1. ACC 424 Financial Reporting II Lecture 9 Inter-company transactions - 2

2. 2 Previous lecture dealt with intercompany asset transfers This lecture deals with intercompany asset/liability holdings –Intercompany bondholdings The holdings are similar to accounts receivable/accounts payable holdings, but an important difference is that the elimination can lead to gains or losses

3. 3 Inter-company bond-holdings Bonds acquired from the affiliate have straightforward entries since –Purchaser’s investment in bonds = issuer’s bond liability –Interest revenue = interest expense –Each year the inter-company debt & interest expense can be cleanly eliminated - see text book pages 6-1 to 6-3 Bonds acquired in the open market after issuance do not have straightforward entries if interest rates have changed –Purchaser’s nvestment ≠ issuer’s bond liability –Issuer’s interest expense ≠ purchaser’s interest revenue (different amounts of premium or discount amortization) –There is a consolidated gain if investment<liability a consolidated loss if investment>liability –To which affiliate should the gain or loss accrue? Book allocates to both affiliates Exposure draft allocates to issuer

4. 4 Inter-company bond-holdings example Example - modification of E6.4 P Company owns 90% of S Company’s outstanding common stock. On December 31, 19X6, S acquired $100,000 par value of P’s 8% annual coupon bonds for $80,000. The bonds mature in 10 years and are carried on P’s books at $110,000, reflecting an unamortized premium of $10,000. Both companies use the straight-line method of amortization, and P’s investment in common stock is carried at equity. Assume S earns $50,000 each year Calculation of gain or loss on effective retirement of debt –Investment in Bonds - S par value$100,000 Discount on Investment in Bonds 20,000 Net Bond Investment$ 80,000 –Bonds Payable - P par value$100,000 Premium on Bonds Payable 10,000 Net Bond Liability$110,000 –Gain on retirement of debt$ 30,000 Allocation of gain S receives its discount $20,000 & P its premium $10,000

5. 5 Inter-company bond-holdings example At 12/31/X6 P makes following entry in its books Investment in S$73,000 Equity in income of S $73,000.9 of S’s net income, $50,000 $45,000 + P’s share of gain, $10,000 +.9 of S’s share of gain,.9  20,000 $18,000$73,000 X6 consolidated working papers elimination entries Equity in Income of S$ 73,000 Investment in S$ 73,000 Bonds Payable - P 100,000 Investment in bonds 100,000 Elimination of par value of bonds Premium on Bonds Payable - P 10,000 Discount on Investment in Bonds 20,000 Gain on Retirement of Consolidated Debt 30,000

6. 6 Inter-company bond-holdings example-subsequent year Entry made in P’s books in 19X7 Interest expense$7,000 Premium on bonds payable 1,000 Cash$8,000 To record interest expense for 19X7 using straight-line amortization. 1/10  $10,000 premium Entry made in S’s books in 19X7 Cash $8,000 Discount on investment in bonds 2,000 Interest revenue$10,000 To record interest revenue for 19X7 using straight-line amortization. 1/10  $20,000 discount The $1,000 & $2,000 amortizations reducing expense and increasing revenue (respectively) in the affiliates’ books are realizations of 1/10 of the $30,000 gain previously recognized in the 19x6 consolidated statements So the amortizations must be eliminated from expense and revenue (along with the $8,000 cash coupon payment) in the 19X7 consolidated working papers. This means a credit to interest expense of $7,000 and a debit to interest revenue of $10,000

7. 7 Inter-company bond-holdings example-subsequent year Elimination entries (1) Interest revenue $10,000 Discount on investment in bonds ($20,000-2,000) 18,000 Premium on bonds payable ($10,000-1,000) 9,000 Retained earnings- S1/1/X7 $18,000 Minority interest in S RE 1/1/X7 2,000 Investment in S 10,000 Interest expense 7,000 This entry not only eliminates interest revenue & expense, it: a) eliminates the unamortized discount & premium in S & P’s books at 12/X7 b) increases S’s 1/1/X7 RE & MI for S’s gain recognized in consolidation (but not S’s books) last year c) decreases Investment in S for P’s gain recognized in consolidation last year so that Investment in S can be eliminated against S’s owners’ equity The increase in S’s RE and the decrease in Investment in S for gains recognized in the consolidation but not in the affiliates’ books in the previous year are analogous to the decrease in S’s RE and increase in Investment in S for upstream and downstream unrealized profits on land recognized in the affiliates’ books but not in the consolidation in a previous year

8. 8 Inter-company bond-holdings example-subsequent year nElimination entries (continued) (2) Bonds payable - P$100,000 Investment in bonds$100,000 This entry eliminates the par value of the bonds