January 1, Year 1 Equipment ,000 Note Payable ,000

(1)

1

Web

This reading illustrates the accounting for the interest rate swaps in Examples 13 and 14 in Chapter 11. Web problem

DERIVATIVE 1 illustrates the accounting for the forward foreign exchange contract in Example 12 and DERIVATIVE 2

illustrates the accounting for the forward whiskey price contract in Example 15.

Fair Value Hedge: Interest Swap to Convert Fixed-Rate Debt

to Variable-Rate Debt

Refer to Examples 9 and 13 in Chapter 11. Firm B desires to maintain the market value of its note payable in the event

that it wishes to repay it prior to maturity. Changes in interest rates will change the market value of its fixed-rate note. It

enters into an interest swap contract to convert the fixed-rate debt into variable-rate debt. The net market value of the debt

and its related swap contract will remain at $100,000 as long as the interest rate incorporated into the swap contract is the

same as the rate used by the equipment supplier to value the note payable. Firm B designates the swap contract as a fair

value hedge.

Firm B issues the note to the supplier on January 1, Year 1, and makes the following entry:

January 1, Year 1

Equipment . . . 100,000

Note Payable . . . 100,000

The swap contract is a mutually unexecuted contract on January 1, Year 1. The variable interest rate on this date is 8

percent, the same as the fixed rate for the note to the equipment supplier. The swap contract has a market value of zero on

this date. Thus, Firm B makes no entry to record the swap contract.

On December 31, Year 1, Firm B makes the required interest payment on the note for Year 1:

December 31, Year 1

Interest Expense 0.08 x $100,000 . . . . 8,000

Cash . . . 8,000

Interest rates declined during Year 1. On December 31, the counterparty with whom Firm B entered into the swap

contract resets the interest rate for Year 2 to 6 percent. Firm B must restate the note payable to market value and record

the change in the market value of the swap contract caused by the decline in the interest rate.

The present value of the remaining cash flows on the note payable when discounted at 6 percent is:

Present Value of Interest Payments: $8,000 x 1.83339 . . . $ 14,667 Present Value of Principal: $100,000 x 0.89000 . . . 89,000 Total Present Value . . . $103,667 [See Table 4, 2-period row, 6% column for factor 1.83339 and Table 2, 2-period row, 6%

column for factor 0.89000]

I

llustrations of Accounting for Derivatives

Extension of Chapter 11

. . . 100,000 . . . 100,000 8,000 . . . 8,000 (0.08 x $100,000) . . .

(2)

Firm B makes the following entry to record the change in market value:

Loss on Revaluation of Note Payable . . . 3,667

Note Payable ($103,667 – $100,000) . . . 3,667

Firms typically do not revalue financial instruments, such as this note payable, to market value when interest rates change.

They continue to account for the financial instruments using the interest rate at the time of the initial recording of the

finan-cial instrument in the accounts. When a firm hedges a finanfinan-cial instrument, however, it must recognize changes in market

values. It must likewise recognize changes in the market value of the swap contract.

The decline in interest rates to 6 percent means that Firm B will save $2,000 each year in interest payments. The

pres-ent value of a $2,000 annuity for two periods at 6 percpres-ent is $3,667 (= $2,000 x 1.83339). Thus, the value of the swap

con-tract increased from zero at the beginning of Year 1 to $3,667 at the end of the year. Firm B makes the following entry:

Swap Contract . . . 3,667

Gain on Revaluation of Swap Contract . . . 3,667

The loss from the revaluation of the note payable exactly offsets the gain from the revaluation of the swap contract,

indi-cating that the swap contract was effective in hedging the interest rate risk.

Firm B follows a similar process at the end of Year 2. First, it records interest expense on the note payable:

Interest Expense 0.06 x $103,667 . . . . 6,220 Note Payable (plug) . . . 1,780

Cash (0.08 x $100,000) . . . 8,000

Firm B uses the effective interest method to compute interest expense for the year. The effective interest rate for Year 2 is

6 percent and the book value of the note payable at the beginning of the year is $103,667. The cash payment of $8,000 is

the amount set forth in the original borrowing arrangement with the equipment supplier.

Second, the firm records interest revenue for the change in the present value of the swap contract for the year.

