Chapter 7 Intercompany Profit Transactions - Bonds

Intercompany Direct Loan Parent Bonds Purchased by Subsidiary Subsidiary Bonds Purchased by Parent

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Intercompany Direct Loans

Parent/Subsidiary Issue Bond 100 at 90, 10 years maturity, 10% interest annually. Cash 90 Bond payable 90
Recog. interest on bond payable Interest expense 11 Interest payable 10 Bond payable 1 Subsidiary/Parent Purchase Bond securities 100 at 90, 10 years maturity, 10% interest annually. Investment in Bond 90 Cash 90 Recog. interest on Bond investment Interest receivable 10 Investment in Bond 1 Interest revenue 11
2

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Intercompany Direct Loans

Parent I/S Interest Expense 11 b. 11 Subsidi ary AJE & ELM (D) AJE & ELM (C) Consoli dated F.S.

Interest Revenue
B/S Assets Interest Receivable Investment in Bond Liabilities Interest Payable Bond Payable 10 91

11

b. 11

10 91

c. 10 a.91

c. 10 a. 91
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Intercompany Direct Loans

Adjustment and Elimination Workpaper entries: a. Bond Payable 91 Investment in Bond 91 b. Interest Revenue 11 Interest Expense 11 c. Interest Payable 10 Interest Receivable 10
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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 from outside entities - resulting in IC constructive retirement Parent -> Outside -> Subsidiary Subsidiary -> Outside -> Parent
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Subsidi ary

Parent

Parent

Outside

Subsidi ary

Outside

DOWNSTREAM

UPSTREAM

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Constructive Gains/Loss
From consolidated point of view: Bond retired Reciprocal elimination: Bond payable and Bond investment The difference Book Value of Bond Payable vs Purchase Price of Bond Investment = Gain/Loss If BV Bond Payable > Purchase Price Bond Investment = Constructive Gain If BV Bond Payable < Purchase Price Bond Investment = Constructive Loss
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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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Constructive Retirement
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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Subsidiary Acquisition of Parent Bonds

Sun is an 80% owned affiliate of Pat Pat issues $1,000,000 par of 10%, 10-year bonds at par value to public on Dec. 31, 2010. On Dec. 31, 2011 Sun purchases $100,000 of the bonds for $104,500 in the open market. BV Bond Payable $100,000 (10% of Pats Bond Payable ) Purchase Price Bond Investment 104,500 Constructive Loss $ 4,500 Charge full amount of loss/gain to the Issuer -> Parents Parent as a seller, Subsidiary as a Buyers of BOND = DOWNSTREAM
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Subsidiary Acquisition of Parent Bonds

Under Equity method Pat adjust investment and income from investment at Dec. 31, 2011 Income from Investment $4,500 Investment in Sun $4,500 Workpaper adjustment and elimination on preparing consolidated FS: Loss on constructive retirement of bonds 4,500 Bond Payable 100,000 Investment in bonds 104,500
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Parent Acquisition of Subsidiary Bonds

Sun sold $1,000,000 par of 10%, 10 year bonds to public at par on Dec. 30, 2010 Pat acquires $100,000 par of these bonds for $104,500 on Dec. 31, 2011 in the open market BV Bond Payable $100,000 (10% of Suns Bond Payable ) Purchase Price Bond Investment 104,500 Constructive Loss $ 4,500 Charge full amount of loss/gain to the Issuer -> Subsidiary Subsidiary as a seller, Parent as a Buyers of BOND = UPSTREAM So, Constructive loss/gain allocated between Controlling and Non Controlling interest shares
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Parent Acquisition of Subsidiary Bonds

Under Equity method Pat adjust investment and income from investment at Dec. 31, 2011 Income from Investment $3,600* Investment in Sun $3,600* * = 80% of 4,500 Workpaper adjustment and elimination on preparing consolidated FS: Loss on constructive retirement of bonds 4,500 Bond Payable 100,000 Investment in bonds 104,500
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Comprehensive: Parent Bonds Purchased by Subsidiary (DOWNSTREAM)

Sue is a 70% owned subsidiary of Pam, acquired at fair value equal to its $6,300,000 book value on Dec. 31, 2011 On Dec. 31, 2011 Sue had capital stock of $5,000,000 and retained earnings of $4,000,000. Pam has $10,000,000 par of 10% bonds outstanding with a $100,000 unamortized premium on Jan. 2, 2012 Sue purchases $1,000,000 par of these bonds for $950,000 from an investment banker. The purchase result a constructive retirement of 10% of Pams bonds: Book value of Pams Bonds Payable $1,010,000 (10%x (10,000,000+100,000)) Purchase price of bond investment 950,000 Constructive gain on bond retirement 60,000 Workpaper for consolidated on Jan. 2, 2012: Bond Payable 1,010,000 Investment in Pams Bonds 950,000 Gain on retirement of bonds 60,000
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Comprehensive: Parent Bonds Purchased by Subsidiary (DOWNSTREAM)

Sues Book Jan. 2, 2012 Jan. 2, 2012 Cash 10,100,000 Investment in Bond 950,000 Bond Payable 10,100,000 Cash 950,000 Issued Bond Payable to public Purchased bond securities at public July 1, 2012 July 1, 2012 Interest expense 500,000 Cash 50,000 Cash 500,000 Interest revenue 50,000 Dec. 31, 2012 Dec. 31, 2012 Interest expense 500,000 Interest receivable 50,000 Interest payable 500,000 Interest revenue 50,000 Bond payable 20,000* Investment in Pams bond 10,000* Interest expense 20,000* Interest revenue 10,000* * = 100,000 premium/5 years * = 50,000 discount/5 years Equity method: Investment in Sue 202,000* Income from investment 202,000* * = (220,000*70%) + 60,000-12,000 Yie Ke Feliana 15 Pams Book

Comprehensive: Parent Bonds Purchased by Subsidiary (DOWNSTREAM)

Pams Book Dec. 31, 2012 I/S Interest expense 980,000 B/S Sues Book Dec. 31, 2012 I/S Interest revenue 110,000 B/S Assets Interest Receivable 50,000 Investment Bond 960,000

Liabilities Interest payable 500,000 Bond payable 10,080,000

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Comprehensive: Parent Bonds Purchased by Subsidiary (DOWNSTREAM)

Workpaper entries for consolidated FS on Dec. 31, 2012: a. Bond payable 1,008,000* Investment in Pams bonds 960,000 Gain on retirement of bonds 48,000 b. Interest revenue 110,000 Interest expense 98,000* Gain on retirement of bonds 12,000 f. Interest payable 50,000* Interest receivable 50,000 *= 10% of total Pam
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Piecemeal Recognition
Every year, a part of constructive gain/loss will be recognized. Example: Total constructive gain 60,000 Piecemeal recognition under straight line amortization : 60,000/5 years = 12,000 per year. Equity method at Pams Book: Effect of Constructive Gain
2012 Investment in Sue Income from Sue 48 48 2013 2014 2015 2016

Income from Sue

Investment in Sue

12
12
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12
12

12
12

12
12
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2013 Pams Book Interest expense Interest payable Bonds payable Sues Book Interest revenue Interest receivable Investment in Pams bonds Workpaper Journal 2013 110 50 970 980 500 10,060

2014 980 500 10,040 110 50 980 2014

2015 980 500 10,020 110 50 990 2015

2016 980 500 10,000 110 50 1,000 2016

Bond Payable Investment in Ps Bond

Investment in Sue Interest revenue Interest expense Investment in Sue Interest Payable Interest Receivable

1,006 970
36 110 98 12 50 50

1,004 980
24 110 98 12 50
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1,002 990
12 110 98 12 50 50 50

1,000 1,000
110 98 12 50 50 19

Comprehensive: Subsidiary Bonds Purchased by Parent (UPSTREAM)

