Sandretto Corporation issues a note payable on January 1, 2013, to a supplier in return for equipment. The note has a face value of $50,000 and bears interest at 6% each year. Interest is payable annually on December 31, and the note matures on December 31, 2015. Sandretto Corporation has the option of repaying the note at any time prior to maturity at its fair value. Sandretto Corporation will repay the note early only if interest rates drop. In that event, the fair value of the note would exceed $50,000, and Sandretto Corporation will not capture the benefits of the lower interest rate. To neutralize the effects of changes in the fair value of the note payable, Sandretto enters into an interest rate swap with its bank. The swap has the effect of allowing Sandretto to exchange its fixed interest rate liability for a variable rate obligation.
Assume that the variable interest rate is 6% on January 1, 2013, and the rate is reset to 8% on December 31, 2013, and to 4% on December 31, 2014.
a. Give the journal entries that Sandretto Corporation will make on January 1, 2013, December 31, 2013, and December 31, 2014.
b. Sandretto Corporation decides to repay this note on January 1, 2015. Give the journal entries for the repayment of the note and to close out the swap agreement, assuming that Sandretto Corporation does not incur any additional costs for the early repayment or closing out the swap contract.
c. How would the entries in part a differ if Sandretto Corporation elected the fair value option for the note payable and interest rate swap?