Swap Contract . . . 220

Interest Expense 0.06 x $3,667 . . . 220

Interest expense (net) as a result of the two entries is $6,000 (= $6,220 – $220), which is the variable rate for Year 2 of 6

percent times the face value of the note.

Third, Firm B receives $2,000 under the swap contract from the counterparty because interest rate decreased from 8

percent to 6 percent.

Cash [$100,000 x (0.08 – 0.06)] . . . 2,000

The $2,000 cash received from the counterparty in a sense reimburses Firm B for paying interest at 8 percent on the note

whereas the swap contract provides that the firm benefits when interest rates decline, in this case to 6 percent.

Fourth, Firm B must revalue the note payable and the swap contract for changes in market value. Interest rates

increased during Year 2, so the bank resets the interest rate in the swap agreement to 10 percent for Year 3. The present

value of the remaining payments on the note at 10 percent is:

Present Value of Interest Payment: $8,000 x 0.90909 . . . $ 7,273 Present Value of Principal: $100,000 x 0.90909 . . . 90,909 Total Present Value . . . $98,182 . . . 3,667 . . . 3,667 . . . 3,667 . . . 3,667 . . . 6,220 . . . 1,780 . . . 8,000 . . . 220 . . . 220 . . . 2,000 . . . 2,000 (0.06 x $103,667) (0.06 x $3,667)

(3)

The book value of the note payable before revaluation is $101,887 (= $103,667 - $1,780). The entry to revalue the note

payable is:

Note Payable (Decrease in Book Value = $101,887 – $98,182) . . . 3,705 Gain on Revaluation of Note Payable . . . 3,705

The market value of the swap contract decreases. Firm B must now pay an additional $2,000 in interest to the counterparty

in Year 3 because of the swap contract. Thus, the swap contract becomes a liability instead of an asset. The present value

of $2,000 when discounted at 10 percent is $1,818 (= $2,000 x 0.90909). The book value of the swap contract before

reval-uation is an asset of $1,887 (= $3,667 + $220 – $2,000). The entry to revalue the swap contract is:

Loss on Revaluation of Swap Contract . . 3,705

Swap Contract . . . 1,887 Swap Contract . . . 1,818

The gain on revaluation of the note exactly offsets the loss on revaluation of the swap contract, so the swap contract hedges

the change in interest rates.

The entries for Year 3 are as follows:

Interest Expense 0.10 x $98,182 . . . 9,818

Note Payable (plug) . . . 1,818 Cash (0.08 x $100,000) . . . 8,000

Interest Expense 0.10 x $1,818 . . . 182

Interest expense (net) after these two entries is $10,000 (= $9,818 + $182), which equals the variable interest rate of 10

percent times the face value of the note.

Firm B must pay the counterparty an extra 2 percent because the variable interest rate of 10 percent exceeds the fixed

interest rate of 8 percent.

Swap Contract [$10,000 x (0.10 – 0.08)] . . . 2,000

Cash . . . 2,000

Firm B must also repay the note and close out the Swap Contract.

Note Payable ($98,182 + $1,818) . . . 100,000

Cash . . . 100,000

The Swap Contract account has a zero balance (= $1,818 + $182 – $2,000) on December 31, Year 3, after making the

entries above, so it need make no additional entries to close out this account.

. . . 3,705 . . . 3,705 . . . 3,705 . . . 1,887 . . . 1,818 . . . 9,818 . . . 1,818 . . . 8,000 . . . 2,000 . . . 2,000 . . . 100,000 . . . 100,000 . . . 182 . . . 182 (0.10 x $98,182) (0.10 x $1,818)

(4)

Exhibit 1 summarizes the effect of these entries on various accounts (credit entries in parentheses).

EXHIBIT 1 Effects on Various Accounts of $100,000 Fixed-Rate Note and Related Interest

Rate Swap Accounted for as a Fair-Value Hedge

Equipment Notes Swap Income Cash (at cost) Payable Contract Statement Year 1

Issue Note for Equipment . . . — $100,000 $(100,000) — — Enter Swap Contract . . . — — — — — Record Interest on Note . . . $ (8,000) — — — $ 8,000 Revalue Note Payable . . . — — (3,667) — 3,667 Revalue Swap Contract . . . — — — $ 3,667 (3,667)

