Chapter 7

INTERCOMPANY PROFIT TRANSACTIONS BONDS

Answers to Questions 1 2 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. 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. Constructive gains and losses are gains and losses from the viewpoint of the consolidated entity but not from the viewpoint of the separate affiliates involved. The purchase of a parents outstanding bonds by its subsidiary at a price below the book value of the bonds on the parents books results in a constructive gain. Although the bonds are not actually retired, they are constructively retired from the viewpoint of the consolidated entity because they are no longer liabilities of the consolidated entity to outside parties. 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]. 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. 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. 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.

8a

Assume bonds were purchased at the beginning of the current year 10% bonds payable 52,000 Interest income 5,250 Interest payable 2,500 Investment in S bonds 49,000 Interest expense 4,500 Interest receivable 2,500 Constructive gain on bonds 3,750 To eliminate reciprocal bond investment and liability amounts, reciprocal interest income and expense amounts, reciprocal interest receivable and payable amounts, and enter the constructive gain on bonds. The constructive gain is computed as the $52,500 book value of bonds that were retired for $48,750.

8b

Assume bonds were purchased one year earlier 10% bonds payable 52,000 Interest income 5,250 Interest payable 2,500 Investment in S bonds 49,000 Interest expense 4,500 Interest receivable 2,500 Investment in S stock (90%) 3,375 Noncontrolling interest 375 To eliminate reciprocal bond investment and liability amounts, reciprocal interest income and expense amounts, reciprocal interest receivable and payable amounts, and adjust controlling and noncontrolling interest holdings for constructive gain less piecemeal recognition. The constructive gain is computed as: $53,000 book value - $48,500 cost = $4,500 of which $750 was recognized on the books of the affiliates in the prior year.

Separate entries are as follows: Investment in S Income from S To recognize income subsidiary income. Investment in S Income from S To recognize gain on constructive retirement of bonds (parents books). The full amount of constructive gain on bonds is recognized as investment income because we assign the full amount to the parent issuer. equal to 80% of reported 4,000 4,000 40,000 40,000

10

Investment income from subsidiary 75% of subsidiarys $100,000 reported income Less: 75% of $8,000 constructive loss on retirement of subsidiary bonds Investment income

$75,000 6,000 $69,000

11a 11b 11c

A constructive gain will result when interest income exceeds interest expense on the bonds that are constructively retired. The constructive gain is associated with the parent since the issuer reports interest expense. The $200 difference between interest income and expense represents a piecemeal recognition of the constructive gain from the constructive retirement of bonds payable.

SOLUTIONS TO EXERCISES Solution E7-1 1 c 2 a 3 4 d a

Solution E7-2 1 a Book value of Pan bonds acquired by Sow ($900,000 + $48,000) 2/3 Cost to Sow Constructive gain 2 d Nominal interest on Pans remaining outstanding bonds $300,000 8% Less: Amortization of premium ($48,000 1/3)/ 4 years Interest expense on consolidated income statement Solution E7-3 1 c Cost of $80,000 par of Pal bonds January 1, 2011 Book value acquired ($400,000 par - $8,000 discount) 20% Constructive gain 2 d Par value of bonds payable Less: Unamortized discount ($8,000 - $2,000) Book value of bonds Percent outstanding Bonds payable 3 c Constructive gain $2,400/4 years 3 years 4 c Nominal interest Add: Amortization of discount Percent outstanding Interest expense 5 b

$632,000 602,000 $ 30,000 $ 24,000 4,000 $ 20,000

$ 76,000 78,400 $ 2,400 $400,000 (6,000) 394,000 80% $315,200 $ 1,800

$ 40,000 2,000 42,000 80% $ 33,600

Piecemeal recognition of gain is $2,400 25% in 2012.

Solution E7-4 1 Controlling Interest Share of Consolidated net income (in thousands) Pats separate income Add: Income from Sal Share of Sals income ($500 80%) Less: Loss on bonds constructively retired Book value ($1,000 - $40) 40% Cost to Sal Add: Piecemeal recognition of loss ($16,000/4 years) Controlling Interest Share of Consolidated net income 2 Noncontrolling interest share Sals reported income $500 20% Consolidated Net Income = $1,188 + $100 = $1,288. Solution E7-5 Pim Corporation and Subsidiary Consolidated Income Statement for the year ended December 31, 2019 (in thousands) Sales Less: Cost of sales Gross profit Add: Gain on constructive retirement of bondsb Less: Operating expenses Operating profit Other Items: Bond interest expensea Consolidated net income
a b

$ $400

800

$384 400

(16) 4 388 $1,188

100

$1,500 (870) 630 6 (250) 386 $ (30) 356

Parents bond interest expense $50,000 less interest on bonds held intercompany $20,000 = $30,000. Book value of parents bonds purchased $200,000 less purchase price $194,000 = $6,000 gain on constructive retirement.

