Intercompany Profit Transactions – Bonds Chapter 7

Differentiate between intercompany receivables Learning Objective 1 Differentiate between intercompany receivables and payables, and assets or liabilities of the consolidated reporting entity.

Receivable and Payable Accounts Companies frequently hold the debt instruments of affiliates. Direct loans among affiliates produce reciprocal receivable and payable accounts.

Receivable and Payable Accounts Companies eliminate these reciprocal accounts in preparing consolidated financial statements.

Defer unrealized profits and later recognize realized profits on bond Learning Objective 2 Defer unrealized profits and later recognize realized profits on bond transfers between parent and subsidiary companies.

Intercompany Bond Transactions At the time a company issues bonds, its bond liability will reflect the current market rate of interest.

Intercompany Bond Transactions If the market rate of interest increases… – market value of the liability is less then book value (a realized gain that is not recognized). A decline in the market rate of interest gives rise to a realized loss that is not recognized.

Constructive Gains and Losses on Intercompany Bonds They are realized from the consolidated viewpoint. They arise when a company purchases the bonds of an affiliate from other entities at a price other than the book value of the bonds.

Acquisition of Parent Company Bonds Sugar Corporation is an 80%-owned affiliate of Peach Corporation. On January 2, 2006, Peach sells $1,000,000 10% , 10-year bonds at par. On December 31, 2006, Sugar purchases $100,000 of these outstanding bonds for $104,500.

Acquisition of Parent Company Bonds Peach's books (equity method) Income from Sugar 4,500 Investment in Sugar 4,500 To adjust income from Sugar for the constructive loss on bonds

Acquisition of Parent Company Bonds Working paper adjustments Loss on Constructive Retirement of Bonds 4,500 10% Bonds Payable 100,000 Investment in Bonds 104,500 To enter loss and eliminate reciprocal bond investment and liability amounts

Acquisition of Subsidiary Bonds On January 2, 2006, Sugar sold $1,000,000 10% , 10-year bonds at par to the public. On December 31, 2006, Peach purchases $100,000 of these outstanding bonds for $104,500. Peach owns 80% of Sugar.

Acquisition of Subsidiary Bonds Peach's books (equity method) Income from Sugar 3,600 Investment in Sugar 3,600

Demonstrate how a consolidated reporting entity constructively Learning Objective 3 Demonstrate how a consolidated reporting entity constructively retires debt.

Parent Company Bonds Purchased by a Subsidiary A constructive retirement of parent company bonds occurs when an affiliate purchases the outstanding bonds of the parent.

Acquisition of Parent Company Bonds Sue is a 70%-owned subsidiary of Pam, acquired at its $5,600,000 book value on December 31, 2003. At the time of acquisition Sue had capital stock of $5,000,000 and retained earnings of $3,000,000.

Acquisition of Parent Company Bonds Pam has $10,000,000 par of 10% bonds outstanding with a $100,000 unamortized premium on January 1, 2005, at which time Sue purchases $1,000,000 par of these bonds for $950,000 from an investment broker.

Acquisition of Parent Company Bonds What is Sue’s entry? Investment in Pam Bonds 950,000 Cash 950,000 To record acquisition of Pam bonds at 95

Acquisition of Parent Company Bonds Working paper entry 10% Bonds Payable 1,010,000 Investment in Pam Bonds 950,000 Gain on Retirement of Bonds 60,000

Acquisition of Parent Company Bonds A piecemeal recognition occurred during 2005 as Pam amortized premium and Sue amortized $10,000 discount on bonds that were constructively retired.

Acquisition of Parent Company Bonds Working paper entries 10% Bonds Payable 1,008,000 Investment in Pam Bonds 960,000 Gain on Retirement of Bonds 48,000

Acquisition of Parent Company Bonds Interest Income 110,000 Interest Expense 98,000 Gain on Retirement of bonds 12,000 Interest Payable 50,000 Interest Receivable 50,000

Consolidation Working Papers for the Year Ended December 31, 2005 Adjustments/ Consol- Pam Sue Eliminations idated Sales Income from Sue Gain on retirement of bonds Interest income Expenses Interest expense Minority interest expense Net income Retained earnings – Pam Retained earnings – Sue Retained earnings 12/31/05 $4,000 202 (1,910) (980) $1,312 4,900 $6,212 $2,000 110 (1,890) $ 220 4,000 $4,220 c 202 a 48 b 12 b 110 b 98 d 66 e 4,000 $6,000 60 (3,800) (882) (66) $4,900 Income Statement

Consolidation Working Papers for the Year Ended December 31, 2005 Balance Sheet Adjustments/ Consol- Pam Sue Eliminations idated Other assets Interest receivable Investment in Sue Investment (Pam bonds) Other liabilities Interest payable 10% bond payable Common stock Retained earnings Minority interest $39,880 6,502 $46,382 $ 9,590 500 10,080 20,000 6,212 $19,100 50 960 $20,110 $10,890 5,000 4,220 f 50 c 202 e 6,300 a 960 f 50 a 1,008 e 5,000 d 66 e 2,700 $58,980 $20,480 450 9,072 20,000 6,212 2,766

Subsidiary Bonds Purchased by Parent On December 31, 2003, Sky had $10,000,000 par of 10% bonds outstanding with an unamortized discount of $300,000. The bonds pay interest on January 1 and July 1. They mature in five years on January 1, 2009.

