Chapter 7: Intercompany Profit Transactions – Bonds Beams, Advanced Accounting 10e, Ch. 7 4/15/2017 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 © Pearson Education, Inc. publishing as Prentice Hall 7-1 Pearson Education Inc., publishing as Prentice Hall 1

Intercompany Profits on Bonds: Objectives Differentiate between intercompany receivables and payables, and assets or liabilities of the consolidated reporting entity. Defer unrealized profits and later recognize realized profits on bond transfers between parent and subsidiary companies. Demonstrate how a consolidated reporting entity constructively retires debt. Adjust calculation of noncontrolling interest amounts in the presence of intercompany profits on debt transfers. © Pearson Education, Inc. publishing as Prentice Hall 7-2

1: Intercompany Receivables and Payables Intercompany Profit Transactions – Bonds 1: Intercompany Receivables and Payables © Pearson Education, Inc. publishing as Prentice Hall 7-3

Intercompany Payables and Receivables Remove intercompany: Payables and interest expense Receivables and interest income Loans directly between affiliates generally pose no special problems © Pearson Education, Inc. publishing as Prentice Hall 7-4

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 © Pearson Education, Inc. publishing as Prentice Hall 7-5

Constructive Retirement One company purchases debt instruments of an affiliate from outside entities Constructive gains and losses on bonds are Realized gains and losses from the consolidated viewpoint That arise when a company purchases the bonds of an affiliate From other entities At a price other than the book value of the bonds. © Pearson Education, Inc. publishing as Prentice Hall 7-6

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

2: Profits on Bonds Intercompany Profit Transactions – Bonds © Pearson Education, Inc. publishing as Prentice Hall 7-8

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 © Pearson Education, Inc. publishing as Prentice Hall 7-9

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 © Pearson Education, Inc. publishing as Prentice Hall 7-10

Amortizations and Interest   Book value During   During Pam's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011 Bonds payable $10,100 -$20 $10,080 $10,060 10% retired $1,010 $1,008 $1,006 Interest expense 500+500-20 =$980 500+500-20 =$980 $98 Sue's books: Investment in bonds $950 +$10 $960 $970 Interest income 50+50+10 =$110 © Pearson Education, Inc. publishing as Prentice Hall 7-11

Worksheet Entries for Bonds Entries 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 960 Gain on retirement of bonds 48 Interest income 110 Interest expense 98 12 © Pearson Education, Inc. publishing as Prentice Hall 7-12

3: Constructive Retirement of Debt Intercompany Profit Transactions – Bonds 3: Constructive Retirement of Debt © Pearson Education, Inc. publishing as Prentice Hall 7-13

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. © Pearson Education, Inc. publishing as Prentice Hall 7-14

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 © Pearson Education, Inc. publishing as Prentice Hall 7-15

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. © Pearson Education, Inc. publishing as Prentice Hall 7-16

4: Effect on Noncontrolling Interest Intercompany Profit Transactions – Bonds 4: Effect on Noncontrolling Interest © Pearson Education, Inc. publishing as Prentice Hall 7-17

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 © Pearson Education, Inc. publishing as Prentice Hall 7-18

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 © Pearson Education, Inc. publishing as Prentice Hall 7-19

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 © Pearson Education, Inc. publishing as Prentice Hall 7-20

Amortizations and Interest   Book value During   During Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011 Bonds payable $4,800 +$25 $4,825 $4,850 40% retired $1,920 $1,930 $1,940 Interest expense 250+250+25 =$525 $210 Pine's books: Investment in bonds $2,040 -$5 $2,035 $2,030 Interest income 100+100-5 =$195 © Pearson Education, Inc. publishing as Prentice Hall 7-21

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 © Pearson Education, Inc. publishing as Prentice Hall 7-22

Amortizations and Interest   Book value During   During Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011 Bonds payable $4,800 +$25 $4,825 $4,850 40% retired $1,920 $1,930 $1,940 Interest expense 250+250+25 =$525 $210 Pine's books: Investment in bonds $2,040 -$5 $2,035 $2,030 Interest income 100+100-5 =$195 © Pearson Education, Inc. publishing as Prentice Hall 7-23

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 210 Interest payable 100 Interest receivable © Pearson Education, Inc. publishing as Prentice Hall 7-24

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