1. © The McGraw-Hill Companies, Inc., 2001 Slide 6-1 McGraw-Hill/Irwin 6 C H A P T E R Intercompany Debt and Other Consolidation Issues

2. © The McGraw-Hill Companies, Inc., 2001 Slide 6-2 McGraw-Hill/Irwin Intercompany Debt Transactions Direct loans between affiliated parties create no special consolidation problems.  Eliminate the corresponding receivable and payable from the consolidated financial statements. Also eliminate the effects of any related interest.

3. © The McGraw-Hill Companies, Inc., 2001 Slide 6-3 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) The loss is treated as an extraordinary item only if it meets the criteria of APB Opinion 30. (See SFAS 145) The acquired debt must be treated as if it has been extinguished. Any related loss related to this “early extinguishment of debt” is recorded in the consolidated financial statements in the year of acquisition. (see APB Opinion 26) The loss is treated as an extraordinary item only if it meets the criteria of APB Opinion 30. (See SFAS 145)

4. © The McGraw-Hill Companies, Inc., 2001 Slide 6-4 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party In year of acquisition: Eliminate liability, receivable, interest income, interest expense on consolidation worksheet. Recognize any gain or loss. Income effects assigned to parent (decided to reacquire the debt). NCI not affected by adjustments. In year of acquisition: Eliminate liability, receivable, interest income, interest expense on consolidation worksheet. Recognize any gain or loss. Income effects assigned to parent (decided to reacquire the debt). NCI not affected by adjustments.

5. © The McGraw-Hill Companies, Inc., 2001 Slide 6-5 McGraw-Hill/Irwin Big owns 90% of Little. On 1/1/96, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/00 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/00, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Big owns 90% of Little. On 1/1/96, Little issued $2 million of 6%, 10-year bonds. The current carrying amount on Little’s books at 1/1/00 is: Bonds Payable = $2,000,000 Bond Discount = $161,043 Carrying Amount = $1,838,957 On 1/2/00, Big decides to re-purchase Little’s bonds from the market, effectively extinguishing the debt. Acquisition of Affiliate’s Debt from an Outside Party Continue

6. © The McGraw-Hill Companies, Inc., 2001 Slide 6-6 McGraw-Hill/Irwin On 1/2/00, the market rate is 5%, and Big pays $2,101,514 for the bonds. Because Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/00, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest On 1/2/00, the market rate is 5%, and Big pays $2,101,514 for the bonds. Because Little’s carrying value is $1,838,957, there is an effective loss of $262,557 to be recorded by the consolidated entity. At 12/31/00, the consolidated entity must:  Record the loss of $262,557  Eliminate the related intercompany debt at BV  Eliminate the intercompany interest Acquisition of Affiliate’s Debt from an Outside Party Continue

7. © The McGraw-Hill Companies, Inc., 2001 Slide 6-7 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Entry B This entry is made at the end of the year that the debt is “extinguished” We will assume that any gains/losses from this transaction belong to the parent. Thus, there will be no effect on Noncontrolling Interest. Entry B This entry is made at the end of the year that the debt is “extinguished” We will assume that any gains/losses from this transaction belong to the parent. Thus, there will be no effect on Noncontrolling Interest.

8. © The McGraw-Hill Companies, Inc., 2001 Slide 6-8 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party After year of retirement: Eliminate liability, receivable, interest income, interest expense on consolidation worksheet. Adjust beginning retained earnings for gain/loss (only interest income and expense were recognized). R/E change = original gain/loss ± discount/premium amortization. After year of retirement: Eliminate liability, receivable, interest income, interest expense on consolidation worksheet. Adjust beginning retained earnings for gain/loss (only interest income and expense were recognized). R/E change = original gain/loss ± discount/premium amortization.

9. © The McGraw-Hill Companies, Inc., 2001 Slide 6-9 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Entry *B (Subsequent Years) Adjust the BV’s of the Bonds Payable and the Investment in Bonds to reflect amortization. Also, the loss is now reflected in R/E, which must also be adjusted for the difference in interest amounts. Note that, over the remaining life of the bonds, the book values will eventually converge to the point where the adjustment to R/E will be amortized away completely.

10. © The McGraw-Hill Companies, Inc., 2001 Slide 6-10 McGraw-Hill/Irwin Acquisition of Affiliate’s Debt from an Outside Party Example: Problem 22 (page 314) Example: Problem 22 (page 314)

11. © The McGraw-Hill Companies, Inc., 2001 Slide 6-11 McGraw-Hill/Irwin The treatment of subsidiary preferred stock in the consolidated financial statements depends on whether the shares are viewed as: Debt or Equity The parent’s acquisition of the preferred stock is accounted for in a manner similar to the accounting for the parent’s acquisition of the subsidiary’s bonds. The treatment of subsidiary preferred stock in the consolidated financial statements depends on whether the shares are viewed as: Debt or Equity The parent’s acquisition of the preferred stock is accounted for in a manner similar to the accounting for the parent’s acquisition of the subsidiary’s bonds. Subsidiary Preferred Stock

12. © The McGraw-Hill Companies, Inc., 2001 Slide 6-12 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Debt The Preferred Stock is treated as debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The Preferred Stock is treated as debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The first entry is based on the amount the parent paid for the acquired preferred stock.

13. © The McGraw-Hill Companies, Inc., 2001 Slide 6-13 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Debt The Preferred Stock is treated as debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The Preferred Stock is treated as debt when it has no rights other than a cumulative dividend. Two entries are required to eliminate the preferred stock: The second entry recognizes the noncontrolling interest’s share of the preferred stock and is based on the call price.

14. © The McGraw-Hill Companies, Inc., 2001 Slide 6-14 McGraw-Hill/Irwin So, what do we do when the Preferred Stock is viewed as Equity?

15. © The McGraw-Hill Companies, Inc., 2001 Slide 6-15 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity When the Preferred Stock is treated as equity, it has rights other than a cumulative dividend, often including a conversion feature or participation rights. The entry allocates the preferred stock amounts to the investment and to the noncontrolling interest.

16. © The McGraw-Hill Companies, Inc., 2001 Slide 6-16 McGraw-Hill/Irwin Subsidiary Preferred Stock Viewed as Equity Example: Problem 27 (page 315) Example: Problem 27 (page 315)

17. © The McGraw-Hill Companies, Inc., 2001 Slide 6-17 McGraw-Hill/Irwin Consolidated Statement of Cash Flows consolidated consolidated The consolidated statement of cash flows is based on the consolidated balance sheet and the consolidated income statement.

18. © The McGraw-Hill Companies, Inc., 2001 Slide 6-18 McGraw-Hill/Irwin Amortization Add amortization of FMV allocations to Consolidated Net Income. Amortization Add amortization of FMV allocations to Consolidated Net Income. Consolidated Statement of Cash Flows

19. © The McGraw-Hill Companies, Inc., 2001 Slide 6-19 McGraw-Hill/Irwin Consolidated Statement of Cash Flows Intercompany Transactions Intercompany cash flows should not be included on the statement of cash flows. The intercompany cash flows are already eliminated from the balance sheet, so no additional effects appear on the statement of cash flows.

20. © The McGraw-Hill Companies, Inc., 2001 Slide 6-20 McGraw-Hill/Irwin Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a financing cash outflow. Noncontrolling Interest Add back the noncontrolling interest’s share of the sub’s net income. Deduct dividends paid to the outside owners as a financing cash outflow. Consolidated Statement of Cash Flows

21. © The McGraw-Hill Companies, Inc., 2001 Slide 6-21 McGraw-Hill/Irwin Consolidated Statement of Cash Flows Example: Problem 31 (page 316-17) Example: Problem 31 (page 316-17)

22. © The McGraw-Hill Companies, Inc., 2001 Slide 6-22 McGraw-Hill/Irwin Consolidated Earnings Per Share If potentially dilutive items exist on the sub’s own financial statements, then the portion of the sub’s net income included in consolidated net income may not be appropriate for the computation of consolidated earnings per share.

23. © The McGraw-Hill Companies, Inc., 2001 Slide 6-23 McGraw-Hill/Irwin ? Consolidated Earnings Per Share Compute the sub’s own diluted EPS. The earnings used in the above computation are used in the determination of consolidated EPS. The portion assigned to the computation is based on the % of the sub owned by the parent.

24. © The McGraw-Hill Companies, Inc., 2001 Slide 6-24 McGraw-Hill/Irwin Consolidated Earnings Per Share Example: Problem 35 (page 317) Example: Problem 35 (page 317)

25. © The McGraw-Hill Companies, Inc., 2001 Slide 6-25 McGraw-Hill/Irwin Subsidiary Stock Transactions Book value of parent’s investment account increased if subsidiary issues new stock and decreased if subsidiary reacquires treasury stock.

26. © The McGraw-Hill Companies, Inc., 2001 Slide 6-26 McGraw-Hill/Irwin Subsidiary Stock Transactions Measure ownership percentage before and after the transaction, and adjust investment account and APIC by any alteration.

27. © The McGraw-Hill Companies, Inc., 2001 Slide 6-27 McGraw-Hill/Irwin Subsidiary Stock Transactions Treasury stock acquired by subsidiary Similar adjustment to parent’s investment account. Eliminate subsidiary treasury stock during consolidation process as part of Entry S.

28. © The McGraw-Hill Companies, Inc., 2001 Slide 6-28 McGraw-Hill/Irwin Subsidiary Stock Transactions Example: Problem 36 (page 318) Example: Problem 36 (page 318)

29. © The McGraw-Hill Companies, Inc., 2001 Slide 6-29 McGraw-Hill/Irwin Uh, Chester? I wonder if we could discuss a little “intercompany” loan? End of Chapter 6