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Answers to Questions
1 Intercompany borrowing gives rise to notes or advances receivable from and payable to affiliates, as well as
reciprocal interest receivable and payable accounts and interest income and expense accounts.
2 Direct lending and borrowing transactions do not give rise to unrealized gains and losses. Any income
reported by the lender is precisely reciprocal to an expense reported by the borrower, and the transactions
are complete on the date consummated. Similarly, direct lending and borrowing transactions do not give
rise to unrecognized gains and losses since intercompany amounts received and paid are both realized and
recognized from the viewpoint of the separate legal entities.
a) The issuer (parent or subsidiary) use its available resources to purchase and retire its own bonds.
b) The issuer (parent or subsidiary) borrow money from unaffiliated entities at the market rate of
interest and use the proceeds to retire its own bonds. (This option constitutes refunding)
c) The issuer can borrow money from an affiliate and use the proceeds to retire its own bonds.
4 The book value of the liability is $1,004,700, computed as $1,000,000 plus $10,000 minus $5,300. If an
affiliate purchases half of the bonds at 98, it will record a bond investment of $490,000. From the viewpoint
of the consolidated entity, the purchase of the bonds results in a constructive retirement of $500,000 par of
bonds payable. The constructive gain on the bonds is $12,350 [($1,004,700 50%) $490,000].
5 A constructive gain on bonds is a gain for consolidated statement purposes that is not recorded on the books
of the separate affiliates. The affiliates continue to carry the bonds as a liability (issuer) and investment
(purchaser) on their separate books. Alternatively, an unrealized gain on the sale of land is recorded on the
books of the selling affiliate, but it is not recognized as a gain for consolidated statement purposes because
the land is still held within the consolidated entity. Thus, a constructive gain on bonds is realized and
recognized from the viewpoint of the consolidated entity but it is not recognized on the books of the
affiliates. An unrealized gain on the sale of land is recognized on the books of the selling affiliate but is not
realized or recognized from the viewpoint of the consolidated entity.
6 Constructive gains on intercompany bonds are realized and recognized through the interest income and
expense reported on the separate books of the affiliates. The difference between the interest income
reported by the investor and the interest expense reported by the issuer on the intercompany bonds is the
amount of constructive gain recognized in each period. Constructive gains and losses are recognized in the
consolidated financial statements before they are recognized on the books of the affiliates.
7 If a subsidiary purchases parent bonds at a price in excess of book value, a constructive loss results. The
loss is attributed to the parent since it is the parent bonds that are constructively retired. This approach of
associating constructive gains and losses on intercompany bonds with the issuer is consistent with the
procedures used in earlier chapters of associating gains and losses on intercompany sales transactions with
the selling affiliates.
9 The amount of piecemeal recognition of a constructive gain or loss is always the difference between the
intercompany interest expense and income account that are eliminated. If the straight-line amortization is
used, the amount of piecemeal recognition of each year can be calculated with the constructive gain or loss
divided by the remaining life of the bond when the retirement occurred. However, this approach cannot be
applied if effective interest method is used.
10 Elimination of interest expense will eventually increase the controlling share of consolidated income and the
opposite, elimination of interest income will eventually decrease the controlling share of consolidated
income. Logically, interest expense is the debit account of the controlling share, so eliminating it will
eventually increase the income or credit account and vice versa for the interest income.
11a A constructive gain will result when interest income exceeds interest expense on the bonds that are
constructively retired.
11b The constructive gain is associated with the parent since the issuer reports interest expense.
11c The $200 difference between interest income and expense represents a piecemeal recognition of the
constructive gain on the books of the separate companies.
