On January 1, 2021, LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% 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 10% fixed interest rate on a notional amount of $200,000 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 10% at January 1, 8% at March 31, and 6% at 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 follows: January 1 March 31 June 30 Fair value of interest rate swap 0 $ 6,472 $ 11,394 Fair value of note payable $ 200,000 $ 206,472 $ 211,394 Required: 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:

1/01

Dr Cash $200,000  

Cr To notes payable  $200,000

31/03

Dr Interest expense $5,000  

Cr To cash  $5,000

Dr Cash $1,000  

Cr To interest expense  $1,000

Dr Interest rate swap (asset) $6,472

Cr Holding gain—interest rate $6,472

Dr Holding loss $6,472    

Cr  notes payable  $6,472

30/06

Dr  Interest expense $5,000  

Cr To cash  $5,000

Dr Cash $2,000

Cr To interest expense  $2,000

Dr Interest rate swap [asset] $4,922

Cr Holding gain—interest rate swap 4,922

Dr  Holding loss—hedged note $4,922

Cr Note payable  $4,922

Explanation:

Preparation of  the journal entries through June 30, 2021, to record the issuance of the note, interest, and necessary adjustments for changes in fair value

1/01

Dr Cash $200,000  

Cr To notes payable  $200,000

(To record  the issuance of the note)

31/03

Dr Interest expense $5,000  

Cr To cash  $5,000

(200,000 * 10% * 1/4)

( To record Interest)

Dr Cash $1,000  

[5,000 -(8%* 1/4 * 200,000)]

Cr To interest expense  $1,000

(To record the net Cash settlement)

Dr Interest rate swap (asset) $6,472

($6,472 – 0)

Cr Holding gain—interest rate $6,472

(To record change in net value of the derivative)

Dr Holding loss $6,472    

Cr  notes payable  $6,472

($206,472- $200,000)

(To record change in net value of the note)

30/06

Dr  Interest expense $5,000  

($200,000 * 10% * 1/4)

Cr To cash  $5,000

(To record Interest)

Dr Cash $2,000

[$5,000-(6% * 1/4 * $200,000)

Cr To interest expense  $2,000

(To record the net Cash settlement)

Dr Interest rate swap [asset] ($11,394 – 6,472)$4,922

Cr Holding gain—interest rate swap 4,922

(To record change in fair value of the derivative)

Dr  Holding loss—hedged note $4,922

Cr Note payable ($211,394 – 206,472) $4,922

(To record change in fair value of the note)

The journal entries through to record the issuance of the note, interest, and necessary adjustments for changes in fair value will be:

1st January:

31st March

30 June

It should be noted that the interest expense on 31st March was calculated as:

= 200000 × 10% × 1/4

= 5000

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