Chapter 7: Intercompany Profit Transactions - Bonds

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

Chapter 7: Intercompany Profit Transactions – Bonds

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

to accompanyAdvanced Accounting, 10th editionby 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 recognize realized 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 and 1: Intercompany Receivables and PayablesPayables

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 Debt1. Issuing firm uses own resources to retire its

own bonds – no intercompany (IC) issues2. Issuing firm borrows from unaffiliated entity

and uses funds to retire its own debt – no IC3. Issuing firm borrows from affiliate and uses

funds to retire its own debt – simple IC loan4. Non-issuing firm purchases debt securities of an

affiliate resulting in constructive retirement – IC constructive retirement


Constructive RetirementOne company purchases debt instruments of an affiliate

from outside entitiesConstructive 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 affiliate

3. From other entities4. 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 Bonds2: Profits on BondsIntercompany Profit Transactions – Bonds


Parent is IssuerAt 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 is

recognized over the life of the bondsGain or loss is attributed solely to the parent


Subsidiary Acquires Parent BondsPam 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 12/31/2011Bonds payable $10,100 -$20 $10,080 -$20 $10,060 10% retired $1,010 $1,008 $1,006

Interest expense 500+500-20

=$980 500+500-20

=$980 10% retired $98 $98 Sue's books: Investment in bonds $950 +$10 $960 +$10 $970

Interest income 50+50+10

=$110 50+50+10

=$110


Worksheet Entries for BondsEntries for 2010 worksheet.

• Had a consolidated balance sheet been prepared on 1/1/2010, 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 960Gain on retirement of bonds 48

Interest income 110Interest expense 98Gain on retirement of bonds 12


3: Constructive Retirement of Debt3: Constructive Retirement of DebtIntercompany Profit Transactions – Bonds


Piecemeal RecognitionThe 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 to

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

the controlling and noncontrolling interests.


2011 Worksheet EntriesEntries for 2011 worksheet, assuming that Pam has not yet paid the

second interest payment.

Bonds payable 1,006 Interest income 110

Investment in bonds 970Interest expense 98Investment in Sue 48

Interest payable 50Interest receivable 50


Subsequent Worksheet EntriesNotice 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 Interest4: Effect on Noncontrolling InterestIntercompany Profit Transactions – Bonds


Subsidiary Issuer with GainConstructive gain

– Purchase price of the debt is less than the book value

– Share gain between CI and NCI in year of retirement. • Increase Income from subsidiary• Increase Noncontrolling interest share

– In current and subsequent years, use piecemeal recognition• Reduce Income from subsidiary• Reduce Noncontrolling interest share


Subsidiary Issuer with LossConstructive loss

– Purchase price of the debt is greater than the book value

– Share loss between CI and NCI in year of retirement. • Reduce Income from subsidiary• Reduce Noncontrolling interest share

– In current and subsequent years, use piecemeal recognition• Increase Income from subsidiary• Increase Noncontrolling interest share


Parent Acquires Subsidiary BondsPine 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 12/31/2011Bonds payable $4,800 +$25 $4,825 +$25 $4,85040% retired $1,920 $1,930 $1,940

Interest expense 250+250+25

=$525 250+250+25

=$525 40% retired $210 $210 Pine's books: Investment in bonds $2,040 -$5 $2,035 -$5 $2,030

Interest income 100+100-5

=$195 100+100-5

=$195


2010 Entries with LossEntries for 2010 worksheet.Bonds payable 1,930 Interest income 195Loss on retirement of bonds 120

Interest expense 210Investment in bonds 2,035




Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011Bonds payable $4,800 +$25 $4,825 +$25 $4,85040% retired $1,920 $1,930 $1,940

Interest expense 250+250+25

=$525 250+250+25

=$525 40% retired $210 $210 Pine's books: Investment in bonds $2,040 -$5 $2,035 -$5 $2,030

Interest income 100+100-5

=$195 100+100-5

=$195


2011 Worksheet EntriesEntries for 2011 worksheet, assuming that Scent has not yet paid the

second interest payment.

Bonds payable 1,940 Interest income 195Investment in Scent 105

Investment in bonds 2,030Interest expense 210

Interest payable 100Interest receivable 100


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Chapter 7: Intercompany Profit Transactions - Bonds

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