chapter 7 - 12thedition

8/10/2019 Chapter 7 - 12thEDITION

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Chapter 7

INTERCOMPANY PROFIT TRANSACTIONSBONDS

Answers to Questions

1 Intercompany borrowing gives rise to notes or advances receivable from and payable to affiliates, as well asreciprocal 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 incomereported by the lender is precisely reciprocal to an expense reported by the borrower, and the transactionsare complete on the date consummated. Similarly, direct lending and borrowing transactions do not giverise to unrecognized gains and losses since intercompany amounts received and paid are both realized andrecognized from the viewpoint of the separate legal entities.

3 Constructive gains and losses are gains and losses from the viewpoint of the consolidated entity but notfrom 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 theconsolidated entity because they are no longer liabilities of the consolidated entity to outside parties.

4 The book value of the liability is $1,004,700, computed as $1,000,000 plus $10,000 minus $5,300. If anaffiliate purchases half of the bonds at 98, it will record a bond investment of $490,000. From theviewpoint 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 thebooks of the separate affiliates. The affiliates continue to carry the bonds as a liability (issuer) andinvestment (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 statementpurposes because the land is still held within the consolidated entity. Thus, a constructive gain on bonds isrealized and recognized from the viewpoint of the consolidated entity but it is not recognized on the booksof the affiliates. An unrealized gain on the sale of land is recognized on the books of the selling affiliate butis 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 andexpense reported on the separate books of the affiliates. The difference between the interest incomereported by the investor and the interest expense reported by the issuer on the intercompany bonds is theamount of constructive gain recognized in each period. Constructive gains and losses are recognized in theconsolidated 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. Theloss 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 theprocedures used in earlier chapters of associating gains and losses on intercompany sales transactions withthe selling affiliates.


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8a Assume bonds were purchased at the beginning of the current year

10% bonds payable 52,000Interest income 5,250Interest payable 2,500

Investment in S bonds 49,000Interest expense 4,500Interest receivable 2,500Constructive gain on bonds 3,750

To eliminate reciprocal bond investment and liability amounts,reciprocal interest income and expense amounts, reciprocalinterest receivable and payable amounts, and enter theconstructive gain on bonds. The constructive gain is computed asthe $52,500 book value of bonds that were retired for $48,750.

8b Assume bonds were purchased one year earlier

10% bonds payable 52,000Interest income 5,250Interest payable 2,500

Investment in S bonds 49,000Interest expense 4,500Interest receivable 2,500Investment in S stock (90%) 3,375Noncontrolling interest 375

To eliminate reciprocal bond investment and liability amounts,reciprocal interest income and expense amounts, reciprocalinterest receivable and payable amounts, and adjust controllingand noncontrolling interest holdings for constructive gain lesspiecemeal recognition. The constructive gain is computed as:$53,000 book value - $48,500 cost = $4,500 of which $750 wasrecognized on the books of the affiliate in the prior year.

9

Separate entries are as follows:

Investment in S 40,000Income from S 40,000

To recognize income equal to 80% of reportedsubsidiary income.

Investment in S 4,000Income from S 4,000

To recognize gain on constructive retirement ofbonds (parents books).

The full amount of constructive gain on bonds is recognized asinvestment income because we assign the full amount to the parentissuer.


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10 Investment income from subsidiary75% of subsidiarys $100,000 reported income $75,000Less: 75% of $8,000 constructive loss on retirement ofsubsidiary bonds 6,000

Investment income $69,000

11a A constructive gain will result when interest income exceeds interestexpense on the bonds that are constructively retired.

11b The constructive gain is associated with the parent since the issuerreports interest expense.

11c The $200 difference between interest income and expense represents apiecemeal recognition of the constructive gain on the books of theseparate companies.

SOLUTIONS TO EXERCISES

Solution E7-1

1 c 3 d2 a 4 a

Solution E7-21 a

Book value of Pan bonds acquired by

Sow ($900,000 + $48,000) 2/3 $632,000

Cost to Sow 602,000Constructive gain $ 30,000

2 dNominal 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


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Solution E7-31 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 $ 2,4002 d

Par value of bonds payable $400,000Less: Unamortized discount ($8,000 - $2,000) (6,000)Book value of bonds 394,000Percent outstanding 80%Bonds payable $315,200

3 c

Constructive gain $2,400/4 years 3 years $ 1,800

4 cNominal interest $ 40,000Add: Amortization of discount 2,000

42,000Percent outstanding 80%Interest expense $ 33,600

5 b Piecemeal recognition of gain is $2,400 25% in 2011.


