Intercompany Transactions: Bonds and Leases 5

Learning Objectives Explain the alternatives a parent company has if it wishes to acquire outstanding subsidiary bonds from outside owners. Follow the procedures used to retire intercompany bonds on a consolidated worksheet. Explain why a parent company would lease assets to the subsidiary. Show how to eliminate intercompany operating lease transactions from the consolidated statements. Eliminate intercompany capital leases on the consolidated worksheet. Demonstrate an understanding of the process used to defer intercompany profits on sales-type leases. (Appendix) Explain the complications caused by unguaranteed residual values with intercompany leases. COPYRIGHT © 2012 South-Western/Cengage Learning

Intercompany Bonds The parent can effectively retire subsidiary bonds by Lending money to the subsidiary for actual retirement Buying the bonds from existing owners Parent purchase of subsidiary bonds The bonds cease to exist from a consolidated viewpoint Bonds are retired on the consolidated worksheet by elimination Difference between the amortized cost and the price paid creates a gain or loss on retirement In subsequent periods the bonds continue to be eliminated Retained earnings is adjusted for the remaining retirement gain or loss that has not already been amortized COPYRIGHT © 2012 South-Western/Cengage Learning 1

Bond Originally Issued Off-Face: Facts Sub (80%) issues to third parties $100,000, 5-year, 8% (annual interest) bond on 1/1/2011 for $96,110 Straight line discount amortization = $778 per year Int. Exp. = ($100,000 × 8%) + $778 = $8,778 per year Parent purchases the bonds from third party for $103,600 on 12/31/2013 Straight line discount amortization = $1,800 per year Int. Rev. = ($100,000 × 8%) - $1,800 = $6,200 per year Consolidated statements: $5,156 loss on the date of purchase Debt carrying value $98,444 Price paid to retire (103,600) $ 5,156 COPYRIGHT © 2012 South-Western/Cengage Learning

Bond Example: Journal Entries (Years 1–3) Sub Journal Entries 1/1/2011 Cash 96,110 Discount 3,890 Bond Pay. 100,000 12/31/2011 - 2013 Int. Exp. 8,778 Discount 778 Cash 8,000 Parent Journal Entries 12/31/2013 Invest S Bonds 103,600 Cash 103,600 Discount Balance 12/31/2013 = $1,556 Bond Carrying Value = $98,444 COPYRIGHT © 2012 South-Western/Cengage Learning

Bond Example: Carrying Values Dec 31, 2014 Loss on retire: $5,156 COPYRIGHT © 2012 South-Western/Cengage Learning

Bond Example: Journal Entries (Years 4-5) Sub Journal Entries 12/31/2014 & 2015 Int. Exp. 8,778 Discount 778 Cash 8,000 Parent Journal Entries 12/31/2014 & 2015 Cash 8,000 Bond Invest. 1,800 Int. Rev. 6,200 COPYRIGHT © 2012 South-Western/Cengage Learning 5

Bond Example: Eliminations (12/31/2014) COPYRIGHT © 2012 South-Western/Cengage Learning

Bond Example: Sub IDS (12/31/2014) Interest adjustment: Sub’s interest exp $6,200 DR Parent’s interest rev 8,778 CR 2,578 CR COPYRIGHT © 2012 South-Western/Cengage Learning

Partial Effective Retirement of Bonds Portion of bonds acquired by parent Effective retirement of only that portion Eliminate the portion of interest that relates to the bonds acquired by the parent Portion of bonds held by outsiders A continuing debt on the consolidated balance sheet Related interest expense is an expense to the consolidated entity COPYRIGHT © 2012 South-Western/Cengage Learning

Effective Interest Bonds Amortization schedule shows interest for Parent and Subsidiary 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 through difference in interest = Gain or loss at start of year (RE adjustment or G/L) COPYRIGHT © 2012 South-Western/Cengage Learning 8

Effective Interest Bond Example: Facts Sub issues to third party a $100,000, 8-year, 10% bond on 1/1/2011 for $102,400 100,000FV; 10,000pmt; 102,400PV; 8n = 9.5574% Parent purchases the bonds from outsiders for $99,200 on 1/1/2015 (4 years remain) 100,000FV; 10,000pmt; 99,200PV; 4n = 10.254% Consolidated statements: $99,200 was paid to retire bonds with a book value of $101,417. $2,217 gain COPYRIGHT © 2012 South-Western/Cengage Learning

