1. Slide 9-1

2. Slide 9-2 Intercompany Bond Holdings and Miscellaneous Topics— Consolidated Financial Statements Advanced Accounting, Fourth Edition 99

3. Slide 9-3 1. 1.Describe the term “constructive retirement of debt.” 2. 2.Describe how the gain or loss on constructive retirement of intercompany bond holdings is allocated between the purchasing and issuing companies. 3. 3.Explain the impact on the consolidated financial statements when a company issues a note to an affiliated company, which then discounts the note with an outside company. 4. 4.Determine the effect on the consolidated financial statements when a subsidiary issues a stock dividend. 5. 5.Understand the difference in how stock dividends and cash dividends issued by a subsidiary company affect the consolidated financial statements. Learning Objectives

4. Slide 9-4 5. 5.Determine the impact on the investment account when a subsidiary issues a stock dividend from preacquisition earnings and from postacquisition earnings. 6. 6.Explain how the purchase price is allocated when the subsidiary has both common and preferred stock outstanding. 7. 7.Determine the controlling interest in income when the parent company owns both common and preferred stock of the subsidiary. Learning Objectives

5. Slide 9-5 Intercompany Bond Holdings LO 1 Constructive retirement of debt. An affiliate company may purchase bonds issued by another affiliate. Intercompany bond investments (receivable), bonds payable (liability), intercompany interest expense and, Intercompany interest revenue, must be eliminated. Bonds not held by external parties are viewed as being constructively retired in the consolidated financial statements. This is viewed as early retirement of debt.

6. Slide 9-6 Illustration: Three year bonds with a par value of $100,000 are issued on Jan. 2, 2010, for $85,000. The bonds pay 7% interest each December 31. Assume straight- line amortization of the discount. Accounting for Bonds - A Review LO 1 Constructive retirement of debt. * * $100,000 – 85,000 = 15,000 / 3 years = $5,000

7. Slide 9-7 Journal entries for 2010: Jan. 2Cash 85,000 Discount on bonds payable15,000 Bonds payable100,000 Dec. 31Interest expense7,000 Cash7,000 Interest expense5,000 Discount on bonds payable5,000 Accounting for Bonds - A Review LO 1 Constructive retirement of debt. Illustration - Issuing Company.

8. Slide 9-8 Journal entries for 2010: Jan. 2Investment in bonds 85,000 Cash85,000 Dec. 31Cash7,000 Interest revenue7,000 Investment in bonds5,000 Interest revenue 5,000 Accounting for Bonds - A Review LO 1 Constructive retirement of debt. Illustration - Investor Company.

9. Slide 9-9 Constructive Gain or Loss on Intercompany Bond Holdings LO 1 Constructive retirement of debt. The acquisition of affiliate’s outstanding bonds from outsiders is considered a constructive retirement by the consolidated entity. The constructive gain or loss is recognized in the consolidated income statement prior to the recognition of the gain or loss on the books of the individual companies. In the period the bonds are purchased, workpaper entries are made to accelerate the recognition of the gain or loss. After the bonds are purchased, workpaper entries are needed to eliminate the portion of the gain or loss recorded during the period on the books of the individual companies.

10. Slide 9-10 Constructive Gain or Loss LO 2 Allocating the constructive gain or loss. Allocation of Constructive Gain or Loss Four methods for allocating the constructive gain or loss between the parent and subsidiary: 1.Entirely to the issuing company. 2.Entirely to the purchasing company. 3.Entirely to the parent company. 4.Between the purchasing and issuing companies. The authors consider the fourth method to be the soundest conceptually.

11. Slide 9-11 Constructive Gain or Loss LO 2 Allocating the constructive gain or loss. Computing the Constructive Gain or Loss On the date bonds of an affiliate are purchased, a constructive gain or loss is computed. The portion allocated to the issuing company is the difference between the book value (carrying value) of the bonds issued and their par value; The portion allocated to the purchasing company is the difference between the par value of the bonds and their cost. There is no constructive gain or loss if the bonds are issued or purchased at par value.

12. Slide 9-12 Constructive Gain or Loss LO 2 Allocating the constructive gain or loss. Computing the Constructive Gain or Loss If the issue price and purchase price were not equal to par value, there are four possible combinations that can result:

13. Slide 9-13 Constructive Gain or Loss LO 2 Allocating the constructive gain or loss. Computing the Constructive Gain or Loss + $10,000 Constructive gain - $15,000 Constructive loss - $5,000 Net constructive loss

14. Slide 9-14 Constructive Gain or Loss LO 2 Allocating the constructive gain or loss. Computing the Constructive Gain or Loss - $10,000 Constructive loss + $15,000 Constructive gain + $5,000 Net constructive gain

15. Slide 9-15 Accounting for Intercompany Bonds Illustrated LO 2 Allocating the constructive gain or loss. Illustration: P Company acquired an 80% interest in S Company for $1,200,000 on January 2, 2009, when the retained earnings and common stock accounts of S Company were $500,000 and $1,000,000, respectively. On December 31, 2012, P Company acquired $300,000 of S Company’s par value bonds (60% of S Company’s bonds) on the open market for $310,000 after the semiannual interest payment had been made. At the time of purchase there were $500,000 par value bonds outstanding with a book value of $480,000. The bonds mature in four years on December 31, 2016, and carry an interest rate of 9%. Interest is paid semiannually on June 30 and December 31. Both companies use the straight-line method to amortize bond discounts and premiums. The fiscal year-end of both companies is December 31.

16. Slide 9-16 Book Entry Related to Bond Investment LO 2 Allocating the constructive gain or loss. Dec. 31 Prepare the entry made by P Company to record the bond investment: Note:  The usual practice of recording a bond investment does not separate the discount or premium.  Since the bonds were purchased on the open market, there is no entry made on the issuing company’s books. Investment in S Company Bonds 310,000 Cash 310,000

17. Slide 9-17 Compute the Constructive Gain or Loss - $12,000 Constructive loss - $10,000 Constructive loss - $22,000 Net constructive loss Book Entry Related to Bond Investment LO 2 Allocating the constructive gain or loss. On the books of the individual companies, the constructive loss is not recorded. The constructive loss is recognized in the determination of consolidated income.

18. Slide 9-18 (1) (5) (4) Consolidated Statements Workpaper—2012 (2) (3) (6) (5) (2) (4) (6) (1) (6)

19. Slide 9-19 (1) (5) Consolidated Statements Workpaper—2012 (2) (3) (6) (5) LO 2 Allocating the constructive gain or loss. * ($125,000 $12,000) x 20% = $22,600 *

20. Slide 9-20 (2) Consolidated Statements Workpaper—2012 (4) (6)(1) (4) (3) (6) LO 2 Allocating the constructive gain or loss. ** $300,000 ($700,000 - $500,000) x 20% = $340,000

21. Slide 9-21 Investment in S Company Stock 160,000 Beginning Retained Earnings—P Company 160,000 To establish reciprocity, or convert to equity Worksheet entries for 2012. Retained earnings balance—January 1, 2012 $ 700,000 Retained earnings balance—date of acquisition 500,000 Increase in retained earnings 200,000 Percentage interest held by P Company 80% Amount to establish reciprocity $ 160,000 LO 2 Allocating the constructive gain or loss. 1. Consolidated Statements Workpaper—2012

22. Slide 9-22 Loss on Constructive Retirement of Bonds 10,000 Investment in S Company Bonds 10,000 To recognize the constructive loss not recorded by P Company and adjust the bond investment to par value. Worksheet entries for 2012. LO 2 Allocating the constructive gain or loss. 2. Loss on Constructive Retirement of Bonds 12,000 Discount on Bonds Payable 12,000 To recognize the constructive loss not recorded by the subsidiary and adjust the intercompany bonds to par value. 3. Entries (2) and (3) recognize the constructive loss allocated to each company and adjust bond investment and carrying value of the intercompany debt to par value. Consolidated Statements Workpaper—2012

23. Slide 9-23 Bonds Payable 300,000 Investment in S Company Bonds 300,000 To eliminate intercompany bond investment and liability. Worksheet entries for 2012. LO 2 Allocating the constructive gain or loss. 4. Dividend Income 16,000 Dividends Declared—S Company 16,000 5. Beginning Retained Earnings—S Company 700,000 Common Stock—S Company 1,000,000 Investment in S Company Stock 1,360,000 Noncontrolling Interest in Equity 340,000 6. Consolidated Statements Workpaper—2012

24. Slide 9-24 If the complete equity method is used, entry (1), the reciprocity entry, is not needed and the following entry replaces entry (5) above. LO 2 Allocating the constructive gain or loss. Equity in S Company Income 80,400 Dividends Declared 16,000 Investment in S Company Stock 64,400 To eliminate the intercompany income and dividends. Consolidated Statements Workpaper—2012 Complete Equity Method

25. Slide 9-25 (3) (2) Consolidated Statements Workpaper —2013 (1) (4) (2) (3) (4) Complete Equity Method (1)

26. Slide 9-26 P Company’s Books Entries on June 30 and December 31 LO 2 Allocating the constructive gain or loss. Cash 13,500 Interest Revenue 13,500 To record receipt of interest ($300,000 x 9% x 6/12). Interest Revenue 1,250 Investment in S Company Bonds 1,250 To amortize premium on outstanding bonds ($10,000 8 periods). Year Subsequent to Acquisition of Bonds, Entries on the Books of Affiliated Companies—2013

27. Slide 9-27 S Company’s Books Entries on June 30 and December 31 LO 2 Allocating the constructive gain or loss. Interest Expense 22,500 Cash 22,500 To record payment of interest ($500,000 x 9% x 6/12). Interest Expense 2,500 Discount on Bonds Payable 2,500 To amortize discount on outstanding bonds ($20,000 / 8 periods). Year Subsequent to Acquisition of Bonds, Entries on the Books of Affiliated Companies—2013

28. Slide 9-28 Investment in S Company Stock 244,000 Beginning Retained Earnings—P Company 244,000 To establish reciprocity, or convert to equity ($805,000 $500,000) x 80% = $244,000 Worksheet entries for December 31, 2013. LO 2 Allocating the constructive gain or loss. 1. Consolidated Statements Workpaper Entries Beginning Retained Earnings—P Company 10,000 Investment in S Company Bonds 10,000 To adjust beginning retained earnings for constructive loss (recorded in prior year as workpaper entry only; see 2012 entry (2) and to adjust investment to par. 2.

29. Slide 9-29 Beginning Retained Earnings—P Company * 9,600 Beginning Noncontrolling Interest **2,400 Discount on Bonds Payable ($15,000 x 60%) 12,000 To adjust beginning retained earnings balances for unrecorded constructive loss at beginning of the year (recorded in 2012 as workpaper entry only; see 2012 entry (3)) and adjust intercompany bonds to par value. Worksheet entries for December 31, 2013. LO 2 Allocating the constructive gain or loss. 3. * ($12,000 x 80%) ** ($12,000 x 20%) Consolidated Statements Workpaper Entries

30. Slide 9-30 Investment in S Company Bonds 2,500 Interest Revenue ($1,250 + $1,250) 2,500 To reverse the amortization of premium on investment recorded by P Company during the current year (and not needed by consolidated entity since the constructive loss was recorded in its entirety in 2012). Worksheet entries for December 31, 2013. LO 2 Allocating the constructive gain or loss. 4. Consolidated Statements Workpaper Entries

31. Slide 9-31 Discount on Bonds Payable ($5,000 x 60%) 3,000 Interest Expense 3,000 To reverse amortization of discount on bonds payable recorded by S Company during current year (and not needed by consolidated entity since the constructive loss was recorded in its entirety in 2012). Worksheet entries for December 31, 2013. LO 2 Allocating the constructive gain or loss. 5. Interest Revenue * 27,000 Interest Expense 27,000 To eliminate intercompany interest. 6. * ($45,000 x 60%) or ($13,500 + $13,500) Consolidated Statements Workpaper Entries

32. Slide 9-32 Bonds Payable ($500,000 x 60%) 300,000 Investment in S Company Bonds 300,000 To eliminate intercompany bond investment and bonds payable. Worksheet entries for December 31, 2013. LO 2 Allocating the constructive gain or loss. 7. Dividend Income 48,000 Dividends Declared—S Company 48,000 8. Beginning Retained Earnings—S Company 805,000 Common Stock—S Company 1,000,000 Investment in S Company Stock 1,444,000 Noncontrolling Interest in Equity 361,000 9. Consolidated Statements Workpaper Entries

33. Slide 9-33 (8) Consolidated Statements Workpaper—2013 (2) Cost Method (6)(4) (5) (6) (3) (9) (1) (2) (7) (9) (3) (9) (4) (1) (7) (5) (9) (3)

34. Slide 9-34 Had the bonds been held during 2012, P Company would have amortized a portion of the premium and S Company would have amortized a part of the discount. Assuming that P Company amortized $500 and S Company amortized $600 during 2012, the original workpaper entries (2) and (3) for constructive losses) are modified as follows: Interim Purchase of Intercompany Bonds 2.Loss on Constructive Retirement Bonds 10,000 Interest Revenue 500 Investment in S Company Bonds 9,500 Loss on Constructive Retirement of Bonds 12,000 Interest Expense 600 Discount on Bonds Payable 11,400 3.

35. Slide 9-35 A company may issue a note to an affiliated company that may then discount the note with an outside party. OR A company holding a note receivable from an outside party may discount the note with an affiliated company. Notes Receivable Discounted LO 3 Discounting a note issued to an affiliated company with an outside company. From a consolidation point of view, a receivable held by one of the affiliated companies should be reported in the consolidated balance sheet only if the note is due from an outside party.

36. Slide 9-36 Stock Dividends Issued by a Subsidiary Company LO 4 Stock dividends issued by a subsidiary. Parent company records receipt of shares in a memorandum entry only. Subsidiary records the declaration of a stock dividend as a transfer from retained earnings to one or more paid-in capital account. Amount transferred is dependent on a large or small stock dividend.

37. Slide 9-37 Stock Dividends Issued by a Subsidiary Company LO 4 Stock dividends issued by a subsidiary. Illustration: Assume that P Company purchased 4,000 shares of S Company’s $100 par value common stock on January 2, 2009, for $560,000. At the time of purchase, S Company reported common stock and retained earnings balances of $500,000 and $200,000, respectively. If consolidated statements were prepared on January 2, 2009, the investment eliminating entry would be: Capital Stock—S Company 500,000 1/1 Retained Earnings—S Company 200,000 Investment in S Company 560,000 Noncontrolling Interest in Equity 140,000

38. Slide 9-38 Stock Dividends Issued by a Subsidiary Company LO 4 Stock dividends issued by a subsidiary. Illustration: Now assume that S Company reports net income of $50,000 and declares a 30% stock dividend (1,500 shares) on December 31, 2009. S Company would record the dividend as follows (par value): Stock Dividend Declared (or R/E) 150,000 Capital Stock (1,500 shares $100) 150,000 The only entry made by P Company in 2009 is a memorandum entry to record the receipt of 1,200 shares from S Company.

39. Slide 9-39 Consolidated Statements Workpaper—2009 Cost Method (2) (1) (2) (1) (2) LO 4 Stock dividends issued by a subsidiary. Consolidated Statement Workpaper December 31, 2009

40. Slide 9-40 Capital Stock—S Company 120,000 Stock Dividends Declared—S Company 120,000 To reverse effects of stock dividend ($150,000 x 80%). 1/1 Retained Earnings—S Company 200,000 Capital Stock—S Company 500,000 Investment in S Company 560,000 Noncontrolling Interest in Equity 140,000 To eliminate investment account and recognize noncontrolling interest. Worksheet Entries – Year Stock Dividends Are Declared 1. 2. Stock Dividends Issued by a Subsidiary Company LO 4 Stock dividends issued by a subsidiary.

41. Slide 9-41 If the stock dividend had been more than retained earnings ($200,000), some of the postacquisition earnings of the subsidiary would have been capitalized. Committee on Accounting Procedure: Occasionally, subsidiary companies capitalize retained earnings arising since acquisition, by means of a stock dividend or otherwise. This does not require a transfer to capital surplus on consolidation. Stock Dividends Issued from Postacquisition Earnings Stock Dividends Issued by a Subsidiary Company LO 6 Subsidiary stock dividends issued from postacquisition earnings.

42. Slide 9-42 Effects of a liquidating dividend on the consolidated statements workpaper entries: Assume that P Company acquired an 80% interest in S Company on January 2, 2009, for $560,000. At the time of purchase, S Company had capital stock and retained earnings in the amounts of $500,000 and $200,000, respectively. During the first year that the investment was held, S Company reported net income of $200,000. On December 31, 2009, the subsidiary declared and paid a cash dividend of $250,000. Dividends from Preacquisition Earnings Stock Dividends Issued by a Subsidiary Company LO 6 Subsidiary stock dividends issued from preacquisition earnings.

43. Slide 9-43 Liquidating dividends are accounted for as a return of part of the original investment. Dividends from Preacquisition Earnings Stock Dividends Issued by a Subsidiary Company LO 6 Subsidiary stock dividends issued from preacquisition earnings. Cash 200,000 Dividend Income ($200,000 x 80%) 160,000 Investment in S Company ($50,000 x 80%) 40,000 To record receipt of a cash dividend from S Company P Company’s Books

44. Slide 9-44 The December 31, 2009, eliminating entries are as follows: Dividends from Preacquisition Earnings Stock Dividends Issued by a Subsidiary Company LO 6 Subsidiary stock dividends issued from preacquisition earnings. Dividend Income 160,000 Dividends Declared—S Company 160,000 To eliminate intercompany dividends. Investment in S Company 40,000 Dividends Declared—S Company 40,000 To reverse the liquidating dividend. 1. 2.

45. Slide 9-45 The December 31, 2009, eliminating entries are as follows: Dividends from Preacquisition Earnings Stock Dividends Issued by a Subsidiary Company LO 6 Subsidiary stock dividends issued from preacquisition earnings. Beginning Retained Earnings—S Co. 200,000 Capital Stock—S Company 500,000 Investment in S Company 560,000 Noncontrolling Interest in Equity 140,000 To eliminate investment account and create noncontrolling interest. 3.

46. Slide 9-46 Subsidiary company preferred shares not held by the parent company are considered part of the noncontrolling interest. Determining Equity Interest of Each Class of Stockholders Subsidiary with Preferred and Common Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. In consolidation, each class of stockholders has an interest in the net assets of the firm, so it is necessary to allocate:  Subsidiary’s Stockholders’ Equity between preferred and common stock interests.  Retained Earnings and Net Income amounts to each class of stockholders, based on dividend preference.

47. Slide 9-47 Illustration: Assume the following information concerning the capital accounts of S Company as of January 2, 2009: Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. 8%, $100 par value preferred stock, cumulative, nonparticipating, dividends in arrears for 2008, call price is $103,5,000 shares outstanding $ 500,000 Common stock, $10 par value 1,000,000 Other contributed capital—excess on issue of common stock over par 305,000 Retained earnings 200,000 Total stockholders’ equity $2,005,000

48. Slide 9-48 On January 2, 2009, P Company acquired 80% of the outstanding common stock for $1,160,000 and 30% of the outstanding preferred stock for $180,000. During the year, S Company reported net income of $200,000 and declared no cash dividends. The entry to record the purchase is: Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. Investment in S Co. preferred stock180,000 Investment in S Co. Common Stock 1,160,000 Cash 1,340,000 P Company’s Books

49. Slide 9-49 Computation and Allocation of Difference Between Implied and Book Value Acquired—Preferred Stock * Noncontrolling interest after adjustment $420,000 - $31,500 = $388,500 ** ($103 call + $8 dividends in arrears - $100 par) x 5,000 shares = $11 x 5,000 = $55,000 Date of Acquisition - 1/1/ 2009 Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders.

50. Slide 9-50 Cost Method or Partial Equity Method Beginning Retained Earnings—S Co.55,000 Preferred Stock—S Co.500,000 Difference Between Implied and BV 45,000 Investment in S Co. Preferred Stock 180,000 Noncontrolling Interest in Equity 420,000 To eliminate the preferred stock investment account and recognize the noncontrolling interest in equity. 1a. Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. Consolidated Statements Workpaper Entries—2009

51. Slide 9-51 Cost Method or Partial Equity Method Other Contributed Capital—P Company 13,500 Noncontrolling Interest in Equity 31,500 Difference Between Implied and Book Value 45,000 To allocate the difference between implied and book values of preferred stock to equity. 1b. Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. Consolidated Statements Workpaper Entries—2009

52. Slide 9-52 Computation and Allocation of Difference Between Implied and Book Value Acquired—Common Stock * $200,000 - $55,000 = $145,000 Date of Acquisition - 1/1/ 2009 Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders.

53. Slide 9-53 Cost Method or Partial Equity Method Beginning Retained Earnings—S Co. 145,000 Common Stock—S Co.1,000,000 Other Contributed Capital—S Co.305,000 Investment in S Co. Common Stock 1,160,000 NCI in Equity 290,000 To eliminate the common stock investment account and recognize NCI. 2. Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders. Consolidated Statements Workpaper Entries—2009

54. Slide 9-54 Noncontrolling interest in the consolidated income for 2009 is computed as follows: Consolidating with Preferred Stock Outstanding LO 7 Allocating the purchase price between common and preferred stockholders.

55. Slide 9-55 (1a) Consolidated Statement Workpaper December 31, 2009 Consolidating with Preferred Stock Outstanding (2) (1a) (2) (1a)(1b) Cost Method Page 1

56. Slide 9-56 (2) Consolidating with Preferred Stock Outstanding (1a)(1b) (2) (1b) (2) (1a) (1b) (2) (1a) Cost Method Page 2

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