December 31, Year 1 . . . $ (8,000) $100,000 $(103,667) $ 3,667 $ 8,000

Year 2

Record Interest on Note . . . (8,000) — 1,780 — $ 6,220 Record Interest on Swap Contract . . . — — — 220 (220) Record Swap Interest Received . . . 2,000 — — (2,000) — Revalue Note Payable . . . — — 3,705 — (3,705) Revalue Swap Contract . . . — — — (3,705) 3,705

December 31, Year 2 . . . $ (14,000) $100,000 $ (98,182) $(1,818) $ 6,000

Year 3

Record Interest on Note . . . (8,000) — (1,818) — $ 9,818 Record Interest on Swap Contract . . . — — — $ (182) 182 Record Swap Interest Paid . . . (2,000) — — 2,000 — Repay Note Payable . . . (100,000) — 100,000 — — December 31, Year 3 . . . $(124,000) $100,000 — — $10,000

Net income reflects the variable interest rate each year: 8 percent for Year 1, 6 percent for Year 2, and 10 percent for

Year 3. The note payable netted against the swap contract is $100,000 at the end of each year.

Cash Flow Hedge: Interest Swap to Convert Variable-Rate Debt

to Fixed-Rate Debt

Refer to Examples 10 and 14 in Chapter 11. Firm C desires to hedge the risk of changes in interest rates on its cash

payments for interest. It enters into a swap contract with a counterparty to convert its variable rate note payable to a fixed

rate note. Firm C designates the swap contract as a cash flow hedge. The facts for the case are similar to those for Firm B.

The note has a $100,000 face value, an initial variable interest rate of 8 percent, which the counterparty resets to 6 percent

for Year 2 and 10 percent for Year 3. The note matures on December 31, Year 3.

The entry to record the note payable is:

January 1, Year 1

Equipment . . . 100,000

Note Payable . . . 100,000

Firm C records interest on the note for Year 1.

Cash . . . 8,000

The market value of the note in this case, unlike that for Firm B, will not change as interest rates change because the note

carries a variable interest rate. The market value of the swap contract does change. The market value on December 31, Year

1, after the counterparty resets the interest rate to 6 percent is $3,667. This amount is the present value of the $2,000 that Firm

C will pay the counterparty on December 31 of Year 2 and Year 3 if the interest rate remains at 6 percent. The entry is:

. . . 100,000

. . . 8,000

. . . 8,000 (0.08 x $100,000)

(5)

Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract)

The loss from the revaluation of the swap contract does not affect net income immediately on a cash flow hedge. Instead,

it reduces other comprehensive income for Year 1 and accumulated other comprehensive income on December 31, Year 1.

Note that the book value of the note payable of $100,000 plus the book value of the swap contract of $3,667 is

$103,667. This amount is the present value of the expected cash flows under the variable rate note and swap contract

combined, discounted at 6 percent.

The entry on December 31, Year 2 to recognize and pay interest on the variable rate note is:

Cash . . . 6,000

Firm C must also increase the book value of the swap contract for the passage of time.

Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract

(0.06 x $3,667) . . . 220

Note that the interest charge does not affect net income immediately but instead decreases accumulated other

comprehensive income.

Firm C pays the counterparty the $2,000 [= $100,000 x (0.08 – 0.06)] required by the swap contract. The entry is:

Cash . . . 2,000

Because the swap contract hedged cash flows related to interest rate risk during Year 2, Firm C reclassifies a portion of

accumulated other comprehensive income to net income. The entry is:

Interest Expense $100,000 x (0.08 – 0.06) . . . 2,000 Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract)

The Swap Contract account has a credit balance of $1,887 (= $3,667 + $220 – $2,000). Accumulated other comprehensive

income on December 31, Year 2, related to this transaction likewise has a debit balance of $1,887. Interest Expense on the

income statement is $8,000 (= $6,000 + $2,000).

Restating the interest rate on December 31, Year 2, to 10 percent changes the value of the swap contract from a

liabil-ity to an asset. The present value of the $2,000 that Firm C will receive from the counterparty at the end of Year 3 when

discounted at 10 percent is $1,818. The entry to revalue to swap contract is:

Swap Contract . . . 1,887 Swap Contract . . . 1,818

Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract)

Accumulated other comprehensive income on December 31, Year 2, now has a credit balance of $1,818, which equals the

debit balance in the Swap Contract account.

(Unrealized Loss on Swap Contract) . . .

