Chapter 5 Intercompany Debt

Intercompany debt Intercompany loans are eliminated with interest Bonds held by affiliate are retired Capital lease debt is eliminated; asset becomes an owned asset C5 1

Simple intercompany loan Parent loans sub $100,000 at 8% on July 1; annual interest Parent Journal Entries 7/1 Note Rec 100,000 Cash 100,000 12/31 Int Rec 4,000 Int Rev 4,000 Sub Journal Entries 7/1 Cash 100,000 Note Pay 100,000 12/31 Int Exp 4,000 Int Pay 4,000 C5 2

Simple intercompany loan (continued) Worksheet Eliminations LN1 Note Payable 100,000 Int Payable 4,000 Note Rec 100,000 Int Rec 4,000 LN2 Interest Revenue 4,000 Interest Expense 4,000 No impact on income distribution schedule C5 2

Intercompany bonds A subsidiary may have debt that is more expensive than if it were issued by the parent. One member of the affiliated group (usually the Subsidiary) has bonds outstanding that are held by outsiders - The other member (usually the parent) purchases the bonds from the outsiders. We treat it as WS retirement with an ordinary gain or loss (no longer extraordinary). The result is the same if the parent loans money to the subsidiary and the subsidiary retires the bonds. C5 4

Bond example: Facts Sub (80%) issues to third parties $100,000, 8 year, 10% (annual interest) bond on 1/1/1 for $102,400 premium amortization (straight line) = $300 per year Int Exp = $9,700 per year Parent purchases the bonds from third party for $99,200 on 1/1/5 (4 remaining years) discount amortization (straight-line) = $200 per year Int Rev = $10,200 per year Consolidated statements: $99,200 was paid to retire bonds with a book value of $101,200. There is $2,000 gain on the date of purchase. C5

Bond example: Journal entries years 1-4 Sub Journal Entries Year 1 Cash 102,400 Bond Pay 100,000 Premium 2,400 Years 1, 2, 3, & 4 Int Exp 9,700 Premium 300 Int Pay 10,000 Parent Journal Entries No entries Premium Balance 1/1/5 = $1,200 C5

Bond example: Carrying values Parent buys 1/1/5 C5

Bond example: Journal entries years 5-8 Sub Journal Entries Year 5 Int Exp 9,700 Premium 300 Int Pay 10,000 Years 6, 7, & 8 Parent Journal Entries Year 5 Bond invest 99,200 Cash 99,200 Int Rec 10,000 Bond Invest 200 Int Rev 10,200 Years 6, 7, & 8 C5 5

Bond example: Eliminations 12/31/5 C5

Bond example: Eliminations 12/31/5 (continued) Proof of gain on 12/31/5: Book value of debt 100,900 Investment balance 99,400 1,500 Interest revenue 10,200 Interest expense 9,700 500 Gain on 1/1/5 2,000 C5

Bond example: Sub IDS 12/31/5 Interest adj. (B1) 500 Int generated inc 34,000 Gain on retire 2,000 Adjusted net inc 35,500 NCI % 20% NCI share 7,100 C5

Bond example: Eliminations 12/31/6 C5

Eliminations 12/31/6 (continued) Bond example: Eliminations 12/31/6 (continued) Proof of gain on 12/31/6: Book value of debt 100,600 Investment balance 99,600 1,000 Interest revenue 10,200 Interest expense 9,700 500 Gain on 1/1/6 1,500 C5

Bond example: Sub IDS 12/31/6 Sub IDS Interest adj. (B1) 500 Int generated inc 24,000 Adjusted net inc 23,500 NCI % 20% NCI 4,700 C5

Effective interest bonds Need an amortization schedule to see it See worksheet 5-4 and supporting amortization tables in text The “easy out” entry - eliminate bonds payable, discount or premium on bonds, interest expense and interest revenue Gain or loss at year end + Gain or loss amortized = Gain or loss at start of year (RE adj or G/L) C5 8

Effective interest bond example: Facts Sub issues to third party a $100,000, 8 year, 10% bond on 1/1/1 for $102,400 100,000FV;10,000pmt; 102,400PV; 8n = 9.5574% Parent purchases the bonds from outsiders for $99,200 on 1/1/5 (4 remaining years) 100,000FV; 10,000pmt; 99,200PV; 4n = 10.254% Consolidated statements: $99,200 was paid to retire bonds with a book value of $101,200. There is a $2,000 gain C5

Effective interest bond example: Amortization tables

Effective interest bond example: Eliminations 12/31/6 9

Effective interest bond example: Eliminations 12/31/6 (continued) Proof of gain on 12/31/6: Book value of debt 100,773 Investment balance 99,561 1,212 Interest revenue 10,189 Interest expense 9,663 526 Gain on 1/1/6 1,738 C5

Effective interest bond example: Sub IDS 12/31/6 Interest adj. (B1) 526 Int generated inc 24,000 Adjusted net inc 23,474 NCI % 20% NCI 4,695 C5

Intercompany Leases Operating lease Financing type (capital) lease just eliminate rental expense and revenue no adjustment to consolidated net income Financing type (capital) lease asset is on lessor’s books at cost similar to intercompany loan trick is that Lessee has Capt Lease Obligation (at PV) while Lessor has Min LP Rec (at gross) less Unearned Interest (brings gross amount down to PV) no adjustment to consolidated net income C5

Intercompany leases (continued) Sales type lease recorded same as financing type lease there is a profit for the lessor, it is deferred in the same manner as the gain on a fixed asset sale. Residual values chapter assumes there is a bargain purchase option or guaranteed residual which means the residual value is included in the minimum lease payments appendix considers unquaranteed residual: interest expense and revenue are not equal. In this case, there is an impact on consolidated net income. C5

Financing-type lease example: Data Sub is 80% owned by Parent Cost of equipment leased is $21,682 Implicit rate is 12% for both parties Origination date is 1/1/1 Terms: start-of-period payments = $6,000 4 years bargain purchase option = $2,000 C5

Financing-type lease example: Amortization schedule 11

Financing-type lease example: Journal entries year 1 Sub/Lessee Journal Entries 1/1/1 Leased Asset 21,682 Lease Oblig 15,682 Cash 6,000 12/31/1 Int Exp 1,882 Int Pay 1,882 Parent/Lessor Journal Entries 1/1/1 Min LP Rec 26,000 Unearn Int 4,318 Cash 21,682 Cash 6,000 Min LP Rec 6,000 12/31/1 Unearned Int 1,882 Int Rev 1,882 Unearned interest = $2,436 C5

Financing-type lease example: Eliminations 12/31/1

Sub/Lessee Journal Entries Parent/Lessor Journal Entries Financing-type lease example: Journal entries year 2 Sub/Lessee Journal Entries 1/1/2 Int Pay 1,882 Lease Oblig 4,118 Cash 6,000 12/31/1 Int Exp 1,388 Int Pay 1,388 Parent/Lessor Journal Entries 1/1/1 Cash 6,000 Min LP Rec 6,000 12/31/1 Unearned Int 1,388 Int Rev 1,388 Unearned interest = $1,048 C5

Financing-type lease example: Eliminations 12/31/2

Sales Type Leases First - eliminate the lease Then - the asset is overstated Procedure (like any other fixed asset profit): reduce asset to cost reduce accumulated depreciation and correct RE for prior years depreciation reduce current year depreciation C5