3700

To Profit on Swap $ 3700

5) Loss on revaluation of note payable $ 6622 (WN-2)

To Note Payable $ 6622

Working Note

WN-1 ) Fair value of Note payable = 378172

Note payable current value= 370000

Loss on revaluation = 378172-370000

WN-2 ) Fair value of Note payable = 384794

Note payable current value= 378172

Loss on revaluation = 384794-378172= 6622

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