. . . 3,667 3,667 . . . 6,000 6,000 . . . . . . 220 220 . . . . . . 2,000 2,000 . . . 2,000 2,000 . . . (Unrealized Loss on Swap Contract) . . .

1,887 . . .

1,818 . . .

Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) . . . 1,887 1,818 (0.06 x $100,000)

)

Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract) . . . . [$100,000 x (0.08 – 0.06)]

(6)

The entry during Year 3 to recognize and pay interest on the variable rate note is:

Cash . . . 10,000

Firm C also increases the book value of the swap contract for the passage of time.

Swap Contract (0.10 x $1,818) . . . 182 Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract)

. . . 182

The swap contract requires the bank to pay the firm $2,000 under the swap contract.

Cash [$100,000 x (0.10 – 0.08)] . . . 2,000

Because the swap contract hedged cash flows related to interest rate risk during Year 3, Firm C reclassifies a portion of

other comprehensive income to net income. The entry is:

Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract) . . . 2,000 Interest Expense . . . 2,000

Interest expense for Year 3 is $8,000 (= $10,000 – $2,000).

Firm C repays the note on December 31, Year 3.

Notes Payable . . . 10,000

Cash . . . 10,000

It must also close out the swap contract account. This account has a balance of zero on December 31, Year 3 (= $1,818 +

$182 – $2,000). Thus, Firm C need make no entry. If the swap contract had been highly, but not perfectly, effective in

neu-tralizing the interest rate risk, then accumulated other comprehensive income would have a balance related to the swap

contract, which Firm C would reclassify to net income at this point.

Exhibit 2 summarizes the effect of these entries on various accounts (credit entries in parentheses).

EXHIBIT 2 Effect on Various Accounts of $100,000 Variable-Rate Note and Related Interest

Rate Swap Accounting for as a Cash-Flow Hedge

Other Equipment Notes Swap Income Compre. Cash (at cost) Payable Contract Statement Income Year 1

Issue Note for Equipment . . . — $100,000 $(100,000) — — — Enter Swap Contract . . . — — — — — — Record Interest on Note . . . $ (8,000) — — — $ 8,000 — Revalue Swap Contract . . . — — — $(3,667) — $ 3,667

December 31, Year 1 . . . $ (8,000) $100,000 $(100,000) $(3,667) $ 8,000 $ 3,667

(continued on next page)

. . . 10,000

10,000 . . . .

(Unrealized Gain on Swap Contract) . . . 182 . . . 182

. . . 2,000

. . . 2,000 (Unrealized Gain on Swap Contract) . . . 2,000

. . . 10,000 . . . 10,000

(7)

Year 2

Record Interest on Note . . . (6,000) — — — $ 6,000

Record Interest on Swap Contract . . . — — — (220) — 220 Record Swap Interest Paid . . . (2,000) — — 2,000 — — Reclassify Portion of Accumulated Other

Comprehensive Income . . . — — — — 2,000 (2,000) Revalue Swap Contract . . . — — — 3,705 — (3,705) December 31, Year 2 . . . $ (16,000) $100,000 $(100,000) $ 1,818 $ 8,000 $(1,818)

Year 3

Record Interest on Note . . . (10,000) — — — $10,000

Record Interest on Swap Contract . . . — — — 182 (182) Record Swap Interest Received . . . 2,000 — (2,000) — — Reclassify Portion of Accumulated Other

Comprehensive Income . . . — — — (2,000) 2,000 Repay Note Payable . . . (100,000) — 100,000 — —

Close Out Swap Contract . . . — — — — —

December 31, Year 3 . . . $(124,000) $100,000 — — $ 8,000 —

Note that interest expense is $8,000 each year, the fixed rate of 8 percent that Firm C accomplished by entering into

the swap contract. The amounts in other comprehensive income reflect changes in the market value of the swap contract.

The swap contract begins and ends with a zero value.

