1. Advanced Accounting, Fifth Edition9
Intercompany
Bond Holdings and Miscellaneous Topics—Consolidated Financial Statements
Advanced Accounting, Fifth Edition

2. Learning Objectives
Describe the term “constructive retirement of debt.”
Describe how the gain or loss on constructive retirement of intercompany bond holdings is allocated between the purchasing and issuing companies.
Explain the impact on the consolidated financial statements when a company issues a note to an affiliated company, which then discounts the note with an outside company.
Determine the effect on the consolidated financial statements when a subsidiary issues a stock dividend.
Understand the difference in how stock dividends and cash dividends issued by a subsidiary company affect the consolidated financial statements.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

3. Learning Objectives
Determine the impact on the investment account when a subsidiary issues a stock dividend from preacquisition earnings and from postacquisition earnings.
Explain how the purchase price is allocated when the subsidiary has both common and preferred stock outstanding.
Determine the controlling interest in income when the parent company owns both common and preferred stock of the subsidiary.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Intercompany Bond Holdings
An affiliate company may purchase bonds issued by another affiliate.
Intercompany
bond investments (receivable),
bonds payable (liability),
intercompany interest expense and,
Intercompany interest revenue,
must be eliminated.
Bonds not held by external parties are viewed as being constructively retired in the consolidated financial statements. This is viewed as early retirement of debt.
LO 1 Constructive retirement of debt.

5. Accounting for Bonds - A Review
Illustration: Three year bonds with a par value of $100,000 are issued on Jan. 2, 2010, for $85,000. The bonds pay 7% interest each December 31. Assume straight-line amortization of the discount. *
* $100,000 – 85,000 = 15,000 / 3 years = $5,000
LO 1 Constructive retirement of debt.

6. Accounting for Bonds - A Review
Illustration - Issuing Company.
Journal entries for 2010:
Jan. 2 Cash 85,000
Discount on bonds payable 15,000
Bonds payable 100,000
Dec. 31 Interest expense 7,000
Cash 7,000
Interest expense 5,000
Discount on bonds payable 5,000
LO 1 Constructive retirement of debt.

7. Accounting for Bonds - A Review
Illustration - Investor Company.
Journal entries for 2010:
Jan. 2 Investment in bonds 85,000
Cash 85,000
Dec. 31 Cash 7,000
Interest revenue 7,000
Investment in bonds 5,000
Interest revenue 5,000
LO 1 Constructive retirement of debt.

8. Constructive Gain or Loss on Intercompany Bond Holdings
The acquisition of an affiliate’s outstanding bonds from outsiders is considered a constructive retirement by the consolidated entity.
The constructive gain or loss is recognized in the consolidated income statement prior to the recognition of the gain or loss on the books of the individual companies.
In the period the bonds are purchased, workpaper entries are made to accelerate the recognition of the gain or loss. After the bonds are purchased, workpaper entries are needed to eliminate the portion of the gain or loss recorded during the period on the books of the individual companies.
LO 1 Constructive retirement of debt.

9. Constructive Gain or Loss
Allocation of Constructive Gain or Loss
Four methods for allocating the constructive gain or loss between the parent and subsidiary:
Entirely to the issuing company.
Entirely to the purchasing company.
Entirely to the parent company.
Allocated between the purchasing and issuing companies.
The authors consider the fourth method to be the soundest conceptually.
LO 2 Allocating the constructive gain or loss.

10. Constructive Gain or Loss
Computing the Constructive Gain or Loss
On the date bonds of an affiliate are purchased, a constructive gain or loss is computed.
The portion allocated to the issuing company is the difference between the book value (carrying value) of the bonds issued and their par value;
The portion allocated to the purchasing company is the difference between the par value of the bonds and their cost.
There is no constructive gain or loss if the bonds are issued or purchased at par value.
LO 2 Allocating the constructive gain or loss.

