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Derivatives: Accounting for Swaps

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  1. Chapter 18 Illustrated Solution: Problem 18-25 Derivatives: Accounting for Swaps

  2. Kindall Company • Kindall has a loan that calls for interest payments computed at a variable rate over a five-year period. The company would prefer to have their interest payments fixed during this period. • Kindall is essentially willing to give up any possible benefits it may receive if interest rates declined during this period in exchange for eliminating the possibility that its interest costs on this loan could increase if rates were to go up.

  3. Problem Assumptions • The interest rate on January 1, 2002 is 10%. • The interest rate used to compute interest payments at December 31 of each year is equal to prevailing market interest rate on January 1 of that year. • At any point in time, the current interest rate is the best forecast of the future interest rate.

  4. Journal Entries Kindall Company 2002 Jan. 1 Cash …………………………………. 2,000,000 Loan Payable ……………………. 2,000,000

  5. Journal Entries Kindall Company 2002 Jan. 1 Cash …………………………………. 2,000,000 Loan Payable ……………………. 2,000,000 No entry is made to record the swap agreement because, as of January 1, 2002, the swap has a fair value of $0.

  6. Journal Entries Kindall Company The interest payment that Kindall makes on December 31 is based on the 10% interest rate that was in place on January 1 when the loan was signed. Thus, on this date, Kindall makes an interest payment of $200,000 ($2,000,000 x .10). 2002 Dec. 31 Interest Expense …………………… 200,000 Cash ……………………………… 200,000

  7. Journal Entries Kindall Company • Kindall will receive a $40,000 payment [$2,000,000 x (12% - 10%)] at the end of 2003 under the swap agreement because this payment is based on the prevailing market rate of 12% at January 1, 2003.

  8. Journal Entries Kindall Company • Kindall will receive a $40,000 payment [$2,000,000 x (12% - 10%)] at the end of 2003 under the swap agreement because this payment is based on the prevailing market rate of 12% at January 1, 2003. • In addition, if the rate prevailing at January 1, 2003, is the best forecast of the rate that will prevail in subsequent years, then Kindall can also expect to receive a $40,000 payment at the end of 2004, 2005, and 2006.

  9. Journal Entries Kindall Company • Kindall will receive a $40,000 payment [$2,000,000 x (12% - 10%)] at the end of 2003 under the swap agreement because this payment is based on the prevailing market rate of 12% at January 1, 2003. • In addition, if the rate prevailing at January 1, 2003, is the best forecast of the rate that will prevail in subsequent years, then Kindall can also expect to receive a $40,000 payment at the end of 2004, 2005, and 2006. • Using Table IV, Present Value of an Ordinary Annuity, on p. B-23 of the text, the prevent value factor for four periods at 12% is 3.0373. Using this factor, the annuity of swap payments has a present value of $121,492 ($40,000 x 3.0373).

  10. Journal Entries Kindall Company • Kindall will receive a $40,000 payment [$2,000,000 x (12% - 10%)] at the end of 2003 under the swap agreement because this payment is based on the prevailing market rate of 12% at January 1, 2003. • In addition, if the rate prevailing at January 1, 2003, is the best forecast of the rate that will prevail in subsequent years, then Kindall can also expect to receive a $40,000 payment at the end of 2004, 2005, and 2006. • Using Table IV, Present Value of an Ordinary Annuity, on p. B-23 of the text, the present value factor for four periods at 12% is 3.0373. Using this factor, the annuity of swap payments has a present value of $121,492 ($40,000 x 3.0373). Interest Rate Swap …………………………… 121,482 Other Comprehensive Income …………. 121,492

  11. Journal Entries Kindall Company On December 31, 2003, Kindall is obligated to make an interest payment of $240,000 based on the 12% rate which was the market rate on January 1, 2003 ($240,000 = $2,000,000 x .12). Interest Expense ……………………………… 240,000 Cash ………………………………………. 240,000

  12. Journal Entries Kindall Company • On December 31, Kindall also receives the $40,000 payment from the swap agreement. This amount is debited to cash and credited against the Interest Rate Swap asset. Cash (from swap agreement) ………………… 40,000 Interest Rate Swap ……………………….. 40,000

  13. Journal Entries Kindall Company • On December 31, Kindall also receives the $40,000 payment from the swap agreement. This amount is debited to cash and credited against the Interest Rate Swap asset that was established on January 1. • Comprehensive Income is reduced by the amount that the asset (Interest Rate Swap) has declined in value and the off-setting part of this entry is a credit to Interest Expense. This entry (combined with the previous entry to Interest Expense) reduces Kindall’s effective interest expense to $200,000 for the year. This amount is equal to the fixed-rate cost of 10% which Kindall achieved by entering into the swap agreement. Cash (from swap agreement) ………………… 40,000 Interest Rate Swap ……………………….. 40,000 Other Comprehensive Income ………………. 40,000 Interest Expense …………………………. 40,000

  14. Interest Rate Swap Valuation Kindall Company • Because the prevailing market rate of 9% as of January 1, 2004, is below the 10% rate in swap agreement, Kindall be required to make a payment of $20,000 [$2,000,000 (10% – 9%)] at the end of 2004.

  15. Interest Rate Swap Valuation Kindall Company • Because the prevailing market rate of 9% as of January 1, 2004, is below the 10% rate in swap agreement, Kindall be required to make a payment of $20,000 [$2,000,000 (10% – 9%)] at the end of 2004. • In addition, if the rate prevailing at January 1, 2004, is the best forecast of the rate that will prevail in subsequent years, then Kindall can also expect to make a $20,000 payment at the end of 2005 and 2006.

  16. Interest Rate Swap Valuation Kindall Company • Because the prevailing market rate of 9% as of January 1, 2004, is below the 10% rate in swap agreement, Kindall be required to make a payment of $20,000 [$2,000,000 (10% – 9%)] at the end of 2004. • In addition, if the rate prevailing at January 1, 2004, is the best forecast of the rate that will prevail in subsequent years, then Kindall can also expect to make a $20,000 payment at the end of 2005 and 2006. • Using Table IV, Present Value of an Ordinary Annuity, on p. B-23 of the text, the present value factor for three periods at 9% is 2.5313. Using this factor, the annuity of swap payments has a present value of $50,626 ($20,000 x 2.5313). This amount should be the ending balance in the Interest Rate Swap Account as of December 31, 2003. And, since this is the present value of payments that Kindall is expecting to pay under the swap agreement, the Interest Rate Swap account is now a liability and the $50,626 will be a credit balance.

  17. Interest Rate Swap Valuation

  18. Interest Rate Swap Valuation

  19. Interest Rate Swap Valuation

  20. Interest Rate Swap Valuation

  21. Interest Rate Swap Valuation Therefore, to bring the Interest Rate Swap account to the correct balance, Kindall must make an entry crediting this account for $132,118.

  22. Adjusting Entry for Interest Rate Swap Therefore, to bring the Interest Rate Swap account to the correct balance, Kindall must make an entry crediting this account for $132,118. Other Comprehensive Income ………………. 132,118 Interest Rate Swap ………………………. 132,118

  23. End of Problem