Appendix 3
Bob Jensen at Trinity University

Interest Rate Swap Journal Entries Under Method 4 Legal 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
Company A cannot declare the swap as a hedge under SFAS 133 rules..

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
Swap is declared a Company B cash flow hedge of interest rates under SFAS 133.

Things to watch for include the following:
1.   Note that, unlike the Exhibit 2 outcomes for Method 2, the Method 4 swap
      valuations are symmetrical between swap parties. For example, the value of
      Company B's Swap Payable is equal to Company A's Swap Receivable and
      vice versa.

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.

 

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 $481,284 $481,284 ($481,284) ($481,284)
Gain/Loss on Swap ($481,284) ($481,284)
OCI $481,284 $481,284
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 ($26,526) $454,758 $26,526 ($454,758)
Gain/Loss On Swap $87,524 ($454,758) $0 $0
OCI $0 $0 ($26,526) $454,758
Retained Earnings $345,242 $345,242 $1,100,000 $1,100,000
Interest Expense ($800,000) $0 ($1,100,000) $0
Gain/Loss On Swap $454,758 $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 ($180,058) $274700 $180,058 ($274,700)
Gain/Loss On Swap $180,058 $180,058 $0 $0
OCI $0 $0 ($264,991) 274,700
Retained Earnings $1,030,058 $1,375,300 $1,100,000 $2,200,000
Interest Expense ($850,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($180,058) $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 ($154,661) $120,039 $154,661 ($120,039)
Gain/Loss On Swap $154,661 $154,661 $0 $0
OCI $0 $0 (154,661) $120,039
Retained Earnings 1,054,661 $2,429,961 $1,100,000 $3,300,000
Interest Expense ($900,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($154,661) $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 ($120,039) $0 $120,039 $0
Gain/Loss On Swap $120,039 $120,039 $0 $0
OCI $0 $0 ($120,039) $0
Retained Earnings $1,070,039 $3,500,000 $1,100,000 $4,400,000
Interest Expense ($950,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($120,039) $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 ($72,628) ($72,628) $72,628 $72,628
Gain/Loss On Swap $72,628 $72,628 $0 $0
OCI $0 $0 ($72,628) ($72,628)
Retained Earnings $1,072,628 $4,572,628 $1,100,000 $5,500,000
Interest Expense ($1,000,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($72,628) $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 ($7,810) ($80,438) $7,810 $80,438
Gain/Loss On Swap $7,810 $7,810 $0 $0
OCI $0 $0 ($7,810) ($80,438)
Retained Earnings $1,057,810 $5,630,438 $1,100,000 $6,600,000
Interest Expense ($1,050,000) $0 ($1,100,000) $0
Gain/Loss On Swap ($7,810) $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 $80,438 $0 ($80,438) $0
Gain/Loss On Swap ($80,438) ($80,438) $0 $0
OCI $0 $0 $80,438 $0
Retained Earnings $1,019,562 $6,650,000 $1,100,000 $7,700,000
Interest Expense ($1,100,000) $0 ($1,100,000) $0
Gain/Loss On Swap $80,438 $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)

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