Sarazan Corp purchased a 1 million four year 7 5 fixed rate

interest only #1311

Sarazan Corp. purchased a $1-million, four-year, 7.5% fixed-rate interest only, non-prepayable
bond on December 31, 2011. The bond is actively traded and is held as a fair value through net
income (FV-NI) investment. Sarazan later decided to hedge the interest rate and change from a
fixed rate to variable rate, so it entered into a swap agreement with M&S Corp. The swap
agreement specified that Sarazan will pay a fixed rate of 7.5%and receive variable rate interest
with settlement dates that match the interest payments on the instrument. Assume that interest
rates increased during 2012 and that Sarazan received $13,000 as a net settlement on the
swap for the settlement at December 31, 2012. The loss related to the investment (due to
interest rate changes) was $48,000. The value of the swap contract increased by
$48,000.Instructions(a) Prepare the journal entry to record the receipt of interest on December
31, 2012, from the company that issued the bond.(b) Prepare the journal entry to record the
receipt of the swap settlement on December 31, 2012.(c) Prepare the journal entry to record the
change in the fair value of the swap contract on December 31, 2012.(d) Prepare the journal
entry to record the change in the fair value of the bond on December 31, 2012. Note how this is
different from how the fair value change would have been booked if the bond had not been
hedged.(e) Explain why the interest rate swap is a fair value hedge in this situation.(f) Explain
how an interest rate swap can act as both a fair value hedge and a cash flow hedge.View
Solution:
Sarazan Corp purchased a 1 million four year 7 5 fixed rate interest only

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