18-1

Derivatives: Accountingfor Swaps

Chapter 18Illustrated Solution: Problem 18-25Illustrated Solution: Problem 18-25

18-2

Kindall CompanyKindall 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.

18-3

Problem AssumptionsProblem 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.

18-4

2002

Jan. 1 Cash…………………………………. 2,000,000

Loan Payable……………………. 2,000,000

Kindall Company

Journal EntriesJournal Entries

18-5

2002

Jan. 1 Cash…………………………………. 2,000,000

Loan Payable……………………. 2,000,000

Kindall Company

Journal EntriesJournal Entries

No entry is made to record the swap agreement because, as of January 1, 2002, the swap has a fair value of $0.

18-6

2002

Dec. 31 Interest Expense…………………… 200,000

Cash……………………………… 200,000

Kindall Company

Journal EntriesJournal Entries

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).

18-7

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.

Kindall Company

Journal EntriesJournal Entries

18-8

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.

Kindall Company

Journal EntriesJournal Entries

18-9

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).

Kindall Company

Journal EntriesJournal Entries

18-10

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

Kindall Company

Journal EntriesJournal Entries

18-11

Journal EntriesJournal Entries

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).

Kindall Company

Interest Expense……………………………… 240,000

Cash………………………………………. 240,000

18-12

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.

Kindall Company

Journal EntriesJournal Entries

Cash (from swap agreement)………………… 40,000

Interest Rate Swap……………………….. 40,000

18-13

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.Other Comprehensive Income………………. 40,000

Interest Expense…………………………. 40,000

Kindall Company

Journal EntriesJournal Entries

Cash (from swap agreement)………………… 40,000

Interest Rate Swap……………………….. 40,000

18-14

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.

Kindall Company

Interest Rate Swap ValuationInterest Rate Swap Valuation

18-15

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.

Kindall Company

Interest Rate Swap ValuationInterest Rate Swap Valuation

18-16

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.

Kindall Company

Interest Rate Swap ValuationInterest Rate Swap Valuation

18-17

Interest Rate Swap ValuationInterest Rate Swap Valuation

Interest Rate Swap12/31/02 121,492

18-18

Interest Rate Swap ValuationInterest Rate Swap Valuation

Interest Rate Swap12/31/02 121,492 Cash Receipt in 2003 40,000

18-19

Interest Rate Swap ValuationInterest Rate Swap Valuation

Interest Rate Swap12/31/02 121,492 Cash Receipt in 2003 40,000

12/31/03 50,626

18-20

Interest Rate Swap ValuationInterest Rate Swap Valuation

Interest Rate Swap12/31/02 121,492 Cash Receipt in 2003 40,000

Value Change in 2003 ?

12/31/03 50,626

18-21

Interest Rate Swap ValuationInterest Rate Swap Valuation

Interest Rate Swap12/31/02 121,492 Cash Receipt in 2003 40,000

Value Change in 2003 132,118

12/31/03 50,626

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

18-22

Adjusting Entry for Interest Rate SwapAdjusting Entry for Interest Rate Swap

Interest Rate Swap12/31/02 121,492 Cash Receipt in 2003 40,000

Value Change in 2003 132,118

12/31/03 50,626

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

18-23

End of ProblemEnd of Problem