SOLUTIONS TO EXERCISES
Solution E7-1
1 c 3 d
2 a 4 a
Solution E7-2
1 a
Book value of Pan bonds acquired by
Sow ($900,000 + $48,000) 2/3 $632,000
Cost to Sow 602,000
Constructive gain $ 30,000
2 d
Nominal interest on Pans remaining
outstanding bonds $300,000 8% $ 24,000
Less: Amortization of premium ($48,000 1/3)/ 4 years 4,000
Interest expense on consolidated income statement $ 20,000
Solution E7-3
1 c
Cost of $80,000 par of Pal bonds January 1, 2011 $ 76,000
Book value acquired ($400,000 par - $8,000 discount) 20% 78,400
Constructive gain $ 2,400
2 d
Par value of bonds payable $400,000
Less: Unamortized discount ($8,000 - $2,000) (6,000)
Book value of bonds 394,000
Percent outstanding 80%
Bonds payable $315,200
3 c
Constructive gain $2,400/4 years 3 years $ 1,800
4 c
Nominal interest $ 40,000
Add: Amortization of discount 2,000
42,000
Percent outstanding 80%
Interest expense $ 33,600
Solution E7-5
Sales $ 750
Less: Cost of sales (435)
Solution E7-6
Solution E7-7
1 a
January 1, 2011 cost of $400,000 par bonds $391,000
Book value acquired ($2,000,000 + $90,000 premium) 20% 418,000
Constructive gain $ 27,000
2 b
Constructive gain $27,000/5 years 4 years $ 21,600
3 c
Book value $2,072,000 80% outstanding $1,657,600
1a Constructive gain
2 The amounts would not be different if Say had been the issuer and Par
the purchaser. However, the constructive retirement gains would belong
to Say and would have been allocated to both Par and the noncontrolling
interests in Say.
Check:
Noncontrolling interest share:
Income from Noa DD x 10% / 90% $38,000
Solution E7-11
Preliminary computations:
Sales $1,800
Less: Cost of sales 950
Solution E7-13
January 2, 2013
Investment in Pap bonds 97,600
Cash 97,600
To record investment in $100,000 par, 8% Pap bonds.
July 1, 2013
Cash 4,000
Investment in Pap bonds 400
Interest income 4,400
To record interest and amortization.
July 1, 2013
Interest expense 8,000
Cash 8,000
To record interest payment for 6 months.
Solution P7-1
Solution P7-2
$3,750 depreciation on
unrealized profit on
equipment in 2013 and 2014 + 3,750 + 3,750 + 7,500
Preliminary computations:
90% of Merry SAs net income $720,000
(90% x ($3,700,000 +$200,000 - $2,400,000 - $700,000))
Unrealized profit from ending inventory ($100,000)b
(100% x $100,000)
Unrealized gain on sale of land ($180,000)
(90% x ($1,000,000 - $800,000)
Unrealized gain on sale of equipment ($100,000)d
(100% x $100,000)
Constructive gain on bond retirement $ 60,000
(($1,000,000 / 2) - $440,000))
Piecemeal recognition of constructive gain ($ 20,000)
($60,000 / 3)
Income from Merry SAs $380,000
THANOS SA AND SUBSIDIARY CONSOLIDATION WORKPAPER FOR THE YEAR ENDED DECEMBER
31, 2014 (IN THOUSANDS)
Consolida
Adjustments and ted
Thanos Merry Eliminations Statement
SA SA Debits Credits s
Income Statement
Sales $ 4,800 $ 3,700 a. 800 $ 7,700
Income from Merry SA $ 380 h. 380
Gain on sale of land $ 200 c. 200
Gain on sale of equipment $ 100 d. 100
Interest income $ 70 f. 70
Gain on retirement of bonds e. 40 $ 60
f. 20
Copyright 2015 Pearson Education Limited
7-16 Intercompany Profit Transactions Bonds
-
Cost of sales
-$ 2,800 $ 2,400 b. 100 a. 800 -$ 4,500
Interest expense -$ 100 f. 50 -$ 50
Other expenses -$ 1,100 -$ 700 -$ 1,800
