ASC 815 Derivatives and Hedging: Interest Rate Swap Transaction Explained with Journal Entries

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The ASC 815 standard, established by the Financial Accounting Standards Board (FASB), governs the accounting for derivatives and hedging activities. One common derivative instrument used by businesses to manage interest rate risk is the interest rate swap. In this article, we will provide an overview of interest rate swap transactions under ASC 815 and illustrate how journal entries can be used to account for them.

 

Interest Rate Swaps under ASC 815

An interest rate swap is a financial contract between two parties who agree to exchange interest rate payments over a specified period. Typically, one party pays a fixed interest rate while the other pays a floating interest rate. Interest rate swaps can be used for hedging purposes, allowing businesses to manage interest rate risk by converting fixed-rate obligations to floating-rate or vice versa.
 

Journal Entries for Interest Rate Swap Transactions

To illustrate the concept of interest rate swaps and the accounting treatment under ASC 815, let's consider a simplified example involving a company that enters into an interest rate swap to hedge its floating-rate debt. The company pays a fixed rate of 3% and receives a floating rate based on the LIBOR.
 

1. Initial recognition of the interest rate swap

When the company enters into the interest rate swap, it must recognize the derivative instrument at its fair value, which is typically zero at inception.

No journal entry is required at this stage.
 

2. Journal entries for periodic interest payments

Assuming the company's floating-rate debt has an interest rate of LIBOR + 2%, and the current LIBOR is 1%, the journal entries for the interest payment and interest rate swap settlement are as follows:
 

a) Record the interest expense on the floating-rate debt:
 

Debit: Interest Expense - $X

Credit: Cash - $X
 

b) Record the settlement of the interest rate swap:
 

Debit: Cash - $(Floating Interest Payment - Fixed Interest Payment)

Credit: Interest Expense - $(Floating Interest Payment - Fixed Interest Payment)
 

3. Journal entries for changes in the fair value of the interest rate swap
 

Under ASC 815, the company must periodically mark the interest rate swap to its fair value, with changes recognized in earnings or as part of a cash flow hedge, depending on the hedge accounting treatment. In this example, we assume that the interest rate swap is not designated as a hedge for accounting purposes:
 

a) Record the change in the fair value of the interest rate swap:
 

Debit: Interest Expense - $Y (if the fair value decreases)

Credit: Interest Rate Swap - $Y (if the fair value decreases)
 

OR
 

Debit: Interest Rate Swap - $Y (if the fair value increases)

Credit: Interest Income - $Y (if the fair value increases)
 

The ASC 815 standard governs the accounting for interest rate swaps and other derivative instruments, which are widely used by businesses to manage interest rate risk. By understanding the concept of interest rate swaps and properly accounting for them through journal entries, organizations can ensure accurate financial reporting and maintain compliance with ASC 815. As businesses continue to navigate the complexities of derivatives and hedging activities, it is essential to invest in the right tools and resources, such as advanced accounting software, to streamline the process and ensure ongoing compliance.