What is an Interest Rate Swap?
Interest rate swaps are an example of financial derivative contracts. With interest rate swaps, entities can exchange one source of interest payments with another. There is also another party that agrees to swap the stream with the entity. The interest rate swap occurs based on a specified principal amount. Usually, interest rate swaps include the exchange of fixed interest rate instruments for floating-rate instruments.
The purpose behind interest rate swaps is to reduce or increase an entity’s exposure to interest rate fluctuations. Some entities may also use them to obtain a marginally lower interest rate. Similarly, some interest rate swaps may also include the exchange of one type of floating-rate instrument for another. Interest rate swaps are only over-the-counter and not traded on public exchanges.
How does an Interest Rate Swap work?
Interest rate swaps start with two parties. Usually, one party will have a fixed-rate interest instrument while the other will have a floating-rate one. These parties mutually agree that they would swap their loan arrangement to the other. For both parties, the opposite interest rate type of what they have will be the preferable option. The purpose behind a swap may differ according to both parties.
With interest rate swaps, participants only swap their interest payments. They don’t actually exchange the underlying debt. Neither do they make payments on each other’s behalf. They only pay the difference in the interest payments between both debt instruments. It makes the process much easier, while each participant stays responsible for their own debt instruments.
Interest rate swaps also come with well-defined terms. Therefore, both parties participating in the swap can stay safe within the arrangement. The agreement will define each party’s responsibility, the rates they have to pay, the payment schedule, etc. It will also include the start and maturity date for the swap agreement.
How does the accounting for Interest Rate Swaps work?
The accounting for interest rate swaps considers the adjustment amount receive or paid to the other party. As mentioned, both parties in the interest rate swap do not pay each other’s interest payments. They pay or receive the adjusted difference between the interest payments on both instruments.
When a company pays interest on its debt instruments, it can use the following double entry.
| Dr | Interest Expense |
| Cr | Interest Payable |
The company can then make the payment to the lender as usual. However, once the other party calculates the interest rate, the company must adjust the interest expense. When the other party’s interest is lower, the company will record the receipt for the difference. In that case, the double-entry will be as follows.
| Dr | Cash |
| Cr | Interest Expense |
However, if the other party’s interest expense is higher, the company has to pay the net difference. In that case, the adjustment will be as follows.
| Dr | Interest Expense |
| Cr | Cash |
The company must also calculate any changes in the fair value of the debt and record it. If there is an increase in its value, it can use the following double entry.
| Dr | Swap contract |
| Cr | Unrealized gain |
In case of a loss, it can use the reverse of the above entry.
Conclusion
An interest rate swap is an agreement where two entities swap their interest payments. With these contracts, entities do not exchange their obligations or debt instruments. They only pay or receive the difference between the interest payments in swapped instruments. The accounting for interest rate swaps includes recording the difference and the fair value fluctuations.
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