11. Constructive Gain or Loss
Computing the Constructive Gain or Loss
If the issue price and purchase price were not equal to par value, there are four possible combinations that can result:
LO 2 Allocating the constructive gain or loss.

12. Constructive Gain or Loss
Computing the Constructive Gain or Loss
+ $10,000 Constructive gain
- $15,000 Constructive loss
- $5,000
Net constructive loss
LO 2 Allocating the constructive gain or loss.

13. Constructive Gain or Loss
Computing the Constructive Gain or Loss
- $10,000 Constructive loss
+ $15,000 Constructive gain
+ $5,000
Net constructive gain
LO 2 Allocating the constructive gain or loss.

14. Accounting for Intercompany Bonds Illustrated
Illustration: P Company acquired an 80% interest in S Company for $1,200,000 on January 2, 2009, when the retained earnings and common stock accounts of S Company were $500,000 and $1,000,000, respectively. On December 31, 2012, P Company acquired $300,000 of S Company’s par value bonds (60% of S Company’s bonds) on the open market for $310,000 after the semiannual interest payment had been made. At the time of purchase there were $500,000 par value bonds outstanding with a book value of $480,000. The bonds mature in four years on December 31, 2016, and carry an interest rate of 9%. Interest is paid semiannually on June 30 and December 31. Both companies use the straight-line method to amortize bond discounts and premiums. The fiscal year-end of both companies is December 31.
LO 2 Allocating the constructive gain or loss.

15. Book Entry Related to Bond Investment
Prepare the entry made by P Company to record the bond investment on December 31, 2012:
Dec. 31
Investment in S Company Bonds 310,000
Cash 310,000
Note:
The usual practice of recording a bond investment does not separate the discount or premium.
Since the bonds were purchased on the open market, there is no entry made on the issuing company’s books.
LO 2 Allocating the constructive gain or loss.

16. Book Entry Related to Bond Investment
Compute the Constructive Gain or Loss
- $12,000 Constructive loss
- $10,000 Constructive loss
On the books of the individual companies, the constructive loss is not recorded.
The constructive loss is recognized in the determination of consolidated income.
- $22,000
Net constructive loss
LO 2 Allocating the constructive gain or loss.

17. Consolidated Statements Workpaper—2012
Cost Method
(5)
(2)
(3)
(6)
(1)
(5)
(2)
(4)
(1)
(6)
(4)
(6)
(6)

18. Consolidated Statements Workpaper—2012
Cost Method
(5)
(2)
(3) *
(6)
(1)
(5)
* ($125,000 $12,000) x 20% = $22,600
LO 2 Allocating the constructive gain or loss.

19. Consolidated Statements Workpaper—2012
Cost Method
(2)
(4)
(1)
(6)
(4)
(3)
(6)
(6)
** $300,000 ($700,000 - $500,000) x 20% = $340,000
LO 2 Allocating the constructive gain or loss.

20. Consolidated Statements Workpaper—2012
Worksheet entries for 2012. 1.
Investment in S Company Stock 160,000
Beginning Retained Earnings—P Company 160,000
To establish reciprocity, or convert to equity
Retained earnings balance—January 1, $ 700,000
Retained earnings balance—date of acquisition 500,000
Increase in retained earnings 200,000
Percentage interest held by P Company 80%
Amount to establish reciprocity $ 160,000
LO 2 Allocating the constructive gain or loss.

21. Consolidated Statements Workpaper—2012
Worksheet entries for 2012. 2.
Loss on Constructive Retirement of Bonds 10,000
Investment in S Company Bonds 10,000
To recognize the constructive loss not recorded by P Company and adjust the bond investment to par value. 3.
Loss on Constructive Retirement of Bonds 12,000
Discount on Bonds Payable 12,000
To recognize the constructive loss not recorded by the subsidiary and adjust the intercompany bonds to par value.
Entries (2) and (3) recognize the constructive loss allocated to each company and adjust bond investment and carrying value of the intercompany debt to par value.
LO 2 Allocating the constructive gain or loss.

