Chapter 7

Intercompany
Profit
Transactions
Bonds

Intercompany Profits on Bonds:

Objectives
1. Differentiate between intercompany receivables and
payables, and assets or liabilities of the
consolidated reporting entity.
2. Demonstrate how a consolidated reporting entity
constructively retires debt.
3. Defer unrealized gains/losses and later recognize
realized gains/losses on bond transfers between
parent and subsidiary.
4. Adjust calculation of noncontrolling interest share
amounts in the presence of intercompany
gains/losses 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
Issuing firm uses own resources to retire its own
bonds no intercompany (IC) issues
Issuing firm borrows from unaffiliated entity and
uses funds to retire its own debt no IC
Issuing firm borrows from affiliate and uses
funds to retire its own debt simple IC loan
Non-issuing firm purchases debt securities of an
affiliate resulting in constructive retirement IC
constructive retirement

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Intercompany Profit Transactions Bonds

2: CONSTRUCTIVE
RETIREMENT OF DEBT

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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 superior than other methods

Text:
Follows agency theory
Simplifies discussion using straight line
amortization of premiums & discounts

Other methods
Assign gain or loss to affiliates based on the par
value of the bonds par value theory
Assign all gain or loss to the parent
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Intercompany Profit Transactions Bonds

3: GAINS AND LOSSES ON

BOND TRANSFERS

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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 1/1/12, Pam has $10,000 bonds outstanding with
unamortized premium of $100. Bonds mature in 5
years. Straight line amortization. Interest is 10%,
payable semi-annually.
On 1/1/12, 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

Book
value
1/1/20
12

Fiscal
Year
2012

Book
value
12/31/
2012

Fiscal
Year
2013

Book
value
12/31/
2013

$10,100

-$20

$10,080

-$20

$10,060

PAMS BOOKS:
Bonds payable
Retired 10%

$1,010

$1,008

$1,006

Interest expense

500+500-20
=$980

500+500-20
=$980

Retired 10%

$98

$98

SUE'S BOOKS:
Investment in
bonds
Interest income

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$950

+$10
50+50+10
=$110

$960

+$10

$970

50+50+10
=$110

7-12

Worksheet Entries for Bonds

Entries for 2012 worksheet.
Bonds payable (-L)

1,008

Investment in bonds (-A)

960

Gain on retirement of bonds (Ga, +SE)

Interest income (-R, -SE)

48
110

Interest expense (-E, +SE)

98

Gain on retirement of bonds (Ga, +SE)

12

Interest payable (-L)

50

receivable
(-A) sheet been prepared on 1/1/2012,
50
Had a Interest
consolidated
balance
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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Piecemeal Recognition
The constructive gain of $60 is recognized in
2012 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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Amortizations and Interest

Book
value
1/1/20
12
$10,100

PAMS BOOKS:
Bonds payable
Retired 10%

Fiscal
Year
2012

Book
value
12/31/
2012

Fiscal
Year
2013

Book
value
12/31/
2013

-$20

$10,080

-$20

$10,060

$1,010

$1,008

$1,006

Interest expense

500+500-20
=$980

500+500-20
=$980

Retired 10%

$98

$98

SUE'S BOOKS:
Investment in
bonds
Interest income

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$950

+$10
50+50+10
=$110

$960

+$10

$970

50+50+10
=$110

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2013 Worksheet Entries

Entries for 2013 worksheet, assuming that Pam has
not yet paid the second interest payment.
Bonds payable (-L)
Interest income (-R, -SE)

1,006
110

Investment in bonds (-A)

970

Interest expense (-E, +SE)

98

Investment in Sue (-A)

48

Interest payable (-L)

Interest receivable (-A)

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50
50

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Subsequent Worksheet Entries

Notice that there is no gain in subsequent years.
The $60 gain is amortized each year by $12, so
the Investment account is increased by $48 in
2013.
The Investment in Sue account will be credited
by $36 in 2014, by $24 in 2015, and so forth.
Had Sue been the issuer, the $48 credit for 2012
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 2012 is $500.
On 1/1/12, Scent has $5,000, bonds outstanding with unamortized
discount of $200. Bonds mature in 8 years. Straight line amortization.
Interest is 10% payable semi-annually. Interest expense = $525.
On 1/1/12, Pine acquires $2,000 of Scent's bonds on the open market
at $2,040. Straight line. Interest income = $195.

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 + 210 - 195) =
$316
Noncontrolling interest share: 20%(500 120 + 210 - 195) = $79

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Amortizations and Interest

Book
value
1/1/20
12

Bonds payable

$4,800

Retired 40%

$1,920

SCENT'S
BOOKS:

Fiscal
Year
2012

Book
value
12/31/20
12

Fiscal
Year
2013

Book
value
12/31/20
13

+$25

$4,825

+$25

$4,850

$1,930

$1,940

Interest expense

250+250+25
=$525

250+250+25
=$525

Retired 40%

$210

$210

PINE'S BOOKS:
Investment in
bonds
Interest income

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$2,040

-$5
100+100-5
=$195

$2,035

-$5

$2,030

100+100-5
=$195

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2012 Entries with Loss

Entries for 2012 worksheet, assuming the
second interest payment has not yet been
paid.
Bonds payable (-L)

1,930

Interest income (-R, -SE)

195

Loss on retirement of bonds (Lo, -SE)

120

Interest expense (-E, +SE)

210

Investment in bonds (-A)

Interest payable (-L)
Interest receivable (-A)
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2,035
100
100
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Amortizations and Interest

SCENT'S
BOOKS:

Book
value
1/1/2
012

Bonds payable

$4,800

Retired 40%

$1,920

Interest
expense
Retired 40%

Fiscal
Year
2012

Book
value
12/31/2
012

Fiscal
Year
2013

Book
value
12/31/2
013

+$25

$4,825

+$25

$4,850

$1,930

$1,940

250+250+2
5 =$525

250+250+2
5 =$525

$210

$210

PINE'S
BOOKS:
Investment in
bonds
Interest income
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$2,040

-$5
100+100-5
=$195

$2,035

-$5

$2,030

100+100-5
=$195
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2013 Worksheet Entries

Entries for 2013 worksheet, assuming that
Scent has not yet paid the second interest
payment.
Bonds payable (-L)

1,940

Interest income (-R, -SE)

195

Investment in Scent (+A)

105

Investment in bonds (-A)

2,030

Interest expense (-E, +SE)

Interest payable (-L)
Interest receivable (-A)
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210
100
100
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