7 - 1 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Intercompany Profit Transactions – Bonds Chapter 7

7 - 2 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 1 Differentiate between intercompany receivables and payables, and assets or liabilities of the consolidated reporting entity.

7 - 3 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Companies frequently hold the debt instruments of affiliates. Direct loans among affiliates produce reciprocal receivable and payable accounts. Receivable and Payable Accounts

7 - 4 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Companies eliminate these reciprocal accounts in preparing consolidated financial statements. Receivable and Payable Accounts

7 - 5 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 2 Defer unrealized profits and later recognize realized profits on bond transfers between parent and subsidiary companies.

7 - 6 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn At the time a company issues bonds, its bond liability will reflect the current market rate of interest. Intercompany Bond Transactions

7 - 7 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn If the market rate of interest increases… – market value of the liability is less then book value (a realized gain that is not recognized). Intercompany Bond Transactions A decline in the market rate of interest gives rise to a realized loss that is not recognized.

7 - 8 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

7 - 9 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds Income from Sugar4,500 Investment in Sugar4,500 To adjust income from Sugar for the constructive loss on bonds

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds Loss on Constructive Retirement of Bonds 4,500 10% Bonds Payable100,000 Investment in Bonds104,500 To enter loss and eliminate reciprocal bond investment and liability amounts

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Subsidiary Bonds Income from Sugar3,600 Investment in Sugar3,600

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 3 Demonstrate how a consolidated reporting entity constructively retires debt.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn A constructive retirement of parent company bonds occurs when an affiliate purchases the outstanding bonds of the parent. Parent Company Bonds Purchased by a Subsidiary

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds Sue is a 70%-owned subsidiary of Pam, acquired at its $5,600,000 book value on December 31, At the time of acquisition Sue had capital stock of $5,000,000 and retained earnings of $3,000,000.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds Investment in Pam Bonds950,000 Cash950,000 To record acquisition of Pam bonds at 95

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds 10% Bonds Payable1,010,000 Investment in Pam Bonds950,000 Gain on Retirement of Bonds 60,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Acquisition of Parent Company Bonds 10% Bonds Payable1,008,000 Investment in Pam Bonds960,000 Gain on Retirement of Bonds 48,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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, (1,910) (980) $1,312 4,900 $6,212 $2, (1,890) $ 220 4,000 $4,220 c 202 a 48 b 12 b 110 b 98 d 66 e 4,000 $6, (3,800) (882) (66) $1,312 $4,900 $6,212 Income Statement

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Consolidation Working Papers for the Year Ended December 31, 2005 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, ,080 20,000 6,212 $46,382 $19, $20,110 $10,890 5,000 4,220 $20,110 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, ,072 20,000 6,212 2,766 $58,980 Balance Sheet Adjustments/ Consol- Pam Sue Eliminations idated

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Bonds Purchased by Parent 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Bonds Purchased by Parent Investment in Sky675,000 Income from Sky675,000 To record 90% of Sky’s reported income for 2004

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Bonds Purchased by Parent Income from Sky270,000 Investment in Sky270,000 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Bonds Purchased by Parent 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 4 Adjust calculations of minority interest amounts in the presence of intercompany profits on debt transfers.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 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.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Minority Interest 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Minority Interest Loss on Retirement of Bonds 300,000 Interest Income 470,000 10% Bonds Payable5,000,000 Investment in Sky Bonds5,240,000 Interest Expense 530,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Consolidation Working Papers for the Year Ended December 31, 2004 Adjustments/ Consol- Pro SkyEliminations 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, (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) $ 5,000 $13,000 $18,000 Income Statement

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Consolidation Working Papers for the Year Ended December 31, 2004 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, ,584 5,120 $50,000 $12,000 20,000 18,000 $50,000 $25,000 $ 2, ,760 10,000 2,000 $25,000 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, ,880 20,000 18,000 1,176 $59,046 Balance Sheet Adjustments/ Consol- Pro Sky Eliminations idated

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Minority Interest Investment in Sky 216,000 Minority Interest 24,000 Interest Income 470,000 10% Bonds Payable5,000,000 Investment in Sky Bonds5,180,000 Interest Expense 530,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Minority Interest 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Intercompany Bond Account Balances on Separate Books December 31, Pro’s Books (000) Investment in Sky bonds$5,090$5,060$5,030$ 5,000 Interest income Interest receivable 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

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Consolidation Working Paper Adjustments December 31, Debits Investment in Sky (90%)$ 216$ 162$ 108$ 54 Minority interest (10%) Interest income % bonds payable 4,910 4,940 4,970 5,000 Interest payable Credits Investment in Sky bonds$5,090$5,060$5,030$5,000 Interest expense Interest receivable

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn End of Chapter 7