22. Consolidated Statements Workpaper—2012
Worksheet entries for 2012. 4.
Bonds Payable 300,000
Investment in S Company Bonds 300,000
To eliminate intercompany bond investment and liability. 5.
Dividend Income 16,000
Dividends Declared—S Company 16,000
To eliminate intercompany dividends. 6.
Beginning Retained Earnings—S Company 700,000
Common Stock—S Company 1,000,000
Investment in S Company Stock 1,360,000
Noncontrolling Interest in Equity 340,000
To eliminate investment account and create NCI.
LO 2 Allocating the constructive gain or loss.

23. Consolidated Statements Workpaper—2012
Complete Equity Method
If the complete equity method is used, entry (1), the reciprocity entry, is not needed and the following entry replaces entry (5) above.
Equity in S Company Income 80,400
Dividends Declared 16,000
Investment in S Company Stock 64,400
To eliminate the intercompany income and dividends.
LO 2 Allocating the constructive gain or loss.

24. Consolidated Statements Workpaper —2013
Complete Equity Method
(3)
(1)
(4)
(3)
(1)
(2)
(3)
(4)
(2)
(1)
(4)
(4)

25. Year Subsequent to Acquisition of Bonds, Entries on the Books of Affiliated Companies—2013
P Company’s Books
Entries on June 30 and December 31
Cash 13,500
Interest Revenue 13,500
To record receipt of interest ($300,000 x 9% x 6/12).
Interest Revenue 1,250
Investment in S Company Bonds 1,250
To amortize premium on outstanding bonds ($10,000/ 8 periods).
LO 2 Allocating the constructive gain or loss.

26. Year Subsequent to Acquisition of Bonds, Entries on the Books of Affiliated Companies—2013
S Company’s Books
Entries on June 30 and December 31
Interest Expense 22,500
Cash 22,500
To record payment of interest ($500,000 x 9% x 6/12).
Interest Expense 2,500
Discount on Bonds Payable 2,500
To amortize discount on outstanding bonds ($20,000 / 8 periods).
LO 2 Allocating the constructive gain or loss.

27. Consolidated Statements Workpaper Entries
Worksheet entries for December 31, 2013. 1.
Investment in S Company Stock 244,000
Beginning Retained Earnings—P Company 244,000
To establish reciprocity, or convert to equity
($805, $500,000) x 80% = $244,000 2.
Beginning Retained Earnings—P Company 10,000
Investment in S Company Bonds 10,000
To adjust beginning retained earnings for constructive loss (recorded in prior year as workpaper entry only; see 2012 entry (2) and to adjust investment to par.
LO 2 Allocating the constructive gain or loss.

28. Consolidated Statements Workpaper Entries
Worksheet entries for December 31, 2013. 3.
Beginning Retained Earnings—P Company * 9,600
Beginning Noncontrolling Interest ** 2,400
Discount on Bonds Payable ($15,000 x 60%) 12,000
To adjust beginning retained earnings balances for unrecorded constructive loss at beginning of the year (recorded in 2012 as workpaper entry only; see 2012 entry (3)) and adjust intercompany bonds to par value.
* ($12,000 x 80%)
** ($12,000 x 20%)
LO 2 Allocating the constructive gain or loss.

29. Consolidated Statements Workpaper Entries
Worksheet entries for December 31, 2013. 4.
Investment in S Company Bonds 2,500
Interest Revenue ($1,250 + $1,250) 2,500
To reverse the amortization of premium on investment recorded by P Company during the current year (and not needed by consolidated entity since the constructive loss was recorded in its entirety in 2012).
LO 2 Allocating the constructive gain or loss.

