INTERMEDIATE ACCOUNTING
INTERMEDIATE ACCOUNTING
8th Edition
ISBN: 9780078025839
Author: J. David Spiceland
Publisher: McGraw-Hill Education
Question
Book Icon
Chapter A, Problem A.3P

 (1)

To determine

Derivatives: Derivatives are some financial instruments which are meant for managing risk and safeguard the risk created by other financial instruments. These financial instruments derive the values from the future value of underlying security or index. Some examples of derivatives are forward contracts, interest rate swaps, futures, and options.

Interest rate swap: This is a type of derivative used by two parties under a contract to exchange the consequences (net cash difference between interest payments) of fixed interest rate for floating interest rate, or vice versa, without exchanging the principal or notional amounts.

The net cash settlement as at December 31, 2016, 2017, and 2018.

 (1)

Expert Solution
Check Mark

Explanation of Solution

Determine the net cash settlement as at December 31, 2016.

Particulars Amount ($)
Fixed interest payments $8,000
Floating interest payments (9,000)
Net interest receipts (payments) $(1,000)

Table (1)

Working Notes:

Compute fixed interest receipts.

Computation of Fixed Interest Receipts
Notional Amount ($) × Fixed Interest Rate × Time Period = Fixed Interest Receipts (S)
$100,000 × 8% × 1 year = $8,000

Table (2)

Compute floating interest payments.

Computation of FloatingInterest Payments
Notional Amount ($) × Floating Interest Rate × Time Period = FloatingInterest Payments (S)
$100,000 × 9% × 1 year = $9,000

Table (3)

Determine the net cash settlement as at December 31, 2017.

Particulars Amount ($)
Fixed interest payments $8,000
Floating interest payments (7,000)
Net interest receipts (payments) $1,000

Table (4)

Working Notes:

Refer to Table (2) for value and computation of fixed interest payments.

Compute floating interest payments.

Computation of FloatingInterest Payments
Notional Amount ($) × Floating Interest Rate × Time Period = FloatingInterest Payments (S)
$100,000 × 7% × 1 year = $7,000

Table (5)

Determine the net cash settlement as at December 31, 2018.

Particulars Amount ($)
Fixed interest payments $8,000
Floating interest payments (7,000)
Net interest receipts (payments) $1,000

Table (6)

Working Notes:

Refer to Table (2) for value and computation of fixed interest payments.

Compute floating interest payments.

Computation of FloatingInterest Payments
Notional Amount ($) × Floating Interest Rate × Time Period = FloatingInterest Payments (S)
$100,000 × 7% × 1 year = $7,000

Table (7)

(2)

To determine

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

  • Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
  • Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2016

(2)

Expert Solution
Check Mark

Explanation of Solution

Entry for issuance of note:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
January 1 Cash   100,000
           Notes Payable   100,000
(To record issuance of note)

Table (8)

  • Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
  • Notes Payable is a liability account. Since obligation to pay the note increased, liability increased, and an increase in liability is credited.

Entry for interest expense payment:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Interest Expense   8,000
           Cash   8,000
(To record interest expense payment)

Table (9)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Entry for net interest receipt and accrued interest:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Interest Expense   0
    Holding Loss–Interest Rate Swap   2,759
           Interest Rate Swap     1,759
           Cash     1,000
(To record net cash settlement, accrued interest, and decrease in fair value)

Table (10)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited. (Since opening balance of fair value of interest rate swap is $0, the expense paid would be $0).
  • Holding Loss–Interest Rate Swap is an expense account. Since interest rate increased causing holding loss increase, which decrease equity, so equity value is decreased, and a decrease in equity is debited.
  • Interest Rate Swap is a liability account because the fair value of derivative has increased, and an increase in liability is credited.
  • Cash is an asset account. Since cash (net cash settlement) is paid, asset account decreased, and a decrease in asset is credited.

Entry for changes in fair value of note:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Notes Payable   1,759
             Holding Gain–Hedged Note   1,759
(To record decrease in fair value from $100,000 to $98,241)

Table (11)

  • Notes Payable is a liability account. Since fair value of the note decreased, liability decreased, and a decrease in liability is debited.
  • Holding Gain–Hedged Note is a revenue account. The fair value of hedged liability has decreased causing a holding gain. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.

(3)

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2017.

(3)

Expert Solution
Check Mark

Explanation of Solution

Entry for interest expense payment:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2017        
December 31 Interest Expense   8,842
           Notes Payable     842
           Cash   8,000
(To record interest expense payment)

Table (12)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Notes Payable is a liability account. Since part of principal amount of the note has increased, liability increased, and an increase in liability is credited.
  • Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Refer to Table (2) for value and computation of interest expense value at fixed interest rate.

Compute notes payable value.

Step 1: Compute floating interest payment.

Computation of Floating Interest Payment
Fair Value of Note ($) × Floating Interest Rate × Time Period = FloatingInterest Payments (S)
$98,241 × 9% × 1 year = $8,842

Table (13)

Step 2: Compute notes payable value.