Solution E7-6 1 Constructive loss Cost paid to retire 1/2 of Sons bonds Book value of bonds retired ($990,000 .5) Constructive loss on bond retirement 2 Income from Son Share of Sons reported income $14,000 70% Less: Constructive loss $8,000 70% Add: Piecemeal recognition of constructive loss ($8,000/4 years) 70% Income from Son Solution E7-7 1 a January 1, 2011 cost of $200,000 par bonds Book value acquired ($1,000,000 + $45,000 premium) 20% Constructive gain b Constructive gain $13,500/5 years 4 years c Book value $1,036,000 80% outstanding $195,500 209,000 $ 13,500 $ 10,800 $828,800 $ 9,800 (5,600) 1,400 5,600 $503,000 495,000 $ 8,000

2 3

Solution E7-8 1a Constructive gain Book value of bonds January 1, 2012 Amortization for 6 months ($30,000/4 years 1/2 year) Book value of bonds July 1, 2012 Percent purchased by Say Book value of bonds purchased Purchase price Constructive gain 1b Consolidated bond interest expense for 2012 Bond interest expense January 1 to July 1 ($1,000,000 8% 1/2 year) + $3,750 amortization Bond interest expense July 1 to December 31 [($1,000,000 8% 1/2 year) + $3,750 amortization] 40% Consolidated bond interest expense $ 43,750 17,500 $ 61,250 $970,000 3,750 973,750 60% $584,250 574,800 $ 9,450

1c

Bond liability of Par January 1, 2012 Amortization 2012 December 31, 2012 Par $1,000,000 $1,000,000 Discount $30,000 - 7,500 $22,500 Book Value $970,000 + 7,500 $977,500 $391,000

Consolidated bond liability $977,500 40% outstanding Alternative Calculation: Book value at July 1, 2012 Portion left Remaining book value at July 1, 2012 Add: Discount amortization(40% x $3,750) Book value at December 31, 2012 2 $973,750 x 40% $389,500 1,500 $391,000

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.

Solution E7-9 (amounts in thousands) Subsidiary purchases parent company bonds: 1a Gain on constructive retirement of bonds Book value of Pins bonds constructively retired ($5,000 - $100 unamortized discount) 40% Purchase price of $1,000 par bonds Gain on constructive bond retirement 1b 1c 1d Consolidated interest payable ($3,000 + $1,000) 10% interest 1/2 year Bonds payable at par ($3,000 + $1,000) None But Sids investment in Pin bonds will be $1,920. Cost January 2 Add: Amortization ($100,000/5 years) Total (Eliminated in consolidation) 2a Parent purchases subsidiary bonds: Loss on constructive retirement of bonds Sids bonds payable ($1,000 + $20) Price paid by Pin Loss on constructive retirement of bonds (80% to Pin and 20% to Noncontrolling interests) Consolidated interest expense Pin bonds ($5,000 10% interest) + $20 amortization $1,900 20 $1,920

$1,960 1,900 $ 60 $ 200

$4,000

$1,020 1,030 $ (10)

2b

520

2c 2d

None Interest receivable of $50 is eliminated in consolidation. Book value of bonds payable Pins bonds December 31, 2011 $4,900

Add: Amortization for 2012 ($100 / 5 years) Book value of bonds payable

20 $4,920

Solution E7-10 (in thousands) 1 Gain from constructive retirement of bonds Book value of bonds purchased by Sal ($2,000 + $60) 25% Price paid by Sal Gain from constructive retirement of bonds

$515 490 $ 25

Working paper entry to eliminate effect of intercompany bond holdings 12% bonds payable 512 62 Interest incomea Interest payable 30 Investment in Pad bonds 492 Gain on retirement of bonds 25 57 Interest expenseb Interest receivable 30
a b ($500 12% interest) + $2 amortization = $62 [($2,000 12%) - $12 amortization] 25% intercompany = $57

Consolidated income statement amounts 2013 a Constructive gain b c d Noncontrolling interest share ($300 20%) Bond interest expense [($2,000 12%) - $12] 75% outsiders Bond interest income $ $