30. Consolidated Statements Workpaper Entries
Worksheet entries for December 31, 2013. 5.
Discount on Bonds Payable ($5,000 x 60%) 3,000
Interest Expense 3,000
To reverse amortization of discount on bonds payable recorded by S Company during current year (and not needed by consolidated entity since the constructive loss was recorded in its entirety in 2012). 6.
Interest Revenue * 27,000
Interest Expense 27,000
To eliminate intercompany interest.
* ($45,000 x 60%) or ($13,500 + $13,500)
LO 2 Allocating the constructive gain or loss.

31. Consolidated Statements Workpaper Entries
Worksheet entries for December 31, 2013. 7.
Bonds Payable ($500,000 x 60%) 300,000
Investment in S Company Bonds 300,000
To eliminate intercompany bond investment and bonds payable. 8.
Dividend Income 48,000
Dividends Declared—S Company 48,000 9.
Beginning Retained Earnings—S Company 805,000
Common Stock—S Company 1,000,000
Investment in S Company Stock 1,444,000
Noncontrolling Interest in Equity 361,000
LO 2 Allocating the constructive gain or loss.

32. Consolidated Statements Workpaper—2013
Cost Method
(8)
(6)
(4)
(5)
(6)
(2)
(3)
(1)
(9)
(1)
(4)
(2)
(7)
(1)
(9)
(7)
(5)
(3)
(9)
(3)
(9)

33. Interim Purchase of Intercompany Bonds
Had the bonds been held during 2012, P Company would have amortized a portion of the premium and S Company would have amortized a part of the discount.
Assuming that P Company amortized $500 and S Company amortized $600 during 2012, the original workpaper entries (2) and (3) for constructive losses) are modified as follows: 2.
Loss on Constructive Retirement Bonds 10,000
Interest Revenue 500
Investment in S Company Bonds 9,500
Loss on Constructive Retirement of Bonds 12,000
Interest Expense 600
Discount on Bonds Payable 11,400 3.

34. Interim Purchase of Intercompany Bonds
Notes:
1. The consolidated income statement will still show a total loss on the constructive retirement of $22,000.
2. The credits to interest revenue and interest expense add back the portion of the loss that was recorded by the individual companies, but which is reported in total in 2012.
3. Failure to add back the $1,100 ($500 + $600) to the reported income of the individual companies will result in reporting this portion of the loss twice.

35. Notes Receivable Discounted
A company may issue a note to an affiliated company that may then discount the note with an outside party. OR
A company holding a note receivable from an outside party may discount the note with an affiliated company.
From a consolidation point of view, a receivable held by one of the affiliated companies should be reported in the consolidated balance sheet only if the note is due from an outside party.
LO 3 Discounting a note issued to an affiliated company with an outside company.

36. Stock Dividends Issued by a Subsidiary Company
Parent company records receipt of shares in a memorandum entry only.
Subsidiary records the declaration of a stock dividend as a transfer from retained earnings to one or more paid-in capital accounts.
Amount transferred is dependent on whether the dividend is a large or small stock dividend.
For consolidated purposes, the stock dividend does not alter the investor’s proportionate interest in the sub.
LO 4 Stock dividends issued by a subsidiary.

37. Stock Dividends Issued by a Subsidiary Company
Illustration: Assume that P Company purchased 4,000 shares of S Company’s $100 par value common stock on January 2, 2012, for $560,000. At the time of purchase, S Company reported common stock and retained earnings balances of $500,000 and $200,000, respectively. If consolidated statements were prepared on January 2, 2012, the investment eliminating entry would be:
Capital Stock—S Company 500,000
1/1 Retained Earnings—S Company 200,000
Investment in S Company 560,000
Noncontrolling Interest in Equity 140,000
LO 4 Stock dividends issued by a subsidiary.

38. Stock Dividends Issued by a Subsidiary Company
Illustration: Now assume that S Company reports net income of $50,000 and declares a 30% stock dividend (1,500 shares) on December 31, S Company would record the dividend as follows (par value):
Stock Dividend Declared (or R/E) 150,000
Capital Stock (1,500 shares $100) 150,000
The only entry made by P Company in 2012 is a memorandum
entry to record the receipt of 1,200 shares from S Company.
LO 4 Stock dividends issued by a subsidiary.