Particulars Amount ($)
Interest expense amount $8,842
Cash paid (8,000)
Notes payable amount $842

Table (14)

Note: Refer to Table (2) for value and computation of interest expense value at fixed interest rate, and Table (13) for interest expense amount.

Entry for net interest receipt and accrued interest:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2017        
December 31 Cash   1,000
    Interest rate Swap   2,694
    Interest Expense   158  
         Holding Gain–Interest Rate Swap     3,852
(To record net cash settlement and increase in fair value of swap from $(1,759) to $935)

Table (15)

  • Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
  • Interest Rate Swap is an asset account because the fair value has increased from $(1,759) to $935 causing an increase of $2,694, and an increase in asset is debited.
  • Interest Expense is an expense account. Since fixed interest payment is received as per the agreement, the expense value increased, and an increase in expense is debited.
  • Holding Gain–Interest Rate Swap is a revenue account. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Compute interest revenue from interest rate swap.

Computation of Floating Interest Payment
Fair Value of Swap ($) × Floating Interest Rate × Time Period = Interest Received (S)
$1,759 × 9% × 1 year = $159

Table (16)

Compute holding gain on interest rate swap value.

Particulars Amount ($)
Cash receipt $1,000
Interest rate swap value 2,694
Interest revenue 159
Holding gain value $3,852

Table (17)

Entry for changes in fair value of note:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2017        
December 31 Holding Loss–Hedged Note   1,852
             Note Payable   1,852
(To record increase in fair value from $98,241 to $100,935)

Table (18)

  • Holding Loss–Hedged Note is a loss account. The fair value of hedged liability has increased causing a holding loss. Since holding losses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Notes Payable is a liability account. Since fair value of the note increased, liability increased, and an increase in liability is credited.

Working Notes:

Compute notes payable value.

Particulars Amount ($)
Fair value of note in 2017 100,935
Fair value of note in 2016 (98,241)
Interest on note (842)
Holding gain value $1,852

Table (19)

(4)

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2018.

(4)

Expert Solution
Check Mark

Explanation of Solution

Entry for interest expense payment:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2018        
December 31 Interest Expense   7,065
    Notes Payable   935  
           Cash   8,000
(To record interest expense payment)

Table (20)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Notes Payable is a liability account. Since part of principal amount of the note is paid, liability decreased, and a decrease in liability is debited.
  • Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Working Notes:

Refer to Table (2) for value and computation of interest expense value at fixed interest rate.

Compute notes payable value.

Step 1: Compute floating interest payment.

Computation of Floating Interest Payment
Fair Value of Note ($) × Floating Interest Rate × Time Period = FloatingInterest Payments (S)
$100935 × 7% × 1 year = $7,065

Table (21)

Step 2: Compute notes payable value.

Particulars Amount ($)
Cash paid (fixed interest) $8,000
Interest expense amount (7,065)
Notes payable amount $935

Table (22)

Note: Refer to Table (2) for value and computation of interest expense value at fixed interest rate, and Table (21) for interest expense amount.

Entry for net interest receipt and accrued interest:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2018        
December 31 Cash   1,000
    Holding Loss–Interest Rate Swap   0  
                 Interest rate Swap     935
                 Interest Revenue     65
(To record net interest settlement and decrease in fair value of swap from $935 to $0)

Table (23)

  • Cash is an asset account. Since cash is received, asset account increased, and an increase in asset is debited.
  • Holding Loss–Interest Rate Swap is an expense account. Since interest rate increased causing holding loss increase, which decrease equity, so equity value is decreased, and a decrease in equity is debited.
  • Interest Rate Swap is a liability account because the fair value of derivative has increased, and an increase in liability is credited.
  • Interest Revenue is a revenue account. Since revenues increase equity, equity value is increased, and an increase in equity is credited.

Working Notes:

Compute interest rate swap value.

Particulars Amount ($)
Fair value of interest rate swap in 2016 $0
Fair value of interest rate swap in 2017 935
Interest rate swap value $(935)

Table (24)

Compute interest revenue from interest rate swap.

Computation of Floating Interest Payment
Fair Value of Swap ($) × Floating Interest Rate × Time Period = Interest Received (S)
$935 × 7% × 1 year = $65

Table (25)

Compute holding loss on interest rate swap value.

Particulars Amount ($)
Cash receipt $1,000
Interest rate swap value (935)
Interest revenue (65)
Holding gain (loss) value $0

Table (26)

Entry for repayment of note:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2018        
December 31 Notes Payable   100,000
             Cash   100,000
(To record note being paid)

Table (27)

  • Notes Payable is a liability account. Since obligation to pay the note is decreased, liability decreased, and a decrease in liability is debited.
  • Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

(5)

To determine

The book values of interest rate swap and note in 2016, 2017, and 2018.

(5)

Expert Solution
Check Mark

Explanation of Solution

Determine the book value of swap in the years 2016, 2017, and 2018.

