1. Intercompany Profit Transactions – Bonds
Chapter 7

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

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

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

5. 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.

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

7. 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.

8. 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.

9. 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.

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

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

12. 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.

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

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

15. 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.

16. 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.

17. 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.

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

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

20. 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.

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

22. Acquisition of Parent Company Bonds
Interest Income ,000
Interest Expense ,000
Gain on Retirement of bonds ,000
Interest Payable ,000
Interest Receivable ,000

23. 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

24. 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 c
e 6,300 a f
a 1,008
e 5,000 d
e 2,700
$58,980
$20,480
450
9,072
20,000
6,212
2,766

25. 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.

26. 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.

27. 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.

28. 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 ,000
constructive loss × 90%
Investment income from Sky $459,000

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

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

31. 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 ,000
Investment in Sky 12/31/04 $10,584,000

32. 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.

33. 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.

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

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

36. 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

37. 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 c
d 10,125
a 5,120 e
a 4,880
e 10,000 c
d 1,125
$59,046
$14,740
250
4,880
20,000
18,000
1,176

38. Consolidated working paper entries – 2005
Minority Interest
Consolidated working paper entries – 2005
Investment in Sky ,000
Minority Interest ,000
Interest Income ,000
10% Bonds Payable 5,000,000
Investment in Sky Bonds ,180,000
Interest Expense ,000

39. 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%) ,000
Total decreases $476,000
Annual effect on consolidated net income $ 54,000

40. 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 , , , ,060
Interest payable

41. Summary of Consolidation Working Paper Adjustments
December 31,
Debits
Investment in Sky (90%) $ $ $ $
Minority interest (10%)
Interest income
10% bonds payable 4, , , ,000
Interest payable
Credits
Investment in Sky bonds $5,090 $5,060 $5,030 $5,000
Interest expense
Interest receivable

42. End of Chapter 7