(Note: This is a variation of Problem A-1, modified to consider the extended method demonstrated in Illustration A-3.)

On January 1, 2016, Labtech Circuits borrowed $100,000 from First Bank by issuing a three-year, 8% note, payable on December 31, 2018. 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, 2016, 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 2016, 2017, and 2018, respectively. 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	December 31
	2016	2016 2017	2018
Fair value of interest rate swap	0	$ (1,759) $ 935	0
Fair value of note payable	$100,000	$ 98,241 100,935	$100,000

Required:

Use the extended method demonstrated in Illustration A-3.

1. Calculate the net cash settlement at the end of 2016, 2017, and 2018.

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2. Prepare the journal entries during 2016 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

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3. Prepare the journal entries during 2017 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.

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4. Prepare the journal entries during 2018 to record interest, net cash interest settlement for the interest rate swap, necessary adjustments for changes in fair value, and repayment of the debt.

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5. Calculate the book values of both the swap account and the note in each of the three years.

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

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7. Suppose the fair value of the note at December 31, 2016, 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?

Problem A-1

On January 1, 2016, Labtech Circuits borrowed $100,000 from First Bank by issuing a three-year, 8% note, payable on December 31, 2018. 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, 2016, 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 2016, 2017, and 2018, 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:

	January 1	March 31	June 30
Fair value of interest rate swap	0	$ 6,472	$ 11,394
Fair value of the investment in notes	$200,000	$206,472	$211,394

Required:

1. Calculate the net cash settlement at the end of 2016, 2017, and 2018.

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2. Prepare the journal entries during 2016 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

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3. Prepare the journal entries during 2017 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.

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4. Prepare the journal entries during 2018 to record interest, net cash interest settlement for the interest rate swap, necessary adjustments for changes in fair value, and repayment of the debt.

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5. Calculate the book values of both the swap account and the note in each of the three years.

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

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7. Suppose the fair value of the note at December 31, 2016, 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?

Illustration A-3

Illustration A–3 Interest Rate Swap—Extended Method