39. Consolidated Statements Workpaper—2009
Cost Method
Consolidated Statement Workpaper December 31, 2012
(2)
(1)
(2)
(1)
(2)
(2)
LO 4 Stock dividends issued by a subsidiary.

40. Stock Dividends Issued by a Subsidiary Company
Worksheet Entries – Year Stock Dividends Are Declared 1.
Capital Stock—S Company 120,000
Stock Dividends Declared—S Company 120,000
To reverse effects of stock dividend ($150,000 x 80%).
1/1 Retained Earnings—S Company 200,000
Capital Stock—S Company 500,000
Investment in S Company 560,000
Noncontrolling Interest in Equity 140,000
To eliminate investment account and recognize noncontrolling interest. 2.
LO 4 Stock dividends issued by a subsidiary.

41. Stock Dividends Issued by a Subsidiary Company
Stock Dividends Issued from Postacquisition Earnings
If the stock dividend had been more than retained earnings ($200,000), some of the postacquisition earnings of the subsidiary would have been capitalized.
FASB ASC paragraph :
Occasionally, subsidiary companies capitalize retained earnings arising since acquisition, by means of a stock dividend or otherwise. This does not require a transfer to capital surplus on consolidation.
LO 6 Subsidiary stock dividends issued from postacquisition earnings.

42. Stock Dividends Issued by a Subsidiary Company
Dividends from Preacquisition Earnings
Effects of a liquidating dividend on the consolidated statements workpaper entries:
Assume that P Company acquired an 80% interest in S Company on January 2, 2012, for $560,000. At the time of purchase, S Company had capital stock and retained earnings in the amounts of $500,000 and $200,000, respectively. During the first year that the investment was held, S Company reported net income of $200,000. On December 31, 2012, the subsidiary declared and paid a cash dividend of $250,000.
LO 6 Subsidiary stock dividends issued from preacquisition earnings.

43. Stock Dividends Issued by a Subsidiary Company
Dividends from Preacquisition Earnings
Liquidating dividends are accounted for as a return of part of the original investment.
P Company’s Books
Cash 200,000
Dividend Income ($200,000 x 80%) ,000
Investment in S Company ($50,000 x 80%) 40,000
To record receipt of a cash dividend from S Company.
This entry reduces the investment account to $520,000.
LO 6 Subsidiary stock dividends issued from preacquisition earnings.

44. Stock Dividends Issued by a Subsidiary Company
Dividends from Preacquisition Earnings
The December 31, 2012, eliminating entries are as follows: 1.
Dividend Income 160,000
Dividends Declared—S Company 160,000
To eliminate intercompany dividends.
Investment in S Company 40,000
Dividends Declared—S Company 40,000
To reverse the liquidating dividend. 2.
LO 6 Subsidiary stock dividends issued from preacquisition earnings.

45. Stock Dividends Issued by a Subsidiary Company
Dividends from Preacquisition Earnings
The December 31, 2012, eliminating entries are as follows: 3.
Beginning Retained Earnings—S Co. 200,000
Capital Stock—S Company 500,000
Investment in S Company 560,000
Noncontrolling Interest in Equity 140,000
To eliminate investment account and create noncontrolling interest.
LO 6 Subsidiary stock dividends issued from preacquisition earnings.

46. Subsidiary with Preferred and Common Stock Outstanding
Determining Equity Interest of Each Class of Stockholders
Subsidiary company preferred shares not held by the parent company are considered part of the noncontrolling interest.
In consolidation, each class of stockholders has an interest in the net assets of the firm, so it is necessary to allocate:
Subsidiary’s Stockholders’ Equity between preferred and common stock interests.
Retained Earnings and Net Income amounts to each class of stockholders, based on dividend preference.
LO 7 Allocating the purchase price between common and preferred stockholders.

47. Consolidating with Preferred Stock Outstanding
Illustration: Assume the following information concerning the capital accounts of S Company as of January 2, 2012:
8%, $100 par value preferred stock, cumulative, nonparticipating, dividends in arrears for 2011, call price is $103,5,000 shares outstanding $ 500,000
Common stock, $10 par value 1,000,000
Other contributed capital—excess on issue of common stock over par 305,000
Retained earnings 200,000
Total stockholders’ equity $2,005,000
LO 7 Allocating the purchase price between common and preferred stockholders.

48. Consolidating with Preferred Stock Outstanding
On January 2, 2012, P Company acquired 80% of the outstanding common stock for $1,160,000 and 30% of the outstanding preferred stock for $180,000. During the year, S Company reported net income of $200,000 and declared no cash dividends. The entry to record the purchase is:
P Company’s Books
Investment in S Co. preferred stock 180,000
Investment in S Co. Common Stock 1,160,000
Cash 1,340,000
LO 7 Allocating the purchase price between common and preferred stockholders.

49. Consolidating with Preferred Stock Outstanding
Computation and Allocation of Difference Between Implied and Book Value Acquired—Preferred Stock
Date of Acquisition - 1/2/ 2012
* Noncontrolling interest after adjustment $420,000 - $31,500 = $388,500
** ($103 call + $8 dividends in arrears - $100 par) x 5,000 shares = $11 x 5,000 = $55,000
LO 7 Allocating the purchase price between common and preferred stockholders.

50. Consolidating with Preferred Stock Outstanding
Consolidated Statements Workpaper Entries—2012
Cost Method or Partial Equity Method
1a.
Beginning Retained Earnings—S Co. 55,000
Preferred Stock—S Co. 500,000
Difference Between Implied and BV 45,000
Investment in S Co. Preferred Stock 180,000
Noncontrolling Interest in Equity 420,000
To eliminate the preferred stock investment account and recognize the noncontrolling interest in equity.
LO 7 Allocating the purchase price between common and preferred stockholders.

51. Consolidating with Preferred Stock Outstanding
Consolidated Statements Workpaper Entries—2012
Cost Method or Partial Equity Method
1b.
Other Contributed Capital—P Company 13,500
Noncontrolling Interest in Equity 31,500
Difference Between Implied and Book Value 45,000
To allocate the difference between implied and book values of preferred stock to equity.
LO 7 Allocating the purchase price between common and preferred stockholders.

52. Consolidating with Preferred Stock Outstanding
Computation and Allocation of Difference Between Implied and Book Value Acquired—Common Stock
Date of Acquisition - 1/2/2012
* $200,000 - $55,000 = $145,000
LO 7 Allocating the purchase price between common and preferred stockholders.

53. Consolidating with Preferred Stock Outstanding
Consolidated Statements Workpaper Entries—2012
Cost Method or Partial Equity Method 2.
Beginning Retained Earnings—S Co. 145,000
Common Stock—S Co. 1,000,000
Other Contributed Capital—S Co. 305,000
Investment in S Co. Common Stock 1,160,000
NCI in Equity 290,000
To eliminate the common stock investment account and recognize NCI.
LO 7 Allocating the purchase price between common and preferred stockholders.

54. Consolidating with Preferred Stock Outstanding
Noncontrolling interest in the consolidated income for 2012 is computed as follows:
LO 7 Allocating the purchase price between common and preferred stockholders.

55. Consolidating with Preferred Stock Outstanding
Cost Method Page 1
Consolidating with Preferred Stock Outstanding
Consolidated Statement Workpaper December 31, 2012
(1a)
(2)
(1a)
(2)
(1a)
(1b)

56. Consolidating with Preferred Stock Outstanding
Cost Method Page 2
Consolidating with Preferred Stock Outstanding
(1a)
(2)
(1a)
(1b)
(1a)
(2)
(1b)
(2)
(1b)
(1a)
(2)

57. Copyright
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