Illustrations of accounting for derivatives

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Illustrations of Accounting for Derivatives
The next two sections illustrate the accounting for the derivatives using the two interest rate swap scenarios.
Fair Value Hedge: Interest Rate Swap to Convert Fixed-Rate Debt to Variable-Rate Debt Exhibit 7.15 presents the financial statement effects and journal entries for transactions from January 1, 2013, to December 31, 2015. The following paragraphs explain theaccounting for the note and the associated derivative.

Firm A issues the note to the supplier on January 1, 2013, in exchange for the equipment and enters into the swap contract on the same date. The swap contract is a mutually unexecuted contract on January 1, 2013. The variable interest rate on this date is 8%, the same as the fixed rate for the note to the equipment supplier. The swap contract has a fair value of zero on this date. Thus, Firm A makes no entry to record the swap contract.

 On December 31, 2013, Firm A makes the required interest payment of $8,000 (0.08 3 $100,000) on the note for 2013 and reduces net income by the amount of the interest expense.
 

 Assume interest rates decline during 2013 to 6%. On December 31, the counterparty with whom Firm A entered into the swap contract resets the interest rate to 6% for 2014. Firm A must restate the note payable to fair value and record the change in the market value of the swap contract caused by the decline in the interest rate. The present value of the remaining cash flows on the note payable (twocash interest payments of $8,000 and one $100,000 maturity value received in two years) when discounted at 6% is $103,667. Firm A records the $3,667 increase in the note’s fair value and recognizes a Loss on Revaluation of Note Payable on the income statement in the same amount. Unless the fair value option discussed earlier has been chosen, firms typically do not revalue financial instruments, such as this note payable, to market value when interest rates change. They continue to account for the financial instruments using the interest rate at the time of the initial recording of the financial instrument in the accounts. However, when a firm hedges a financial instrument, it must recognize changes in fair values. It must likewise recognize changes in the fair value of the swap contract. The decline in interest rates to 6% means that Firm A will save $2,000 each year in interest payments because it entered into the swap contract. The present value of a $2,000 annuity for two periods at 6% is $3,667. Thus, the value of the swap contract increased from zero at the beginning of 2013 to $3,667 at the end of the year. Firm A records the increase in the fair value of the swap contract as an asset and recognizes a $3,667 gain on revaluation of swap contract on the income statement. The loss from the revaluation of the note payable exactly offsets the gain from the revaluation of the swap contract, indicating that the swap contract was fully effective (that is, the loss on revaluation of note payable is 100% offset by the gain on revaluation of swap contract) in hedging the interest rate risk


Firm A follows a similar process at December 31, 2014:

•  Firm A records interest expense on the note payable using the effective interest method to compute interest expense for the year. The effective interest rate for 2014 is 6%, and the (new, post-revaluation) book value of the note payable at the beginning of the year is $103,667. Therefore, interest expense is $6,220 (0.06 3 $103,667). The cash payment of $8,000 is the amount set forth in the original borrowing arrangement with the equipment supplier. Because more cash than interest expense is paid, notes payable decreases by the difference, $1,780. (This is a premium amortization.
•  Firm A records an increase in the swap contract asset due to the passage of time of $220 (0.06 3 $3,667) and the associated interest income. Recall that the swap contract was originally valued using present value; thus, its present value increases by the amount of interest each year. Interest expense (net) as a result of the two entries is $6,000 ($6,220 interest expense – $220 interest income), which is the variable rate for 2014 of 6% times the $500,000 face value of the not
•  Firm A receives $2,000 under the swap contract with its counterparty because the interest rate decreased from 8% to 6% [$100,000 3 (0.08 – 0.06)], which also reduces the swap contract asset by $2,000. In a sense, the $2,000 cash received from the counterparty reimburses Firm A for paying interest at 8% on the note, whereas the swap contract provides that the firm benefits when interest rates decline, in this case to 6%
•  Assume interest rates increased during 2014 to 10%, so the bank resets the interest rate in the swap agreement to 10% for 2015. Firm A must revalue the note payable and the swap contract for changes in fair value. The present value of the remaining payments on the note (one cash interest payment of $8,000 and one maturity payment of $100,000 one year hence) at 10% is $98,182. The book value of the note payable before revaluation is $101,887 ($103,667 – $1,780 amortization). The entry to revalue the note payable reduces the note payable by $3,705 ($101,887 – $98,182), which is shown as a gain on revaluation of note payable on the income statement. The fair value of the swap contract decreases. Firm A must now pay an additional $2,000 in interest in 2015 because of the swap contract. Thus, the swap contract becomes a liability instead of an asset. When discounted at 10%, the present value of $2,000 is a $1,818 swap contract liability. The book value of the swap contract asset before revaluation is $1,887 ($3,667 þ $220 – $2,000). The entry to revalue the swap contract from a $1,887 asset to a $1,818 liability results in a  $3,705 loss on revaluation of swap contract reflected on the income statement. Thegain on revaluation of the note exactly offsets the loss on revaluation of the swap contract, so the swap contract hedges the change in interest rates.

Following a similar process at December 31, 2015:

• Firm A records interest expense of $9,818 (0.10 3 $98,182), increasing notes payable by $1,818 (a discount amortization), when it pays $8,000 (0.08 3 $100,000) in cash.
• Firm A also recognizes interest expense of $182 (0.10 3 $1,818) due to the passage of time on the swap contract liability. (Recall that when the swap contract was an asset, interest revenue was generated by the passage of time.) Interest expense (net) after these two effects is $10,000 ($9,818 interest expense þ $182 interest expense), which equals the variable interest rate of 10% times the face value of the note
•  Firm A must pay the counterparty an extra 2% because the variable interest rate of 10% exceeds the fixed interest rate of 8%. Thus, cash and the swap contract liability decrease by $2,000.
•  Firm A also repays the note and closes out the swap contract. The swap contract account has a zero balance on December 31, 2015, after the preceding entries ($1,818 þ $182 – $2,000) are made, so the firm does not need to make additional entries to close out this account.

In summary, note that net income reflects the variable interest rate each year: 8% for 2013, 6% for 2014, and 10% for 2015. The note payable and the swap contract net to $100,000 at the end of each year

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