None 60 171 None None $1,527 None $ 90

Consolidated balance sheet amounts December 31, 2013 a Investment in Pad bonds b c d Book value of bonds payable ($2,000 + $36) 75% outsiders Bond interest receivable Bond interest payable $2,000 12% 75% outsiders 1/2 year

Solution E7-11 Preliminary computations: Book value of Saw bonds on January 1, 2012 Purchase price paid by Par Gain on constructive retirement of Saw bonds Amortization of gain on bonds ($217,000/7 years) Computation of noncontrolling interest share: Share of Saws reported income ($140,000 20%) Add: Share of constructive gain ($217,000 20%) Less: Piecemeal recognition of constructive gain ($31,000 20%) Noncontrolling interest share Par Corporation and Subsidiary Consolidated Income Statement for the year ended December 31, 2012 (in thousands) Sales Less: Cost of sales Gross profit Add: Gain from constructive retirement of Saw Less: Operating expenses Consolidated net income Less: Noncontrolling interest share Controlling interest share of NI Solution E7-12 1 Pub Corporation and Subsidiary, December 31, 2011 Amounts Appearing in Consolidated Financial Statements 0 0 32,000 786,500 0 77,400 7,800a $1,800 950 850 217 400 667 65.2 601.8 $1,000,000 783,000 $ 217,000 $ $ 31,000 28,000 43,400 (6,200) 65,200

$ $

Interest receivable Investment in Sap bonds Interest payable ($40,000 80%) 8% bonds payable (($1,000,000 80%)- 13,500 discount) Interest income Interest expense ($86,000/2) + .8(86,000/2) Loss on retirement of bonds payable

Solution E7-12 (continued)

a Computation of loss on intercompany bonds Balance of investment in bonds at December 31, 2011 Add: Amount amortized for July 1 to December 31, 2011 ($5,000 balance at December 31 30/36 months = $6,000 unamortized at July 1) Investment cost July 1, 2011 Less: Book value acquired [$1,000,000 - ($15,000 unamortized discount at December 31 30/36 months)] 10% Loss on constructive retirement of bonds $105,000 1,000 $106,000 $ 98,200 7,800

Consolidation working paper entries at December 31, 2011 Interest income 3,000 8% bonds payable 98,500 Loss on retirement of bonds 7,800 Investment in Sap bonds 105,000 Interest expense 4,300 To eliminate intercompany bonds, record constructive loss on retirement, and eliminate intercompany interest income and expense. Interest payable 4,000 Interest receivable 4,000 To eliminate reciprocal interest payable and receivable amounts.

Consolidation working paper entries at December 31, 2012 Investment in Sap (80%) 5,200 Noncontrolling interest 1,300 Interest income 6,000 8% bonds payable 99,100 Investment in Sap bonds 103,000 Interest expense 8,600 To eliminate intercompany bonds, interest income and expense, and to charge the unrecognized portion of the constructive loss at the beginning of the period 80% to the investment in Sap and 20% to the noncontrolling interest. Interest payable 4,000 Interest receivable 4,000 To eliminate reciprocal interest payable and receivable amounts.

Solution E7-13 1 Gain on constructive retirement of bonds Purchase price of bonds Book value Gain on constructive retirement of bonds 2 Son accounts for its investment in Pap bonds January 2, 2013 Investment in Pap bonds 48,800 Cash To record investment in $50,000 par, 8% Pap bonds. July 1, 2013 Cash Investment in Pap bonds Interest income To record interest and amortization. 2,000 200 2,200 $48,800 50,000 $ 1,200

48,800

December 31, 2013 Interest receivable 2,000 Investment in Pap bonds 200 Interest income To accrue interest and record amortization. 3 Pap accounts for its bonds payable July 1, 2013 Interest expense Cash To record interest payable for 6 months. December 31, 2013 Interest expense Interest payable To accrue interest for 6 months. 4 Pap accounts for its investment in Son 4,000

2,200

4,000

4,000 4,000

December 31, 2013 Investment in Son 40,800 Income from Son 40,800 To record income from Son (80% $50,000) + $1,200 constructive gain - $400 piecemeal recognition of gain. 5 Noncontrolling interest share ($50,000 20%) $ 10,000 $240,800

Controlling share of NI ($200,000 + $40,800) Consolidated Net Income = $10,000 + $240,800 = $250,800