Interest Rate Swap
Date Details Debit ($)   Date Details Credit ($)
2016       2016    
January 1       December 31 Holding loss 1,759
  Total $0     Total $1,759
        December 31 Balance $1,759
             
2017       2017    
December 31 Holding gain 2,694   January 1 Balance $1,759
  Total 2,694     Total $1,759
December 31 Balance $935        
             
2018       2018    
January 1 Balance 935   December 31 Holding loss 935
  Total 935     Total 935
December 31 Balance $0        

Table (28)

Note: Refer to Requirements 2, 3, and 4 for values and computation of all values.

Determine the book value of note in the years 2016, 2017, and 2018.

Note Payable
Date Details Debit ($)   Date Details Credit ($)
2016       2016    
December 31 Holding gain 1,759   January 1 Cash 100,000
  Total $0     Total 100,000
        December 31 Balance $98,241
             
2017       2017    
December 31       January 1 Balance $98,241
          Holding loss 2,694
  Total 0     Total $100,935
        December 31 Balance $100,935
             
2018       2018    
December 31 Holding gain 935   January 1 Balance 100,935
  Cash 100,000        
  Total 100,935     Total 100,935
        December 31 Balance $0

Table (29)

Note: Refer to requirements 2, 3, and 4 for values and computation of all values.

(6)

To determine

The net effect of fair value hedge on earnings for the years 2016, 2017, and 2018.

(6)

Expert Solution
Check Mark

Explanation of Solution

Determine the net effect offair value hedge on earnings for the years 2016, 2017, and 2018.

L Circuits
Income Statement
For the Years Ended December 31, 2016, 2017, and 2018
  2016 2017 2018
Interest expense (Fixed receipts) (8,000) (8,842) (7,065)
Interest revenue (expense)   (158) 65
Holding gain (loss)–Interest rate swap (2,759) 3,852 (0)
Holding gain (loss)–Hedged note 1,759 (1,852) 0
Net effect on earnings (Floating interest payment on swap) (9,000) (7,000) (7,000)

Table (30)

Note: Refer to Requirements 1, 2, 3, and 4 for values and computation of all values.

(7)

To determine

To journalize: The entries of issue of note, interest payments, and adjustment entries to reflect fair value during 2016, if fair value would have been $97,000 rather than $98,241.

(7)

Expert Solution
Check Mark

Explanation of Solution

The additional decline in fair value from $98,241 to $97,000 would not make any difference in the entries because the reason for decline is not related to interest rate.

Entry for interest expense payment:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Interest Expense   8,000
           Cash   8,000
(To record interest expense payment)

Table (31)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Cash is an asset account. Since cash is paid, asset account decreased, and a decrease in asset is credited.

Entry for net interest receipt and accrued interest:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Interest Expense   0
    Holding Loss–Interest Rate Swap   2,759
           Interest Rate Swap     1,759
           Cash     1,000
(To record net cash settlement, accrued interest, and decrease in fair value)

Table (32)

  • Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited. (Since opening balance of fair value of interest rate swap is $0, the expense paid would be $0).
  • Holding Loss–Interest Rate Swap is an expense account. Since interest rate increased causing holding loss increase, which decrease equity, so equity value is decreased, and a decrease in equity is debited.
  • Interest Rate Swap is a liability account because the fair value of derivative has increased, and an increase in liability is credited.
  • Cash is an asset account. Since cash (net cash settlement) is paid, asset account decreased, and a decrease in asset is credited.

Entry for changes in fair value of note:

Date Account Titles and Explanation Post Ref. Debit ($) Credit ($)
2016        
December 31 Notes Payable   1,759
             Holding Gain–Hedged Note   1,759
(To record decrease in fair value from $100,000 to $98,241)

Table (33)

  • Notes Payable is a liability account. Since fair value of the note decreased, liability decreased, and a decrease in liability is debited.
  • Holding Gain–Hedged Note is a revenue account. The fair value of hedged liability has decreased causing a holding gain. Since holding gains increase equity, equity value is increased, and an increase in equity is credited.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!
Knowledge Booster
Background pattern image
Recommended textbooks for you
Text book image
FINANCIAL ACCOUNTING
Accounting
ISBN:9781259964947
Author:Libby
Publisher:MCG
Text book image
Accounting
Accounting
ISBN:9781337272094
Author:WARREN, Carl S., Reeve, James M., Duchac, Jonathan E.
Publisher:Cengage Learning,
Text book image
Accounting Information Systems
Accounting
ISBN:9781337619202
Author:Hall, James A.
Publisher:Cengage Learning,
Text book image
Horngren's Cost Accounting: A Managerial Emphasis...
Accounting
ISBN:9780134475585
Author:Srikant M. Datar, Madhav V. Rajan
Publisher:PEARSON
Text book image
Intermediate Accounting
Accounting
ISBN:9781259722660
Author:J. David Spiceland, Mark W. Nelson, Wayne M Thomas
Publisher:McGraw-Hill Education
Text book image
Financial and Managerial Accounting
Accounting
ISBN:9781259726705
Author:John J Wild, Ken W. Shaw, Barbara Chiappetta Fundamental Accounting Principles
Publisher:McGraw-Hill Education