On January 1, 2021, Labtech Circuits borrowed $203,300 from First Bank by using a three-year, 8% note, payable on December 31, 2023. Labtech wanted to hedge the risk that general interest rates will decline, causing their fair value of its debt to increase. Therefore, Labtech entered into a three-year interest rate swap agreement on January 1, 2021, and designated the swap at fair value hedge. The agreement called for the company to receive payment based on an 8% fixed interest rate on a notional amount of $203,300 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 2021, 2022, and 2023, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. Those quoted and the fair values of the note are as follows:

Fair value of interest rate swap: January 1, 2021 =$0, December 31, 2021= ($2,700), December 31, 2022 = $1,900, December 31, 2023 = $0

Fair value of note payable: January 1, 2021 =$203,300, December 31, 2021= $200,600, December 31, 2022 = $205,200,

December 31, 2023 = $203,300

Required:

Calculate the net cash settlement at the end of 2021, 2022, and 2023.

Prepare the journal entries during 2021 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.

• Record the issuance of the note.
• Record the interest.
• Record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative.
• Record the change in fair value of the note due to interest.

Prepare the journal entries during 2022 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.

• Record the interest.
• Record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative.
• Record the change in fair value of the note due to interest.

Prepare the journal entries during 2023 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.

• Record the interest.
• Record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative.
• Record the change in fair value of the note due to interest.
• Record the repayment of the loan.

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

Swap Balance

December 31, 2021 =? (Credit/Debit)

December 31, 2022 =? (Credit/Debit)

December 31, 2023 =? (Credit/Debit)

Note Balance

December 31, 2021 =? (Credit/Debit)

December 31, 2022 =? (Credit/Debit)

December 31, 2023 =? (Credit/Debit)

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

Net effect on earnings:

2021 =

2022 =

2023 =

Suppose the fair value of the note at December 31, 2021, had been $197,000 rather than $200,600 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?

• Record the interest.
• Record the net cash settlement, accrued interest on the swap, and change in fair value of the derivative.
• Record the change in fair value of the note due to interest.