Effective Interest Bond Example: Amortization Tables Parent acquires on 1/1/2015 COPYRIGHT © 2012 South-Western/Cengage Learning

Effective Interest Bond Example: Eliminations (12/31/2016) In subsequent years, recognize gain as of beginning of the year for consolidated balance sheet COPYRIGHT © 2012 South-Western/Cengage Learning 9

Effective Interest Bond Example: Eliminations (12/31/2016) continued Proof of gain on 12/31/2016: Book value of debt 100,773 Investment balance 99,562 1,211 Interest revenue 10,190 Interest expense 9,663 527 Gain on 1/1/2016 1,738 COPYRIGHT © 2012 South-Western/Cengage Learning

Effective Interest Bond Example: Sub IDS (12/31/2016) COPYRIGHT © 2012 South-Western/Cengage Learning

Intercompany Lease Operating Eliminate rental expense and revenue No adjustment to consolidated net income COPYRIGHT © 2012 South-Western/Cengage Learning

Intercompany Lease Capital / Direct-Financing Present value of minimum lease payments is equal to asset cost No gain or loss arises from lease; similar to intercompany loan No adjustment to consolidated net income Lessee Lease Obligation carried at present value Interest expense Lessor Minimum Lease Pmt Receivable (gross) less Unearned Interest Interest revenue COPYRIGHT © 2012 South-Western/Cengage Learning

Financing-Type Lease Example: Data Sub is 80% owned by Parent Cost of equipment leased is $21,682 Origination date is 1/1/2011 Terms: 4 years Implicit rate is 12% for both parties Start-of-period payments = $6,000 Bargain purchase option = $2,000 Present value of minimum lease payments: $21,682 COPYRIGHT © 2012 South-Western/Cengage Learning

Financing-Type Lease Example: Amortization Schedule COPYRIGHT © 2012 South-Western/Cengage Learning 11

Financing-Type Lease Example: Journal Entries (Year 1) Sub/Lessee Journal Entries 1/1/2011 Leased Asset 21,682 Lease Oblig. 15,682 Cash 6,000 12/31/2011 Int. Exp. 1,882 Int. Pay. 1,882 Parent/Lessor Journal Entries 1/1/2011 Min. LP Rec. 26,000 Unearned Int. 4,318 Cash 21,682 Cash 6,000 Min. LP Rec. 6,000 12/31/2011 Unearned Int. 1,882 Int. Rev. 1,882 Unearned interest balance = $2,436 COPYRIGHT © 2012 South-Western/Cengage Learning

Financing-Type Lease Example: Eliminations (12/31/2011) COPYRIGHT © 2012 South-Western/Cengage Learning 12

Financing-Type Lease Example: Journal Entries (Year 2) Sub/Lessee Journal Entries 1/1/2012 Int. Pay. 1,882 Lease Oblig. 4,118 Cash 6,000 12/31/2012 Int. Exp. 1,388 Int. Pay. 1,388 Parent/Lessor Journal Entries 1/1/2012 Cash 6,000 Min. LP Rec. 6,000 12/31/2012 Unearned Int. 1,388 Int. Rev. 1,388 Unearned interest balance= $1,048 COPYRIGHT © 2012 South-Western/Cengage Learning

Financing-Type Lease Example: Eliminations (12/31/2012) COPYRIGHT © 2012 South-Western/Cengage Learning 12

Intercompany Lease Capital / Sales-Type Lessor records sale profit (loss) at inception Difference between fair value and cost Sales Profit on Lease Deferred at time of sale Amortize over Asset useful life if lease contains a bargain purchase or renewal option, or if title transfers at lease end Otherwise use lease term Exactly same procedure as deferral of gain (loss) on sale of fixed asset COPYRIGHT © 2012 South-Western/Cengage Learning

Intercompany Transactions Prior to Business Combination When an acquisition occurs, prior sales between the two entities are not eliminated on the consolidated worksheet Profits made prior to the acquisition are allowed to stand Debt and lease instruments between the parties change their nature on the acquisition date Amounts that were due between separate entities now become intercompany debt or leases that must be eliminated COPYRIGHT © 2012 South-Western/Cengage Learning

Intercompany Leases Residual values Chapter assumes there is a bargain purchase option or guaranteed residual The residual value is included in the minimum lease payments Appendix considers unguaranteed residual An UGRV causes the present value of the lease for the lessor to exceed that of the lessee The interest applicable to the UGRV is allowed to remain in the consolidated statements since it will come from the outside world COPYRIGHT © 2012 South-Western/Cengage Learning