Question

Question: (Fair Value Hedge Interest Rate Swap) On December 31, 2017, Mercantile Corp. had a \(10,000,000,

8% fixed-rate note outstanding, payable in 2 years. It decides to enter into a 2-year swap with Chicago First Bank to convert the

fixed-rate debt to variable-rate debt. The terms of the swap indicate that Mercantile will receive interest at a fixed rate of 8% and

will pay a variable rate equal to the 6-month LIBOR rate, based on the \)10,000,000 amount. The LIBOR rate on December

31, 2017, is 7%. The LIBOR rate will be reset every 6 months and will be used to determine the variable rate to be paid for the

following 6-month period.

Mercantile Corp. designates the swap as a fair value hedge. Assume that the hedging relationship meets all the conditions

necessary for hedge accounting. The 6-month LIBOR rate and the swap and debt fair values are as follows

December 31, 2017 7.0% — $10,000,000

June 30, 2018 7.5% (200,000) 9,800,000

December 31, 2018 6.0% 60,000 10,060,000

Instructions

(a) Present the journal entries to record the following transactions.

(1) The entry, if any, to record the swap on December 31, 2017.

(2) The entry to record the semi-annual debt interest payment on June 30, 2018.

(3) The entry to record the settlement of the semi-annual swap amount receivables at 8%, less amount payable at LIBOR, 7%.

(4) The entry to record the change in the fair value of the debt on June 30, 2018. *

(5) The entry to record the change in the fair value of the swap at June 30, 2018.

(b) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2017.

(c) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on June 30, 2018.

(d) Indicate the amount(s) reported on the balance sheet and income statement related to the debt and swap on December 31, 2018.Answer:

Short answer

Answer:

Interest Expense is $350,000. Interest expense debited by $400,000 and cash credited by $400,000. Cash debited by $50,000 and interest expense credited by $50,000.

Step-by-step solution

Necessary journal entries

Date	Particular	Debit	Credit
December 31, 2017	No entry required
June 30, 2018	Interest Expense	$400,000
	Cash		$400,000
	(Being entry for the payment of interest
June 30, 2018	Cash	$50,000
	Interest Expense		$50,000
	(Entry for the semi-annual interest receivable)
June 30, 2018	Notes Payable	$200,000
	Unrealized gain or loss		$200,000
	(Entry for the change in fair value)
June 30, 2018	Unrealized gain or loss	$200,000
	Derivatives-Financial Assets/Liabilities		$200,000
	(Being entry for the change in the fair value of swap)

Indication in balance sheet and income statement

Partial Balance Sheet
Mercantile Corp.
December 31, 2017
Assets:
Swap Contract
Long-term Liabilities
Bonds Payable	$10,000,000

Indication in the balance sheet and income statement

Partial Balance Sheet
Mercantile Corp
June 30, 2018
Assets:
Swap Contract	$200,000
Long-term Liabilities
Bonds Payable	$9,800,000

Mercantile Corp.
Income Statement (Partial)
June 30, 2018
Particular	Amount
Interest Expense	$350,000

Indication in the balance sheet and income statement

Partial Balance Sheet
Mercantile Corp.
December 31, 2018
Assets:
Swap Contract	$60,000
Long-term Liabilities
Bonds Payable	$10,060,000

Mercantile Corp.
Income Statement (Partial)
December 31, 2018
Particular	Amount
Other Expenses and Loses:
Unrealized Holding loss- Swap Contract	$200,000
Unrealized holding loss—bonds payable	$200,000