Pro owns 90% of the voting common stock of Sky. Pro purchased its interest in Sky a number years ago its book value of $9,225,000. Skys capital stock was $10,000,000 and its retained earnings were $250,000 on the acquisition date. At Dec. 31, 2011 Sky had $10,000,000 par of 10% bond outstanding with an unamortized discount of $300,000. The bonds pay interest on Jan. 1 & July 1 of each year, and they mature in 5 years on Jan. 1, 2017. On Jan. 2, 2012, Pro purchases 50% of Skys outstanding bonds for $5,150,000 cash and classifies the bond as a held to maturity investment. Book Value of Skys Bond Payable $ 4,850,000 (50%x (1,000,000 par -300,000 discount)) Purchases price 5,150,000 Constructive Loss on Bond retirement 300,000 Assign the constructive loss to the issuer, Sky. Workpaper Journal for Consolidated FS on Jan. 2, 2012 Bond payable $ 4,850,000 Loss on Bond retirement 300,000 Investment in Skys Bond $5,150,000
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Comprehensive: Subsidiary Bonds Purchased by Parent (UPSTREAM)

Skys Book Dec. 31, 2011 Cash 9,700,000 Bond Payable 9,700,000 Issued Bond Payable to public July 1, 2012 Interest expense 500,000 Cash 500,000 Dec. 31, 2012 Interest expense 500,000 Interest payable 500,000 Interest expense 60,000* Bond payable 60,000* * = 300,000 discount/5 years Pros Book Jan. 2, 2012 Investment in Skys Bond 5,150,000 Cash 5,150,000 Purchased bond securities at public July 1, 2012 Cash 250,000 Interest revenue 250,000 Dec. 31, 2012 Interest receivable 250,000 Interest revenue 250,000 Interest revenue 30,000* Investment in Skys bond 30,000* * = 150,000 discount/5 years Equity method: Investment in Sue 459,000* Income from investment 459,000* * = (750,000-300,000+60,000)x 90%
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Comprehensive: Subsidiary Bonds Purchased by Parent (UPSTREAM)

Pros Book Dec. 31, 2012 I/S Interest revenue 470,000 B/S Assets Interest Receivable 250,000 Investment Skys Bond 5,120,000 Skys Book Dec. 31, 2012 I/S Interest expense 1,060,000 B/S

Liabilities Interest payable 500,000 Bond payable 9,760,000

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Comprehensive: Subsidiary Bonds Purchased by Parent (UPSTREAM)

Workpaper entries for consolidated FS on Dec. 31, 2012: a. Bond payable 4,880,000* Loss on retirement of bonds 240,000 Investment in Skys bonds 5,120,000 b. Interest revenue 470,000 Loss on retirement of bonds 60,000 Interest expense c. Interest payable 250,000* Interest receivable 250,000 *= 50% of total Sky
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530,000*

Piecemeal Recognition
Every year, a part of constructive gain/loss will be recognized. Example: Total constructive loss 300,000 Piecemeal recognition under straight line amortization : 300,000/5 years = 60,000 per year. For Controlling interest (Pro) = 90% * 60,000 = 54,000 For NCI = 10%*60,000 = 6,000 Equity method at Pros Book: Effect of Constructive Loss
2012 Income from Sky Investment in Sky Investment in Sky Income from Sky
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2013

2014

2015

2016

216 216 54 54 54 54 54 54 54 54
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Subsequent Years
2013 Skys Book Interest expense Interest payable Bonds payable Pros Book Interest revenue Interest receivable Investment in Skys bonds 470 250 5,090 470 250 5,060 470 250 5,030 470 250 5,000 1,060 500 9,820 1,060 500 9,880 1,060 500 9,940 1,060 500 10,000 2014 2015 2016

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Workpaper Journal

2013

2014

2015

2016

a. Eliminate reciprocal Bond Payable & Invest. Bond Payable Investment in Sky 4,910 162 4,940 108 4,970 54 5,000 -

NCI
Investment in S Bond

18
5,090

12
5,060

6
5,030

5,000

b. Eliminate reciprocal Bond interest rev. & exp. Interest revenue Investment in Sky NCI Interest expense 470 54 6 530 470 54 6 530 470 54 6 530 470 54 6 530

c. Eliminate reciprocal Bond interest payable & receivable Interest Payable Interest Receivable 250 250
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250 250

250 250

250 250
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