On January 1, 2017, Four Brothers Manufacturing borrowed $10 million from Guiffrie Bank by signing a three-year, 8.0% fixed-rate note. The note calls for interest to be paid annually on December 31. The company then entered into an interest rate swap agreement with Herman Bank. The agreement calls for Four Brothers to receive a fixed-rate of 8.0% and pay a variable LIBOR rate based on a $10 million notional amount each December 31 for three years. Four Brothers will receive or pay a net amount on each December 31. The variable LIBOR rate resets every December 31 and establishes the receipt or payment for the following year. The LIBOR rate for the first year is 8.0%.
Four Brothers designates the swap as a hedge of its fair value exposure to interest rate risk on its fixed-rate note. The hedge is fully effective because the key terms of the note and swap are identical. The variable rate was reset to 8.25% on December 31, 2017, and to 7.75% on December 31, 2018. Four Brothers uses a December 31 year-end and records interest expense annually.
Required:
How much net cash settlement will Four Brothers pay to (or receive from) Herman Bank on December 31 from 2017 to 2019?
How much cash will Four Brothers pay to Guiffrie Bank on December 31 from 2017 to 2019?
On December 31, 2017, the swap has a fair value of $(45,000), a negative amount, and the fair value of the $10 million note was $9,955,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2017.
On December 31, 2018, the swap has a fair value of $23,000, and the fair value of the $10 million note was $10,023,000. Prepare journal entries to record Four Brothers’ cash interest payments and receipts, change in swap value, and interest expense for the year ended December 31, 2018.
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