Question

On January 1, 2013, Marshall Corp. issues $500,000 in 5.0% fixed rate debt with interest payments due every six months. Concurrently, Marshall enters into an interest rate swap in which it receives 5.0% fixed and pays variables at average LIBOR + 65 bp on a nontional amount of $500,000. On June 30, 2013, LIBOR averaged 3.2% during the six-month period. The estimated fair value of the swap to Marshall increased $50,000 on June 30, 2013, and the fair value of the debt is $550,000.

a. Prepare the journal entries made by Marshall on January 1 and June 30 in connection with the debt issuance, the periodic interest, and value changes in the swap and debt.
Did market interest rates increase or decrease during this period? How do you know?
A) The market interest rates decreased, since the present value of the debt decreased.
B) The market interest rates increased, since the present value of the debt increased.
C) The market interest rates decreased, since the present value of the debt increased.
D) The market interest rates increased, since the present value of the debt decreased.
b. Suppose instead that Marshall issued variable rate debt and entered a swap in which it receives variable and pays fixed. If the market rate of interest on its variable rate debt declines, does Marshall recognize a gain or loss on the swap and what is its accounting treatment?

Answer 1

1)

Dr Cash 500,000

Cr Bonds payable 500,000

Dr Interest expense 12,500

Cr Cash 9,625

Cr Unrealized gain 2,875

• C) The market interest rates decreased, since the present value of the debt increased.

When interest rates decrease, the fair market value of debt increases. When the FMV of debt increases, the company's liabilities increase. When the interest rates increase, the opposite happens.

In this case, since the FMV increased, this means that the interest rates decreased.

2)

If Marshall entered a swap where it received variable interest and paid fixed, and the variable interest decreased, it would need to record an unrealized loss on the swap. They will be paying more interest than what they are receiving.