Beams10e Ch07 Intercompany Profit Transactions Bonds

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© Pearson Education, Inc. publishing as Prentice Hall 7-1

Chapter 7: Intercompany ProfitTransactions – Bonds

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany

Advanced Accounting , 10th edition

by Floyd A. Beams, Robin P. Clement,Joseph H. Anthony, and Suzanne Lowensohn




Intercompany Profits on Bonds:

Objectives1. Differentiate between intercompany receivables

and payables , and assets or liabilities of the

consolidated reporting entity.

2. Defer unrealized profits and later recognizerealized profits on bond transfers between

parent and subsidiary companies.

3. Demonstrate how a consolidated reporting entity

constructively retires debt.

4. Adjust calculation of noncontrolling interest

amounts in the presence of intercompany profits

on debt transfers.




1: Intercompany Receivables andPayables

Intercompany Profit Transactions – Bonds




Intercompany Payables and

ReceivablesRemove intercompany:

– Payables and interest expense

– Receivables and interest income

Loans directly between affiliates generally pose no

special problems




Retirement of Debt

1. Issuing firm uses own resources to retire its

own bonds – no intercompany (IC) issues

2. Issuing firm borrows from unaffiliated entity

and uses funds to retire its own debt –

no IC

3. Issuing firm borrows from affiliate and uses

funds to retire its own debt – simple IC loan

4. Non-issuing firm purchases debt securities of an affiliate resulting in constructive retirement

– IC constructive retirement




Constructive Retirement

One company purchases debt instruments of an

affiliate from outside entities

Constructive gains and losses on bonds are

1. Realized gains and losses from the

consolidated viewpoint

2. That arise when a company purchases the

bonds of an affiliate3. From other entities

4. At a price other than the book value of the

bonds.




Agency Theory

• Agency theory

– Assigns gain or loss to the issuing firm

– Conceptually a superior than other methods

• Text:

– Follows agency theory

– Simplifies discussion using straight line

amortization of premiums & discounts• Other methods

– Par value theory or assign all gain or loss to the

parent




2: Profits on Bonds





Parent is Issuer

At constructive retirement

– Remove Investment in Bonds

– Remove proportionate share of Bonds

payable and unamortized premium or

discount

– Realize a gain or loss

The gain or loss at constructive retirement isrecognized over the life of the bonds

Gain or loss is attributed solely to the parent




Subsidiary Acquires Parent Bonds

Pam owns 70% of Sue, acquired at book value. Sue's net

income for 2010 is $220.

On 1/1/10, Pam has $10,000 bonds outstanding with

unamortized premium of $100. Bonds mature in 5

years. Straight line amortization.

On 1/1/10, Sue acquires $1,000 of Pam's bonds on the open

market at $950. Straight line.

• Portion of bonds retired: 1,000/10,000 = 10%• Gain on retirement: 10%(10,100) – 950 = $60

• Pam's Investment in Sue: 70%(220) + 60 – 12 = $202

• Noncontrolling interest share: 30%(220) = $66




Amortizations and Interest

Book value During Book value During Book value

Pam's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011

Bonds payable $10,100 -$20 $10,080 -$20 $10,060

10% retired $1,010 $1,008 $1,006

Interest expense500+500-20

=$980500+500-20

=$980

10% retired $98 $98

Sue's books:

Investment in bonds $950 +$10 $960 +$10 $970

Interest income50+50+10

=$11050+50+10

=$110




Worksheet Entries for Bonds

Entries for 2010 worksheet.

•

Had a consolidated balance sheet been prepared on1/1/2010, the date of the retirement, the first entry would

have recorded amounts at $1010, $950, and $60,

respectively. There would be no interest.

• One entry could have been used above, with a gain of $60.

Bonds payable 1,008

Investment in bonds 960

Gain on retirement of bonds 48

Interest income 110

Interest expense 98

Gain on retirement of bonds 12




3: Constructive Retirement of Debt





Piecemeal Recognition

The constructive gain of $60 is recognized in 2010

when the bonds are constructively retired.

The difference between interest income $98 and

interest expense on the retired bonds $110 is

$12.

This $12 is an adjustment to investment income.

Pam is the issuer, so the full $12 is attributed toPam.

If Sue was the issuer, the $12 would be shared among

the controlling and noncontrolling interests.




2011 Worksheet Entries

Entries for 2011 worksheet, assuming that Pam

has not yet paid the second interest payment.

Bonds payable 1,006

Interest income 110Investment in bonds 970Interest expense 98Investment in Sue 48

Interest payable 50Interest receivable 50




Subsequent Worksheet Entries

Notice that there is no gain in subsequent years.

The $60 is reduced each year by $12 and is a

credit to the Investment in Sue account.

Had Sue been the issuer, the $48 would be shared

between Investment in Sue and Noncontrolling

Interest.




4: Effect on Noncontrolling Interest





Subsidiary Issuer with Gain

Constructive gain

– Purchase price of the debt is less than the

book value

–

Share gain between CI and NCI in year of retirement.

• I ncrease I ncome from subsidiary

• I ncrease Noncontroll ing interest share

– In current and subsequent years, usepiecemeal recognition

• Reduce I ncome from subsidiary

• Reduce Noncontroll ing interest share




Subsidiary Issuer with Loss

Constructive loss

– Purchase price of the debt is greater than

the book value

–

Share loss between CI and NCI in year of retirement.

• Reduce I ncome from subsidiary

• Reduce Noncontroll ing interest share

– In current and subsequent years, usepiecemeal recognition

• I ncrease I ncome from subsidiary

• I ncrease Noncontroll ing interest share




Parent Acquires Subsidiary Bonds

Pine owns 80% of Scent, acquired at book value. Scent's

net income for 2010 is $500.

On 1/1/10, Scent has $5,000 bonds outstanding with

unamortized discount of $200. Bonds mature in 8 years.

Straight line amortization.

On 1/1/10, Pine acquires $2,000 of Scent's bonds on the

open market at $2,040. Straight line.

• Portion of bonds retired: 2,000/5,000 = 40%• Loss on retirement: 40%(4,800) – 2,040 = -$120

• Pine's Investment in Scent: 80%(500 – 120 + 15) = $316

• Noncontrolling interest share: 20%(500 – 120 + 15) = $79






Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011

Bonds payable $4,800 +$25 $4,825 +$25 $4,850

40% retired $1,920 $1,930 $1,940

Interest expense250+250+25

=$525250+250+25

=$525

40% retired $210 $210

Pine's books:

Investment in bonds $2,040 -$5 $2,035 -$5 $2,030

Interest income100+100-5

=$195100+100-5

=$195




2010 Entries with Loss

Entries for 2010 worksheet.

Bonds payable 1,930

Interest income 195

Loss on retirement of bonds 120

Interest expense 210

Investment in bonds 2,035






Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011

Bonds payable $4,800 +$25 $4,825 +$25 $4,850

40% retired $1,920 $1,930 $1,940

Interest expense250+250+25

=$525250+250+25

=$525

40% retired $210 $210

Pine's books:

Investment in bonds $2,040 -$5 $2,035 -$5 $2,030

Interest income100+100-5

=$195100+100-5

=$195




2011 Worksheet Entries

Entries for 2011 worksheet, assuming that Scent

has not yet paid the second interest payment.

Bonds payable 1,940

Interest income 195

Investment in Scent 105

Investment in bonds 2,030

Interest expense 210Interest payable 100

Interest receivable 100




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Beams10e Ch07 Intercompany Profit Transactions Bonds

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