Subsidiary Bonds Purchased by Parent On January 2, 2004, Pro Corporation purchases 50% of Sky’s outstanding bonds for $5,150,000. This transaction results in a loss of $300,000 from the viewpoint of the consolidated entity. The entity retires a liability of $4,850,000 at a cost of $5,150,000.

Subsidiary Bonds Purchased by Parent During 2004, Sky records interest expense on the bonds of $1,060,000 of which $530,000 relates to the intercompany bonds. Pro records interest income from its investment in bonds during 2004 of $470,000. At December 31, 2004, their books do not show the $240,000 of the constructive loss.

Subsidiary Bonds Purchased by Parent Equity method (Pro) 90% of Sky’s $750,000 reported income $675,000 Deduct: $300,000 constructive loss × 90% –270,000 Add: $60,000 recognition of 54,000 constructive loss × 90% Investment income from Sky $459,000

Subsidiary Bonds Purchased by Parent Pro journal entries (12/31/2004) Investment in Sky 675,000 Income from Sky 675,000 To record 90% of Sky’s reported income for 2004

Subsidiary Bonds Purchased by Parent Income from Sky 270,000 Investment in Sky 270,000 To adjust investment income from Sky for 90% of the loss on the retirement of Sky’s bonds Investment in Sky 54,000 Income from Sky 54,000 To adjust investment income from Sky for 90% of the $60,000 piecemeal recognition of the constructive loss on Sky bonds during 2004

Subsidiary Bonds Purchased by Parent Pro's investment in Sky at December 31, 2004 Investment in Sky 01/01/04 ($11,259,000 × 90%) $10,125,000 Add: Income from Sky 459,000 Investment in Sky 12/31/04 $10,584,000

Adjust calculations of minority interest amounts in the Learning Objective 4 Adjust calculations of minority interest amounts in the presence of intercompany profits on debt transfers.

Minority Interest Minority interest expense for 2004 is $51,000, which is assigned to the constructive loss to Sky. The constructive loss reduces consolidated net income for 2004 by $216,000 which is reflected in the consolidated income statement.

Consolidated net income – 2004 Minority Interest Consolidated net income – 2004 Decreased by: Constructive loss $300,000 Elimination of interest income 470,000 Total decreases $770,000 Increased by: Elimination of interest expense $530,000 Reduction of minority interest expense 24,000 Total increases $554,000 Effect on consolidated net income for 2004 $216,000

Consolidated working paper entries – 2004 Minority Interest Consolidated working paper entries – 2004 Loss on Retirement of Bonds 300,000 Interest Income 470,000 10% Bonds Payable 5,000,000 Investment in Sky Bonds 5,240,000 Interest Expense 530,000

Consolidation Working Papers for the Year Ended December 31, 2004 Adjustments/ Consol- Pro Sky Eliminations idated Sales Income from Sky Interest income Expenses Interest expense Loss on bond retirement Minority interest expense Net income Retained earnings – Pro Retained earnings – Sky Retained earnings 12/31/04 $25,750 459 470 (21,679) $ 5,000 13,000 $18,000 $14,250 (12,440) (1,060) $ 750 1,250 $2,000 c 459 b 470 b 530 a 240 b 60 c 51 e 1,250 $40,000 (34,119) (530) (300) (51) $13,000 Income Statement

Consolidation Working Papers for the Year Ended December 31, 2004 Balance Sheet Adjustments/ Consol- Pro Sky Eliminations idated Other assets Interest receivable Investment in Sky Investment in Sky bonds Other liabilities Interest payable 10% bonds payable Capital stock Retained earnings Minority interest $34,046 250 10,584 5,120 $50,000 $12,000 20,000 18,000 $25,000 $ 2,740 500 9,760 10,000 2,000 e 250 c 459 d 10,125 a 5,120 e 250 a 4,880 e 10,000 c 51 d 1,125 $59,046 $14,740 250 4,880 20,000 18,000 1,176

Consolidated working paper entries – 2005 Minority Interest Consolidated working paper entries – 2005 Investment in Sky 216,000 Minority Interest 24,000 Interest Income 470,000 10% Bonds Payable 5,000,000 Investment in Sky Bonds 5,180,000 Interest Expense 530,000

Consolidated net income – 2005 through 2008 Minority Interest Consolidated net income – 2005 through 2008 Increased by: Elimination of interest expense $530,000 Decreased by: Elimination of interest income $470,000 Increase in minority interest expense ($60,000 piecemeal recognition × 10%) 6,000 Total decreases $476,000 Annual effect on consolidated net income $ 54,000

Summary of Intercompany Bond Account Balances on Separate Books December 31, 2005 2006 2007 2008 Pro’s Books (000) Investment in Sky bonds $5,090 $5,060 $5,030 $ 5,000 Interest income 470 470 470 470 Interest receivable 250 250 250 250 Sky’s Books (000) 10% bonds payable $9,820 $9,880 $9,940 $10,000 Interest expense 1,060 1,060 1,060 1,060 Interest payable 500 500 500 500

Summary of Consolidation Working Paper Adjustments December 31, 2005 2006 2007 2008 Debits Investment in Sky (90%) $ 216 $ 162 $ 108 $ 54 Minority interest (10%) 24 18 12 6 Interest income 470 470 470 470 10% bonds payable 4,910 4,940 4,970 5,000 Interest payable 250 250 250 250 Credits Investment in Sky bonds $5,090 $5,060 $5,030 $5,000 Interest expense 530 530 530 530 Interest receivable 250 250 250 250

End of Chapter 7