On January 1, 2021, Labtech Circuits borrowed $280,000 from First Bank by issuing a three-year, 9% note, payable on December 31, 2023. 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, 2021, and designated the swap as a fair value hedge. The agreement called for the company to receive payment based on an 9% fixed interest rate on a notional amount of $280,000 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 9% at inception and 10%, 8%, and 8% at the end of 2021, 2022, and 2023, 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			December 31
	2021			2021			2022			2023
Fair value of interest rate swap		0		$	(3,559	)	$	2,735		$	0
Fair value of note payable	$	280,000		$	276,441		$	282,735		$	280,000

Required:

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

Date	Swap Balance		Note Balance
December 31, 2021
December 31, 2022
December 31, 2023

6. 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

7. Suppose the fair value of the note at December 31, 2021, had been $267,000 rather than $276,441 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?

1 Record the interest.

2 Record the net cash interest settlement for the interest rate swap.

3 Record the change in fair value of the derivative.

4 Record the change in fair value of the note.