Question

On January 1, 2021, JPS Industries borrowed $300,000 from Austin Bank by issuing a three-year, floating rate note based on LIBOR, with interest payable semi-annually on June 30 and December of each year. JPS entered into a three-year interest rate swap agreement on January 1, 2021, and designated the swap as a cash flow hedge. The intent was to hedge the risk that interest rates will rise, increasing its semi-annual interest payments. The swap agreement called for the company to receive payment based on a floating interest rate on a notional amount of $300,000 and to pay a 6% fixed interest rate. The contract called for cash settlement of the net interest amount semi-annually, and the rate on each reset date (June 30 and December 31) determines the variable interest rate for the following six months.

LIBOR rates in 2021 were 6% at January 1, 5.5% at June 30, and 7% at December 31. The fair values of the swap on those dates, obtained by dealer quotes, were as follows:
January 1 June 30 December 31
Swap fair value $0 $(3,100) $4,000
Required:
1. Calculate the net settlement on June 30, 2021.
2. Prepare journal entries for the period January 1 to December 31, 2021, to record the note payable and hedging instrument, necessary adjustments for changes in fair value, and settlement of the swap contract.

Answer 1

Step-by-step explanation:

1)

To determine the net settlement;

For June 30th:

The net cash receipt = receiving floating interest - pay fixed interest

`=( \$300000 * 6\% * (1)/(2)) - (\$300000 * 6\% * (1)/(2))`

`=\$9000 - \$9000\\\\ = \$0`

For December 31st:

Net cash receipt =
`=( \$300000 * 5.5\% * (1)/(2)) - (\$300000 * 6\% * (1)/(2))`

`=\$8250 - \$9000\\\\ = \$750`

2)

Journal Entries for the period of January 1 to December 31, 2021

Date General Journal Debit ($) Credit($)

Jan 1 Cash Account/current (A/C) 300000

Note Payable Account/current 300000

To record the debt

June 30 Interest expense A/C

`(\$300000 * 6\% * (1)/(2))` 9000

To cash A/C 9000

June 30 other huge income (A/C)

(3100 - 0) 3100

Interest rate swap 3100

To record the change in

derivative fair value

At June 30, 2021;

Since the cash settlement is

focused on beginning-of-year

rates (when both fixed and floating

rates were 6%), there is no cash

exchanged for interest rate swap

settlement. It does recognize a fall in the

the fair value of the interest rate trade in the

following half-year because of lower

interest rates. Other comprehensive huge

income is calculated to reflect the decline

in fair value.

Dec 31 Interest expense A/C

`(\$300000 * 5.5\% * (1)/(2))` 8250

To cash A/C 8250

To record interest

Dec 31 Interest expense A/C

`(\$300000 * 6\% * (1)/(2))-\$8250` 750

To cash A/C 750

To record net cash settlement

Dec 31 Interest rate swap A/C 7100

other huge income 7100

To record change in derivative

of the fair value

$3100(June 30) + $4000(Dec 30)

(Fair value swap)