Appendix 2

Bob Jensen at Trinity University

Interest Rate Swap Journal Entries Under Method 2
[Bond + Swap] Rate Method

A = Company A

Company A Bond Rate = .095 Fixed for n = 7 Years
Company A Swap Receivable Rate = .110 Fixed for n = 7 Years
Company A Swap Payable Rate = (.090 + .005t) for t = 1, . . . , 7   years
Company A Net Swap Rate = (.020 - .005t) for t = 1, . . . , 7  years

B = Company B

Company B Bond Rate = (.090 + .005t) for t = 1, . . . , 7  years
Company B Swap Receivable Rate = (.090 + .005t) for t = 1, . . . , 7   years
Company B Swap Payable Rate = .110 Fixed for n = 7 Years
Company B Net Swap Rate = (-.020 + 005t) for t = 1, . . . , 7  years
OCI = Other Comprehensive Income

Things to watch for include the following:
1.   Note that, unlike the Exhibit 3 outcomes for Method 4, the Method 2 swap
      valuations are not symmetrical between swap parties. For example, the value of
      Company B's Swap Payable is not equal to Company A's Swap Receivable and
      vice versa for Years 2, 3, 5, and 6.

2. The swap for Company B, unlike Company A, qualifies as a cash flow hedge
    under SFAS 133. As such, Company B can defer swap gains and losses in Other
    Comprehensive Income (OCI). Company A must post yearly unrealized gains and
    losses in swap values to current earnings through the Gain/Loss on Swap Account.

3.  SFAS 133 changed the balance sheet treatment both by requiring the booking of derivatives and by requiring
     that the booked value be adjusted to fair market value each reporting date.   In both Company A and
     Company B, the sum of all value changes in the swap is zero.   Hence value changes never have permanent
     impacts on Retained Earnings.  In the case of Company A, however, there are yearly impacts on Retained
     Earnings that wash out by the end of the swap.  In the Case of Company B, however, the cash flow hedge
     accounting under SFAS 133 keep the impact out of Retained Earnings year to year as well as in total over
     the life of the swap.

Note:  In the solutions below, the interest accruals each period are not separately entered since the results are the same whether they are netted out or not.  In a downloadable 133exb.xls file, I have the more detailed journal entries and the derivations of the interest accruals.  This file is not available to my students, but accounting practitioners and educators may contact me to obtain this file.  My email address is rjensen@trinity.edu .  The accruals derived in that Excel file are as follows:

Interest Accruals in the Company B Journal Entries
See Example 5 of Beginning in Paragraph 131 of SFAS 133
Especially Note Page 75 of SFAS 133

Year 2   ($1,866)
Year 3 ($22,454)
Year 4 ($38,491)
Year 5   $50,000
Year 6   $57,080
Year 7  $59,910

The condensed solution with these accruals netted out is shown below.

Year t = 0

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 9.50%
Net Swap Rate = 1.50% 1.50%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
January 1, 19x1 (Credit) Balance (Credit) Balance
Cash $10,000,000 $10,000,000 $10,000,000 $10,000,000
Bonds Payable ($10,000,000) ($10,000,000) ($10,000,000) ($10,000,000)
Swap Receivable/Payable $780,956 $780,956 ($706,829) ($706,829)
Gain/Loss on Swap ($780,956) ($780,956)
OCI $706,829 $706,829
Year t = 1

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 9.50%
Net Swap Rate = 1.50% 1.50%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x1 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $950,000 $950,000
Cash ($950,000) $9,050,000 ($950,000) $9,050,000
Cash $150,000 $9,200,000 ($150,000) $8,900,000
Interest Expense ($150,000) $800,000 $150,000 $1,100,000
Swap Receivable/Payable ($87,524) $693,432 $72,249 ($634,581)
Gain/Loss On Swap $87,524 ($693,432) $0 $0
OCI $0 $0 ($72,249) $634,581
Retained Earnings $106,568 $106,568 $1,100,000 $1,100,000
Interest Expense ($800,000) $0 ($1,100,000) $0
Gain/Loss On Swap $693,432 $0 $0 $0
Year t = 2