Noncontrolling interest share i. 60 -$ 60
Controlling share of net income $ 1,350 $ 800 $ 1,350
Retained Earnings Statement
Retained earnings - Thanos SA $ 3,380 $ 3,380
Retained earnings - Merry SA $ 2,085 j. 2085
Controlling share of net income $ 1,350 $ 800 $ 1,350
Dividends -$ 300 -$ 100 h. 90 -$ 300
i. 10
Retained earnings - December 31 $ 4,430 $ 2,785 $ 4,430
Balance Sheet
Cash $ 700 $ 600 $ 1,300
Accounts receivable $ 1,000 $ 400 $ 1,400
Interest receivable $ 25 g. 25
Inventory $ 1,100 $ 700 b. 100 $ 1,700
Land $ 1,900 $ 800 c. 200 $ 2,500
Equipment-net $ 1,100 $ 1,400 d. 100 $ 2,400
Building-net $ 2,000 $ 1,400 $ 3,400
Investment in Thanos SA bonds $ 460 e. 460
Investment in Merry SA $ 3,980 h. 290
j. 3690
Goodwill j. 15 $ 15
Total Assets $ 11,780 $ 5,785 $ 12,715
Solution P7-4
Preliminary Computations:
Acquisition price $ 640,000
Implied fair value of She ($640,000 / 80%) $ 800,000
Shes book value (600,000)
Excess allocated to plant & equipment with 8 year life $ 200,000
2 Consolidated sales
Combined sales $560,000
Less: Intercompany sales 100,000
Consolidated sales $460,000
Alternative computation:
Ending equity of She ($700,000 + $125,000 unamortized
excess)( 20%) $165,000
Less: Unrealized profit in ending inventory ($20,000 20%) (4,000)
Noncontrolling interest December 31, 2013 $161,000
Alternative computation:
Investment in She stock December 31, 2013 $640,000
Less: Income from She for 2013 (40,000)
Add: Dividends from She ($30,000 80%) 24,000
Investment in She stock December 31, 2012 $624,000
Solution P7-6
Preliminary computations:
80% ofNuro AOs net income $1,520,000
(80% x ($12,000,000 + $1,000,000 - $8,800,000
$200,000 $2,100,000))
Unrealized profit from ending inventory ($80,000)
(80% x $1,000,000 / 2 x 20%)
Unrealized gain on sale of building ($800,000)
(80% x ($5,000,000 - $4,000,000))
Piecemeal recognition of gain on sale of building $40,000
(80% x ($5,000,000 - $4,000,000) / 10 / 2)
Constructive loss on bond retirement ($80,000)
(80% x ($900,000 - $800,000)
Piecemeal recognition of constructive gain $40,000
(80% x ($900,000 $800,000) / 2)
Income from Nuro AOs $640,000
Adjustments and
Eliminations Consolidated
Ken AO Nuro AO Debits Credits Statements
Income Statement
a.
Sales
$ 14,000 $ 12,000 1,000 $ 25,000
Income from Nuro AO $ 640 h. 640
Gain on sale of building $ 1,000 c. 1000
Interest income $ 150 f. 150
Loss on retirement of bonds e. 50 -$ 100
f. 50
- a.
Cost of sales
$ 11,100 -$ 8,800 b. 100 1,000 -$ 19,000
Interest expense -$ 200 f. 200
Other expenses -$ 1,700 -$ 2,100 d. 50 -$ 3,750
Noncontrolling interest share i. 160 -$ 160
Controlling share of net
income $ 1,990 $ 1,900 $ 1,990
Retained Earnings Statement
Retained earnings - Ken AO $ 12,000 $ 12,000
Retained earnings - Nuro AO $ 5,000 j. 5000
Controlling share of net
$ 1,990 $ 1,900 $ 1,990
income
Dividends -$ 500 -$ 800 h. 640 -$ 500
i. 160
Retained earnings - December
31 $ 13,490 $ 6,100 $ 13,490
Balance Sheet
Cash $ 1,500 $ 2,000 $ 3,500
Accounts receivable $ 3,640 $ 1,900 $ 5,540
Interest receivable $ 100 g. 100
Inventory $ 1,600 $ 1,800 b. 100 $ 3,300
Land $ 2,000 $ 4,200 $ 6,200
Equipment-net $ 2,100 $ 1,100 $ 3,200
c.
Building-net
$ 6,000 $ 2,000 d. 50 1,000 $ 7,050
Investment in Nuro AO bonds $ 950 e. 950