On January 1, 2024, Avalanche Corporation borrowed $100,000 from First Bank by issuing a two-year, 8% fixedrate note with annual interest payments. The principal of the note is due on December 31, 2025.
∙ Avalanche wanted to hedge against declines in general interest rates, so it also entered into a two-year SOFR based interest rate swap agreement on January 1, 2024, and designates it as a fair value hedge. Because the swap is entered at market rates, the fair value of the swap is zero at inception.
∙ The agreement called for the company to receive fixed interest at the current SOFR swap rate of 5% and pay floating interest tied to SOFR. This arrangement results in an effective variable rate on the note of SOFR + 3%.
∙ The contract specifies that the floating rate resets each year on June 30 and December 31 for the net settlement that is due the following period. In other words, the net cash settlement is calculated using beginning- of-period rates. The SOFR rates on the swap reset dates and the fair values of the swap obtained from a derivatives dealer are as follows:

Avalanche will assess hedge effectiveness by comparing the cumulative change in the fair value of the swap to the cumulative change in the fair value of the debt due to changes in the benchmark interest rate. It will consider a ratio between 80–120% to be highly effective.

Required:
Use the extended or “long-haul” method demonstrated in Illustration A–5.
1. Calculate the effectiveness of the hedging relationship each period. Is the hedge highly effective?
2. Calculate the net cash settlement at each settlement date during 2024 and 2025.
3. Prepare the journal entries during 2024 to record the issuance of the note, interest, net cash settlement for the interest rate swap, and necessary adjustments for changes in fair value.
4. Prepare the journal entries during 2025 to record interest, net cash settlement for the interest rate swap, necessary adjustments for changes in fair value, and repayment of the debt.
5. Rollforward both the swap account and the notes payable account at each settlement/interest payment date.
6. Calculate the net effect on earnings of the hedging arrangement for the six-month periods ending June 30 and December 31, 2024, and June 30 and December 31, 2025.

Transcribed Image Text:

Floating rate (SOFR)-swap Fair value of interest rate swap Cumulative change in the fair value of debt due to changes in SOFR-gain (loss) 1/1/24 5% $0 $0 6/30/24 6% $ (1,414) $ 1,374 12/31/24 4% $ 971 $ (950) 6/30/25 3% $ 985 $ (971) 12/31/25 n/a $0 $0