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 10.00%
Net Swap Rate = 1.00% 1.00%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x2 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,000,000 $1,000,000
Cash ($950,000) $8,250,000 ($1,000,000) $7,900,000
Cash $100,000 $8,350,000 ($100,000) $7,800,000
Interest Expense ($100,000) $850,000 $100,000 $1,100,000
Swap Receivable/Payable ($299,368) $394,064 $264,991 ($369,590)
Gain/Loss On Swap $299,368 $299,368 $0 $0
OCI $0 $0 ($264,991) $369,590
Retained Earnings $1,149,368 $1,255,936 $1,100,000 $2,200,000
Interest Expense ($850,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($299,368) $0 $0 $0
Year t = 3

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 10.50%
Net Swap Rate = 0.50% 0.50%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x3 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,050,000 $1,050,000
Cash ($950,000) $7,400,000 ($1,050,000) $6,750,000
Cash $50,000 $7,450,000 ($50,000) $6,700,000
Interest Expense ($50,000) $900,000 $50,000 $1,100,000
Swap Receivable/Payable ($232,078) $161,986 $214,468 ($155,122)
Gain/Loss On Swap $232,078 $232,078 $0 $0
OCI $0 $0 ($214,468) $155,122
Retained Earnings $1,132,078 $2,388,014 $1,100,000 $3,300,000
Interest Expense ($900,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($232,078) $0 $0 $0
Year t = 4

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 11.00%
Net Swap Rate = 0.00% 0.00%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x4 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,100,000 $1,100,000
Cash ($950,000) $6,500,000 ($1,100,000) $5,600,000
Cash $0 $6,500,000 $0 $5,600,000
Interest Expense $0 $950,000 $0 $1,100,000
Swap Receivable/Payable ($161,986) $0 $155,122 $0
Gain/Loss On Swap $161,986 $161,986 $0 $0
OCI $0 $0 ($155,122) $0
Retained Earnings $1,111,986 $3,500,000 $1,100,000 $4,400,000
Interest Expense ($950,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($161,986) $0 $0 $0
Year t = 5

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 11.50%
Net Swap Rate = -0.50% -0.50%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x5 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,150,000 $1,150,000
Cash ($950,000) $5,550,000 ($1,150,000) $4,450,000
Cash ($50,000) $5,500,000 $50,000 $4,500,000
Interest Expense $50,000 $1,000,000 ($50,000) $1,100,000
Swap Receivable/Payable ($86,777) ($86,777) $85,626 $85,626
Gain/Loss On Swap $86,777 $86,777 $0 $0
OCI $0 $0 ($85,626) ($85,626)
Retained Earnings $1,086,777 $4,586,777 $1,100,000 $5,500,000
Interest Expense ($1,000,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($86,777) $0 $0 $0
Year t = 6

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 12.00%
Net Swap Rate = -1.00% -1.00%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x6 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,200,000 $1,200,000
Cash ($950,000) $4,550,000 ($1,200,000) $3,300,000
Cash ($100,000) $4,450,000 $100,000 $3,400,000
Interest Expense $100,000 $1,050,000 ($100,000) $1,100,000
Swap Receivable/Payable ($3,721) ($90,498) $4,464 $90,090
Gain/Loss On Swap $3,721 $3,721 $0 $0
OCI $0 $0 ($4,464) ($90,090)
Retained Earnings $1,053,721 $5,640,498 $1,100,000 $6,600,000
Interest Expense ($1,050,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($3,721) $0 $0 $0
Year t = 7

Company A

 Company A

Company B

Company B
Notional Bond Rate = 9.50% 12.50%
Net Swap Rate = -1.50% -1.50%
Method 2 Method 2 Method 2 Method 2
A's A's B's B's
Debit Debit
December 31, 19x7 (Credit) Balance (Credit) Balance
Interest Expense $950,000 $950,000 $1,250,000 $1,250,000
Cash ($950,000) $3,500,000 ($1,250,000) $2,150,000
Cash ($150,000) $3,350,000 $150,000 $2,300,000
Interest Expense $150,000 $1,100,000 ($150,000) $1,100,000
Swap Receivable/Payable $90,498 $0 ($90,090) $0
Gain/Loss On Swap ($90,498) ($90,498) $0 $0
OCI $0 $0 $90,090 $0
Retained Earnings $1,009,502 $6,650,000 $1,100,000 $7,700,000
Interest Expense ($1,100,000) $0 ($1,100,000) $0
Gain/Loss On Swap $90,498 $0 $0 $0
Bonds Payable $10,000,000 $0 $10,000,000 $0
Cash ($10,000,000) ($6,650,000) ($10,000,000) ($7,700,000)

Click here to view Working Paper 231 that accompanies this appendix.

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