ACC 424Financial Reporting II

Lecture 9Inter-company transactions - 2

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Inter-company transactions - 2

• Previous lecture dealt with intercompany asset transfers

• This lecture deals with intercompany asset/liability holdings

– Intercompany bondholdings

• The holdings are similar to accounts receivable/accounts payable holdings, but an important difference is that the elimination can lead to gains or losses

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Inter-company bond-holdings• Bonds acquired from the affiliate have straightforward

entries since– Purchaser’s investment in bonds = issuer’s bond liability

– Interest revenue = interest expense

– Each year the inter-company debt & interest expense can be cleanly eliminated - see text book pages 6-1 to 6-3

• Bonds acquired in the open market after issuance do not have straightforward entries if interest rates have changed

– Purchaser’s nvestment ≠ issuer’s bond liability

– Issuer’s interest expense ≠ purchaser’s interest revenue (different amounts of premium or discount amortization)

– There is• a consolidated gain if investment<liability• a consolidated loss if investment>liability

– To which affiliate should the gain or loss accrue?• Book allocates to both affiliates• Exposure draft allocates to issuer

≠

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Inter-company bond-holdingsexample

• Example - modification of E6.4P Company owns 90% of S Company’s outstanding common stock.

On December 31, 19X6, S acquired $100,000 par value of P’s 8% annual coupon bonds for $80,000. The bonds mature in 10 years and are carried on P’s books at $110,000, reflecting an unamortized premium of $10,000. Both companies use the straight-line method of amortization, and P’s investment in common stock is carried at equity. Assume S earns $50,000 each year

• Calculation of gain or loss on effective retirement of debt– Investment in Bonds - S par value $100,000

Discount on Investment in Bonds 20,000

Net Bond Investment $ 80,000– Bonds Payable - P par value $100,000

Premium on Bonds Payable 10,000

Net Bond Liability $110,000– Gain on retirement of debt $ 30,000

• Allocation of gainS receives its discount $20,000 & P its premium $10,000

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Inter-company bond-holdingsexample

• At 12/31/X6 P makes following entry in its booksInvestment in S $73,000

Equity in income of S $73,000

.9 of S’s net income, $50,000 $45,000

+ P’s share of gain, $10,000

+.9 of S’s share of gain, .920,000 $18,000 $73,000

• X6 consolidated working papers elimination entriesEquity in Income of S $ 73,000

Investment in S $ 73,000

Bonds Payable - P 100,000

Investment in bonds 100,000

Elimination of par value of bonds

Premium on Bonds Payable - P 10,000

Discount on Investment in Bonds 20,000

Gain on Retirement of Consolidated Debt 30,000

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Inter-company bond-holdingsexample-subsequent year

• Entry made in P’s books in 19X7

Interest expense $7,000

Premium on bonds payable 1,000

Cash $8,000

To record interest expense for 19X7 using straight-line amortization. 1/10 $10,000 premium

• Entry made in S’s books in 19X7Cash $8,000

Discount on investment in bonds 2,000 Interest revenue $10,000

To record interest revenue for 19X7 using straight-line amortization. 1/10 $20,000 discount

• The $1,000 & $2,000 amortizations reducing expense and increasing revenue (respectively) in the affiliates’ books are realizations of 1/10 of the $30,000 gain previously recognized in the 19x6 consolidated statements

• So the amortizations must be eliminated from expense and revenue (along with the $8,000 cash coupon payment) in the 19X7 consolidated working papers. This means a credit to interest expense of $7,000 and a debit to interest revenue of $10,000

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Inter-company bond-holdingsexample-subsequent year

• Elimination entries (1) Interest revenue $10,000

Discount on investment in bonds ($20,000-2,000) 18,000

Premium on bonds payable ($10,000-1,000) 9,000

Retained earnings- S 1/1/X7 $18,000

Minority interest in S RE 1/1/X7 2,000

Investment in S 10,000

Interest expense 7,000

This entry not only eliminates interest revenue & expense, it:

a) eliminates the unamortized discount & premium in S & P’s books at 12/X7

b) increases S’s 1/1/X7 RE & MI for S’s gain recognized in consolidation (but not S’s books) last year

c) decreases Investment in S for P’s gain recognized in consolidation last year so that Investment in S can be eliminated against S’s owners’ equity

The increase in S’s RE and the decrease in Investment in S for gains recognized in the consolidation but not in the affiliates’ books in the previous year are analogous to the decrease in S’s RE and increase in Investment in S for upstream and downstream unrealized profits on land recognized in the affiliates’ books but not in the consolidation in a previous year

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Inter-company bond-holdingsexample-subsequent year

Elimination entries (continued) (2) Bonds payable - P $100,000

Investment in bonds$100,000

This entry eliminates the par value of the bonds