© The McGraw-Hill Companies, Inc., 2004 Slide 6-1 McGraw-Hill/Irwin Chapter 6 Inter-Company Debt Transactions Direct loans between affiliated parties create no special consolidation problems.  Eliminate the corresponding receivable and payable from the consolidated financial statements. Also eliminate the effects of any related interest.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-2 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party (1) 80% Ownership Parent Sub (2) Assume the Sub issued bonds to outside investors. In effect, the Sub has issued the debt indirectly to the Parent. How should this be accounted for? (3) Investors sell the bonds to the parent company.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-3 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) If material, the loss is treated as an extraordinary item. The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) If material, the loss is treated as an extraordinary item.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-4 McGraw-Hill/Irwin Big owns 90% of Little. On 1/1/00, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/04 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/04, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Note – The Straight-line Method is used to amortize any premiums/discounts Big owns 90% of Little. On 1/1/00, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/04 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/04, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Note – The Straight-line Method is used to amortize any premiums/discounts Acquisition of Affiliate’s Debt from an Outside Party Continue

© The McGraw-Hill Companies, Inc., 2004 Slide 6-5 McGraw-Hill/Irwin On 1/2/04, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/04, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest On 1/2/04, the market rate is 5%, and Big pays $2,101,514 for the bonds. Since Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/04, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest Acquisition of Affiliate’s Debt from an Outside Party Continue

© The McGraw-Hill Companies, Inc., 2004 Slide 6-6 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Entry B This entry is made at the end of the year that the debt is “extinguished” We will assume that any gains/losses from this transaction belong to the parent. Thus, there will be no effect on Noncontrolling Interest. Entry B This entry is made at the end of the year that the debt is “extinguished” We will assume that any gains/losses from this transaction belong to the parent. Thus, there will be no effect on Noncontrolling Interest.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-7 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-8 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Note that, over the remaining life of the bonds, the book values will eventually converge to the point where the adjustment to R/E will be amortized away completely.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-9 McGraw-Hill/Irwin Consolidated Statement of Cash Flows consolidated consolidated The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement.

© The McGraw-Hill Companies, Inc., 2004 Slide 6-10 McGraw-Hill/Irwin Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a cash outflow. Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a cash outflow. Consolidated Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2004 Slide 6-11 McGraw-Hill/Irwin Amortization Add amortization of goodwill and FMV allocations to Consolidated Net Income. Amortization Add amortization of goodwill and FMV allocations to Consolidated Net Income. Consolidated Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2004 Slide 6-12 McGraw-Hill/Irwin Consolidated Statement of Cash Flows Intercompany Transactions Intercompany cash flows should not be included on the statement of cash flows. The intercompany cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows.