Chapter 7: Intercompany Profit Transactions 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

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Intercompany Profits on Bonds: Objectives

1. 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.
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Intercompany Profit Transactions Bonds

1: Intercompany Receivables and Payables

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Intercompany Payables and Receivables

Remove intercompany: Payables and interest expense Receivables and interest income Loans directly between affiliates generally pose no special problems

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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
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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 affiliate 3. From other entities 4. At a price other than the book value of the bonds.
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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
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Intercompany Profit Transactions Bonds

2: Profits on Bonds

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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 is recognized over the life of the bonds Gain or loss is attributed solely to the parent
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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
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Amortizations and Interest

Pam's books: Bonds payable 10% retired Interest expense 10% retired Sue's books: Investment in bonds Interest income Book value 1/1/2010 $10,100 $1,010 During 2010 -$20
500+500-20 =$980

Book value 12/31/2010 $10,080 $1,008

During 2011 -$20

500+500-20 =$980

Book value 12/31/2011 $10,060 $1,006

$98

$98

$950

+$10
50+50+10 =$110

$960

+$10
50+50+10 =$110

$970

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Worksheet Entries for Bonds

Entries for 2010 worksheet.
Bonds payable Investment in bonds Gain on retirement of bonds Interest income Interest expense Gain on retirement of bonds 1,008 960 48 110 98 12

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.
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Intercompany Profit Transactions Bonds

3: Constructive Retirement of Debt

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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 to Pam. If Sue was the issuer, the $12 would be shared among the controlling and noncontrolling interests.
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2011 Worksheet Entries

Entries for 2011 worksheet, assuming that Pam has not yet paid the second interest payment. Bonds payable 1,006 Interest income 110 Investment in bonds 970 Interest expense 98 Investment in Sue 48 Interest payable 50 Interest receivable 50

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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.

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Intercompany Profit Transactions Bonds

4: Effect on Noncontrolling Interest

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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. Increase Income from subsidiary Increase Noncontrolling interest share In current and subsequent years, use piecemeal recognition Reduce Income from subsidiary Reduce Noncontrolling interest share
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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 Income from subsidiary Reduce Noncontrolling interest share In current and subsequent years, use piecemeal recognition Increase Income from subsidiary Increase Noncontrolling interest share
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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
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Amortizations and Interest

Scent's books: Bonds payable 40% retired Interest expense 40% retired Pine's books: Investment in bonds Interest income Book value 1/1/2010 $4,800 $1,920 During 2010 +$25
250+250+25 =$525

Book value 12/31/2010 $4,825 $1,930

During 2011 +$25

250+250+25 =$525

Book value 12/31/2011 $4,850 $1,940

$210

$210

$2,040

-$5
100+100-5 =$195

$2,035

-$5
100+100-5 =$195

$2,030

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2010 Entries with Loss

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

Interest expense Investment in bonds

210 2,035

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Amortizations and Interest

Scent's books: Bonds payable 40% retired Interest expense 40% retired Pine's books: Investment in bonds Interest income Book value 1/1/2010 $4,800 $1,920 During 2010 +$25
250+250+25 =$525

Book value 12/31/2010 $4,825 $1,930

During 2011 +$25

250+250+25 =$525

Book value 12/31/2011 $4,850 $1,940

$210

$210

$2,040

-$5
100+100-5 =$195

$2,035

-$5
100+100-5 =$195

$2,030

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2011 Worksheet Entries

Entries for 2011 worksheet, assuming that Scent has not yet paid the second interest payment.
Bonds payable Interest income Investment in Scent Investment in bonds Interest expense Interest payable Interest receivable
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1,940 195 105 2,030 210

100 100
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