Part 2 (30 Points) Anwer File

Example 5.13--Cash Flow Hedge of a Variable-Rate Loan with an Interest Rate Swap

As of January 1, 20X1, Bank A originates a three-year, $10,000,000 loan receivable that matures on December 31, 20X3.  The interest rate earned on the loan is variable at LIBOR plus 2 percent.  Concerned that interest rates will decline, Bank A simultaneously enters into a three-year interest rate swap with a notional amount of $10,000,000 to receive interest at a fixed rate equal to 7 percent and pay interest at a variable rate equal to LIBOR.  The combination of the swap and the loan receivable results in a net cash inflow of 9 percent.  Both the loan receivable and interest rate swap require payments to be made or received, and to reprice, on December 31.   Bank A has designated the swap as a cash flow hedge of the interest rate risk attributable to the forecasted interest receipts on the loan receivable.

Assumptions:

• All criteria for cash flow hedge accounting have been met.
• The hedging relationship is expected to be 100 percent effective at inception and on an ongoing basis (i.e., the changes in present value of the expected future cash flows on the hedged LIBOR plus 2 percent loan are expected to be offset completely by the changes in the cash flows on the interest rate swap).
• In all years, the cumulative gains or losses on the interest rate swap will equal the cumulative change in expected future cash flows on the hedged transaction.
• The loan debtor and the interest rate swap counterparty have comparable credit quality.   There are no changes in creditworthiness that would alter the effectiveness of the hedge.
• The interest rate swap was issued at market rates; therefore, Bank A neither received nor paid cash to enter into this swap.
• The LIBOR rates and related amounts are as follows:
  
  

  	Rate For Coming Year	(A) Swap Receive Net (Pay) at End of Year	(B) Loan Receive at End of Year	(A) + (B) Hedge Receive (Pay) at End of Year
  01/01/X1 12/31/X1 12/31/X2	7% 6% 5%	$            -- 100,000 200,000	$900,000   800,000   700,000	$900,000   900,000   900,000

• The fair value of the interest rate swap and changes therein at the end of each accounting period after cash settlement is as follows:
  
  

  	Fair Value	Change in Fair Value Gain (Loss)
  01/01/X1 12/31/X1 12/31/X2 12/31/X3	$            -- 300,000 125,000              --	n/a $300,000   (175,000)   (125,000)

What are the journal entries?

Answer

The following journal entries must be made on January 1, 20X1 and December 31, 20X1, 20X2, and 20X3 (ignore interim reporting):

a)    There are no entries on January 1, 20X1, as the swap is entered into at market rates
       and no cash was exchanged at inception.  The origination of the loan is ignored for
       purposes of the illustration.

b)    The journal entries on December 31, 20X1:
        1.    Dr.     Cash (B/S)                                                                900,000
               Cr.     Interest income (P&L)                                                               900,000
(To record the interest received on the LIBOR + 2% loan)

        2.    Dr.     Interest rate swap (B/S)                                             300,000
               Cr.     Other comprehensive income (OCI)                                          300,000
(To record the interest rate swap in the statement of financial position at fair value)

c)    The journal entries on December 31, 20X2:
        1.    Dr.     Cash (B/S)                                                                 800,000
               Cr.     Interest income (P&L)                                                                800,000
(To record the interest received on the LIBOR + 2% loan)

        2.    Dr.     Cash (B/S)                                                                 100,000
               Cr.     Other comprehensive income                                                      100,000
(To record the cash received on the settlement of the interest rate swap in OCI)

        3.    Dr.     Other comprehensive income                                      100,000
               Cr.     Interest income (P&L)                                                                  100,000
(To reclassify into earnings amounts in OCI on account of the hedge.  This is the adjustment required to bring interest income on the loan to $900,000)

        4.    Dr.    Other comprehensive income (OCI)                             175,000
               Cr.     Interest rate swap (B/S)                                                                 175,000

(To adjust the carrying value of the interest rate swap to current fair value)

d)    The journal entries on December 31, 20X3:
        1.    Dr.     Cash (B/S)                                                                   700,000
               Cr.     Interest income (P&L)                                                                 700,000
(To record the interest received on the LIBOR plus 2% loan)

        2.    Dr.     Cash (B/S)                                                                   200,000
               Cr.     Other Comprehensive Income                                                     200,000
(To record the cash received on the settlement of the interest rate swap in OCI)

         3.    Dr.     Other Comprehensive Income                                     200,000
                Cr.     Interest income (P&L)                                                                200,000
(To reclassify into earnings amounts in AOCI on account of the hedge.  This is the adjustment required to bring interest income on the loan to $900,000)

        4.    Dr.     Other comprehensive income (OCI)                             125,000
               Cr.     Interest rate swap (B/S)                                                              125,000
(To adjust the carrying value of the interest rate swap to current fair value)

d)    The journal entries on December 31, 20X3:
        1.    Dr.     Cash (B/S)                                                                   700,000
               Cr.     Interest income (P&L)                                                                700,000
(To record the interest received on the LIBOR plus 2% loan)

        2.    Dr.     Cash (B/S)                                                                   200,000
               Cr.     Other Comprehensive Income                                                    200,000
(To record the cash received on the settlement of the interest rate swap in OCI)

        3.    Dr.     Other Comprehensive Income                                       200,000
               Cr.     Interest income (P&L)                                                                200,000
(To reclassify into earnings amounts in OCI on account of the hedge.  This is the adjustment required to bring income on the loan to $900,000)

        4.    Dr.     Other comprehensive income (OCI)                             125,000
               Cr.     Interest rate swap (B/S)                                                             125,000
(To adjust the carrying value of the interest rate swap to current fair value)

Observations:

As a result of entering into the hedging relationship, Bank A has locked in a 9 percent rate for the term of the loan.  From a statement of financial position perspective, however, the requirement to report the derivative hedging instrument in the statement of financial position at fair value results in volatility in Bank A's accumulated other comprehensive income.  This is evidenced by the following: