On January 1, 2018, Labtech Circuits borrowed $190,000 fromFirst Bank by issuing a three-year, 8% note, payable on December31, 2020. Labtech wanted to hedge the risk that general interestrates will decline, causing the fair value of its debt to increase.Therefore, Labtech entered into a three-year interest rate swapagreement on January 1, 2018, and designated the swap as a fairvalue hedge. The agreement called for the company to receivepayment based on an 8% fixed interest rate on a notional amount of$190,000 and to pay interest based on a floating interest rate tiedto LIBOR. The contract called for cash settlement of the netinterest amount on December 31 of each year. Floating (LIBOR)settlement rates were 8% at inception and 9%, 7%, and 7% at the endof 2018, 2019, and 2020, respectively. The fair values of the swapare quotes obtained from a derivatives dealer. These quotes and thefair values of the note are as follows: January 1 December 31 20182018 2019 2020 Fair value of interest rate swap 0 $ (2,659 ) $1,835 $ 0 Fair value of note payable $ 190,000 $ 187,341 $ 191,835$ 190,000 Required: 1. Calculate the net cash settlement at the endof 2018, 2019, and 2020. 2. Prepare the journal entries during 2018to record the issuance of the note, interest, and necessaryadjustments for changes in fair value. 3. Prepare the journalentries during 2019 to record interest, net cash interestsettlement for the interest rate swap, and necessary adjustmentsfor changes in fair value. 4. Prepare the journal entries during2020 to record interest, net cash interest settlement for theinterest rate swap, necessary adjustments for changes in fairvalue, and repayment of the debt. 5. Calculate the book values ofboth the swap account and the note in each of the three years. 6.Calculate the net effect on earnings of the hedging arrangement ineach of the three years. (Ignore income taxes.) 7. Suppose the fairvalue of the note at December 31, 2018, had been $187,000 ratherthan $187,341 with the additional decline in fair value due toinvestors’ perceptions that the credit worthiness of Labtech wasworsening. How would that affect your entries to record changes inthe fair values?
