On January 1, 2011, Labtech Circuits borrowed $100,000 from First Bank by issuing a three-year, 8% note,

Question:

On January 1, 2011, Labtech Circuits borrowed $100,000 from First Bank by issuing a three-year, 8% note, payable on December 31, 2013. 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, 2011, 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 2011, 2012, and 2013, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. These quotes and the fair values of the note are as follows:

Required:

1. Calculate the net cash settlement at the end of 2011, 2012, and 2013.

2. Prepare the journal entries during 2011 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

3. Prepare the journal entries during 2012 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.

A-18

4. Prepare the journal entries during 2013 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. Calculate the carrying values of both the swap account and the note in each of the three years.

6. Calculate the net effect on earnings of the hedging arrangement in each of the three years. (Ignore income taxes.)

7. Suppose the fair value of the note at December 31, 2011, 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?