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On January 1, 2011, Cam borrows $400,000 from Ven. The five-year term note is a variable-rate one in which the 2011 interest rate is determined to be 8 percent, the LIBOR rate at January 1, 2011, +...

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On January 1, 2011, Cam borrows $400,000 from Ven. The five-year term note is a variable-rate one in which the 2011 interest rate is determined to be 8 percent, the LIBOR rate at January 1, 2011, + 2%. Subsequent years’ interest rates are determined in a similar manner, with the rate set for a particular year equal to the beginning-of-the-year LIBOR rate + 2%. Interest payments are due on December 31 each year and are computed assuming annual compounding.
Also on January 1, 2011, Cam decides to enter into a pay-fixed, receive-variable interest rate swap arrangement with Gra. Cam will pay 8 percent.
Assume that the LIBOR rate on December 31, 2011, is 5 percent.
1. Why is this considered a cash flow hedge instead of a fair value hedge?
2. Do you think that this hedge would be considered effective and therefore would qualify for hedge accounting?
3. Assuming that this hedge relationship qualifies for hedge accounting:
a. Determine the estimated fair value of the hedge at December 31, 2011. Recall that the hedge contract is in effect for the 2012, 2013, 2014, and 2015 interest payments.
b. Prepare the entry at December 31, 2011, to account for this cash flow hedge as well as the December 31, 2011, interest payment.
4. Assuming that the LIBOR rate is 5.5% on December 31, 2012, prepare all the necessary entries to account for the interest rate swap at December 31, 2012, including the 2012 interest payment.

Answered Same DayDec 31, 2021

Solution

Robert answered on Dec 31 2021
47 Votes
Hedge Accounting
1) The situation under the present case is that of the cash flow hedge because the asset which is
underlying and which has been hedged is a financial assets with a transaction in the interest
ate. The changes and the differences in the interest rates and also the payments on account of
LIBOR is being paid off so as to ensure that the effective control and possession of the assets
does not matter and hence the changes in the value are the only factor which determine or has
an impact over the valuation of the asset concerned. It is the changes in values which has the
maximum impact on the...
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