Exhibit 11.12 describes Chalk Hill’s use of an interest rate swap to hedge its cash flow exposure to interest rate risk from variable rate debt. The journal entries in the exhibit illustrate how special “hedge accounting” rules apply to the swap. Suppose instead that the swap did not qualify for special hedge accounting—but that all other aspects of the transaction remain as described in the exhibit.

Required:
Prepare the journal entries needed to account for the variable rate debt and swap transaction for January 1, 2008 through December 31, 2010.

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EXHIBIT 11.12 Using an Interest Rate Swap to Hedge Variable Rate Debt On January 1, 2008, Chalk Hill borrows $10 million by signing a three-year note with interest equal to the LIBOR (currently at 7.5%), reset annually on December 31. To hedge its exposure to the variability in cash flows associated with the floating rate note, Chalk Hill enters into a three-year interest rate swap with Beringer Bank. Under the swap contract, Chalk Hill pays interest to the bank at the fixed 7.5% rate and receives interest payments from the bank at a variable rate equal to the LIBOR, based on a notional amount of $10 million. Both the note and swap require that payments be made or received annually on December 31 of each year. Chalk Hill designates the swap (hedging instrument) as a cash flow hedge of its exposure to variability in the cash flows of the floating-rate note (hedged item) with the specific risk being changes in cash flows due to changes in the LIBOR rate. This hedge is fully effective because the key terms of the note and swap are identical. The LIBOR rates, cash payments made and received, and the fair value of the swap contract (based on dealer quotes) are: Gross Cash Flow LIBOR Rate To Beringer Bank From Beringer Bank Net Cash Flow January 1, 2008 7.50% $750,000 $750,000 December 31, 2008 8.50 December 31, 2009 7.00 750,000 750,000 850,000 700,000 $100,000 (50,000) Swap Fair Value Asset (Liability) from Dealer Quotes $323,000 (55,000) Swap contracts are not traded in an organized exchange (such as the NYMEX where copper futures contracts are traded), so contract fair values can be difficult to determine. Chalk Hill's fair value estimates ("quotes") are from knowledgeable "dealers" (usually investment banks) who are actively involved in structuring swap transactions.*