Problems

DERIVATIVE 1

Accounting for forward foreign exchange contract. Refer to Examples 8 and 11. Firm A places

its firm order for the equipment on June 30, Year 1. It simultaneously signs a forward foreign exchange contract for

£10,000 at the forward rate for June 30, Year 2, of $1.64 per £1. Firm A designates the forward foreign exchange contract

as a fair value hedge of the firm commitment.

a. GAAP do not require Firm A to record either the purchase commitment or the forward foreign exchange contract on

the balance sheet as a liability and an asset on June 30, Year 1. What is GAAP’s reasoning?

b. On December 31, Year 1, the forward foreign exchange rate for settlement on June 30, Year 2, is $1.73 per £1. Give the

journal entries to record the change in the value of the purchase commitment and the change in the value of the

for-ward contract for Year 1. Assume an 8 percent per year interest rate for discounting cash flows to their present values

on December 31, Year 1.

c. Give the journal entries on June 30, Year 2, to record the change in the present value of the purchase commitment and

the forward foreign exchange contract for the passage of time.

d. On June 30, Year 2, the spot foreign exchange rate is $1.75 per £1. Give the journal entries to record the change in the

value of the purchase commitment and the change in the value of the forward contract due to changes in the exchange

rate during the first six months of Year 2.

e. Give the journal entry on June 30, Year 2, to purchase £10,000 with U.S. dollars and acquire the equipment.

f. Give the journal entry on June 30, Year 2, to settle the forward foreign exchange contract.

DERIVATIVE 2

Accounting for forward commodity contract. Refer to the information for Firm D in Examples 11 and

15 in Chapter 11. Firm D holds 10,000 gallons of aging whiskey in inventory on October 31, Year 1, that cost $225 per

gallon. Firm D expects to complete aging of the whiskey on March 31, Year 2. On October 31, Year 1, it purchases a

for-ward contract for 10,000 gallons of whiskey for delivery on March 31, Year 2 at a price of $320 per gallon. The forfor-ward

price for whiskey on December 31, Year 1, for delivery on March 31, Year 2, is $310 per gallon. The spot price for whiskey

on March 31, Year 2, is $270 per gallon. Firm D sells the whiskey on this date for $270 per gallon. To simplify this

prob-lem, ignore the effects of the time value of cash.

a. Assume for this part that Firm D classifies the forward contract as a fair value hedge of the value of the inventory. Give

the journal entries for Firm D on October 31, Year 1, December 31, Year 1, and March 31, Year 2.

b. Assume for this part that Firm D classifies the forward contract as a cash flow hedge. Give the journal entries for Firm

D on October 31, Year 1, December 31, Year 1, and March 31, Year 2.

(8)

DERIVATIVE 3

Journal entries for hedging transactions. Fixed Issue Company issued 9 percent, fixed-rate,

semian-nual coupon bonds on January 1 at par for $10 million. It simultaneously entered into an interest-rate swap with

Counter-party Bank: Fixed will pay the bank at the end of each six-month period if interest rates at the beginning of the six-month

period

exceed 9 percent; and the bank will pay Fixed if interest rates at the beginning of the six-month period are below 9

percent. If the market rate is r at the beginning of each six-month period, then the bank will pay Fixed at the end of the

six-month period an amount equal to

1

_⁄

2

x (0.09 – r) x $10,000,000. The market interest rate is 9 percent at the time of issue.

Interest rates decrease to 6 percent by the end of the first six-month period, increasing the market value of the bonds to

$14 million and increasing the market value of the interest-rate swap to $3.8 million. By the end of the year, interest rates

rise to 7 percent and the market value of the bonds decreases to $12.75 million. The market value of the interest-rate swap

decreases to $2.7 million during the period from July 1 through December 31.

a. Record journal entries for the following dates: January 1, at the time of bond issue; June 30, at the time of the first

debt-service payments; and December 31, at the time of the second debt-debt-service payments.

b. Is this a fair-value hedge or a cash-flow hedge? Has the hedge fulfilled its purpose?

DERIVATIVE 4

Journal entries for hedging transactions. On January 1, when the interest rate is 9 percent per year,

Floating Issue Company issued at par $10 million of variable-rate bonds, with semiannual interest payments based on the

market interest rate at the beginning of each six-month period. It simultaneously entered into an interest-rate swap with

Counterparty Bank: it agrees to pay the bank at the end of each six months the difference between 9 percent interest and

any variable interest rate below 9 percent as of the beginning of the six-month period; the bank agrees to pay Floating for

any difference between the variable rate and 9 percent when the variable rate exceeds 9 percent at the beginning of the

six-month period.

If the market rate is r at the beginning of the six-month period, then Floating will pay the bank at the end

of the six-month period an amount equal to

1

_⁄

2