On January 1, 2014, 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 is that Four Brothers will receive from Herman a fixed-rate interest payment of 8.0% based on a $10 million notional amount each December 31 for three years. Four Brothers will pay Herman a variable LIBOR rate reset every December 31. 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, 2014, and to 7.75% on December 31, 2015. Four Brothers uses a December 31 year-end and records interest expense annually.
1. How much net cash settlement will Four Brothers pay to (or receive from) Herman Bank on December 31, 2014? On December 31, 2015?
2. How much cash will Four Brothers pay to Guiffrie Bank on December 31, 2014? On December 31, 2015?
3. On December 31, 2014, 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 as well as interest expense for the year ended December 31, 2014.
4. On December 31, 2015, 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 as well as interest expense for the year ended December 31, 2015.
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