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Solution E7-4

1 Controlling Share of Consolidated net income (in thousands)

Pats separate income $1,600Add: Income from SalShare of Sals income

($1,000 80%) $800

Less: Loss on bonds constructivelyretiredBook value

($2,000 - $80) 40% $768

Cost to Sal 800 (32)Add: Piecemeal recognition of loss

($32,000/4 years) 8 776Controlling Share of Consolidatednet income

$2,376

2 Noncontrolling interest share

Sals reported income

$1,000 20% $ 200

Solution E7-5

Pim Corporation and SubsidiaryConsolidated Income Statement

for the year ended December 31, 2019(in thousands)

Sales $ 750Less: Cost of sales (435)

Gross profit 315Add: Gain on constructive retirement of bondsb 3Less: Operating expenses (125)

Operating profit 193Other Items:Bond interest expensea (15)

Consolidated net income $ 178

a Parents bond interest expense $25,000 less interest on bonds held intercompany$10,000 = $15,000.

b Book value of parents bonds purchased $100,000 less purchase price $97,000 =$3,000 gain on constructive retirement.


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Solution E7-6

1 Constructive loss

Cost paid to retire 1/2 of Sons bonds $251,500

Book value of bonds retired ($495,000 .5) 247,500

Constructive loss on bond retirement $ 4,000

2 Income from Son

Share of Sons reported income $7,000 70% $ 4,900

Less: Constructive loss $4,000 70% (2,800)

Add: Piecemeal recognition of constructive loss

($4,000/4 years) 70% 700

Income from Son $ 2,800

Solution E7-7

1 aJanuary 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


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Solution E7-8

1a Constructive gain

Book value of bonds January 1, 2012 $485,000

Amortization for 6 months ($15,000/4 years 1/2 year) 1,875

Book value of bonds July 1, 2012 486,875

Percent purchased by Say 60%

Book value of bonds purchased $292,125Purchase price 287,400

Constructive gain $ 4,725

1b Consolidated bond interest expense for 2012

Bond interest expense January 1 to July 1

($500,000 8% 1/2 year) + $1,875 amortization $ 21,875

Bond interest expense July 1 to December 31[($500,000 8% 1/2 year) + $1,875 amortization] 40% 8,750

Consolidated bond interest expense $ 30,625

1c Bond liability of Par

Par Discount Book ValueJanuary 1, 2012 $500,000 $15,000 $485,000Amortization 2012 - 3,750 + 3,750December 31, 2012 $500,000 $11,250 $488,750

Consolidated bond liability $488,750 40% outstanding $195,500

2 The amounts would not be different if Say had been the issuer and Parthe purchaser. However, the constructive retirement gains wouldbelong to Say and would have been allocated to both Par and the

noncontrolling interests in Say.


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Solution E7-9 (amounts in thousands)

Subsidiary purchases parent company bonds:

1a Gain on constructive retirement of bondsBook value of Pins bonds constructively

retired ($5,000 - $100 unamortized

discount) 40% $1,960

Purchase price of $1,000 par bonds 1,900Gain on constructive bond retirement $ 60

1b Consolidated interest payable

($3,000 + $1,000) 10% interest 1/2 year $ 200

1c Bonds payable at par ($3,000 + $1,000) $4,000

1d None But Sids investment in Pin bonds will be $1,920.

Cost January 2 $1,900Add: Amortization ($100,000/5 years) 20

$1,920

Parent purchases subsidiary bonds:

2a Loss on constructive retirement of bondsSids bonds payable ($1,000 + $20) $1,020Price paid by Pin 1,030Loss on constructive retirement of bonds $ (10)

2b Consolidated interest expense

Pin bonds ($5,000 10% interest)+ $20 amortization $ 520

2c None Interest receivable of $50 is eliminated in consolidation.

2d Book value of bonds payablePins bonds December 31, 2011 $4,900Add: Amortization for 2012 ($100 / 5 years) 20Book value of bonds payable $4,920


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Solution E7-10 (in thousands)

1 Gain from constructive retirement of bondsBook value of bonds purchased by Sal

($4,000 + $120) 25% $1,030

Price paid by Sal 980

Gain from constructive retirement of bonds $ 50

2 Working paper entry to eliminate effect of intercompany bond holdings12% bonds payable 1,024Interest incomea 124Interest payable 60

Investment in Pad bonds 984Gain on retirement of bonds 50Interest expenseb 114Interest receivable 60

a ($1,000 12% interest) + $4 amortization = $124

b [($4,000 12%) - $24 amortization] 25% intercompany = $114

3 Consolidated income statement amounts

2013a Constructive gain None

b Noncontrolling interest share ($600 20%) $ 120

c Bond interest expense

[($4,000 12%) - $24] 75% outsiders $ 342

d Bond interest income None

4 Consolidated balance sheet amountsDecember 31, 2013a Investment in Pad bonds None

b Book value of bonds payable($4,000 + $72) 75% outsiders $3,054

c Bond interest receivable None

d Bond interest payable

$4,000 12% 75% outsiders 1/2 year $ 180


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Solution E7-11

Preliminary computations:

Book value of Saw bonds on January 1, 2012 $1,000,000Purchase price paid by Par 783,000

Gain on constructive retirement of Saw bonds $ 217,000

Amortization of gain on bonds ($217,000/7 years) $ 31,000

Computation of noncontrolling interest share:

Share of Saws reported income ($140,000 20%) $ 28,000

Add: Share of constructive gain ($217,000 20%) 43,400

Less: Piecemeal recognition of constructive gain ($31,000 20%) (6,200)

Noncontrolling interest share $ 65,200

Par Corporation and SubsidiaryConsolidated Income Statement


Sales $1,800Less: Cost of sales 950

Gross profit 850Add: Gain from constructive retirement of Saw bonds 217Less: Operating expenses 400

Consolidated net income $ 667Less: Noncontrolling interest share 65.2Controlling interest share of NI $ 601.8


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Solution E7-12

1 Pub Corporation and Subsidiary, December 31, 2011Amounts Appearingin Consolidated

Financial StatementsInterest receivable 0Investment in Sap bonds 0

Interest payable ($40,000 90%) 36,000

8% bonds payable (($1,000,000 90%)- 13,500discount)

886,500

Interest income 0Interest expense ($86,000/2) + .9(86,000/2) 81,700Loss on constructive retirement of bonds 7,800a

a Computation of loss on intercompany bondsBalance of investment in bonds at December 31, 2011 $105,000Add: Amount amortized for July 1 to December 31, 2011

($5,000 balance at December 31 30/36 months = $6,000 unamortizedat July 1) 1,000

Investment cost July 1, 2011 $106,000Less: Book value acquired [$1,000,000 - ($15,000

unamortized discount at December 31 30/36 months)] 10% 98,200

Loss on constructive retirement of bonds $ 7,800

2 Consolidation working paper entries at December 31, 2011Interest income 3,0008% bonds payable 98,500Loss on retirement of bonds 7,800

Investment in Sap bonds 105,000Interest expense 4,300

To eliminate intercompany bonds, record constructive loss onretirement, and eliminate intercompany interest income andexpense.

Interest payable 4,000Interest receivable 4,000

To eliminate reciprocal interest payable and receivable amounts.

3 Consolidation working paper entries at December 31, 2012Investment in Sap (80%) 5,200Noncontrolling interest(20%) 1,300Interest income 6,0008% bonds payable 99,100

Investment in Sap bonds 103,000Interest expense 8,600

To eliminate intercompany bonds, interest income and expense, and

to charge the unrecognized portion of the constructive loss atthe beginning of the period 80% to the investment in Sap and 20%to the noncontrolling interest.


To eliminate reciprocal interest payable and receivable amounts.


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Solution E7-13

1 Gain on constructive retirement of bonds

Purchase price of bonds $ 97,600Book value 100,000

Gain on constructive retirement of bonds $ 2,400

2 Son accounts for its investment in Pap bonds

January 2, 2013Investment in Pap bonds 97,600

Cash 97,600To record investment in $100,000 par, 8% Pap bonds.

July 1, 2013Cash 4,000Investment in Pap bonds 400

Interest income 4,400To record interest and amortization.

December 31, 2013Interest receivable 4,000Investment in Pap bonds 400

Interest income 4,400To accrue interest and record amortization.

3 Pap accounts for its bonds payable

July 1, 2013Interest expense 8,000

Cash 8,000To record interest payment for 6 months.

December 31, 2013Interest expense 8,000

Interest payable 8,000To accrue interest for 6 months.

4 Pap accounts for its investment in Son

December 31, 2013Investment in Son 81,600

Income from Son 81,600To record income from Son

(80% $100,000) + $2,400 constructive gain - $800 piecemealrecognition of gain.

5 Noncontrolling interest share ($100,000 20%) $ 20,000

Controlling share of NI ($400,000 + $81,600) $481,600Consolidated net income $501,600


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SOLUTIONS TO PROBLEMS

Solution P7-1

1 Loss on constructive retirement of bonds

Purchase price of $50,000 par bondsApril 1, 2011 $53,600

Book value of bonds acquired:Par value $100,000Less: Unamortized discount $1,800 for 27

of 36 months ($1,800 .75) 2,400

Book value of bonds 97,600Intercompany bonds 50% 48,800

Loss on constructive retirement of bonds $ 4,800

2 Interest income and expense

Interest income in consolidated income statement2011 0

Interest expense in consolidated income statement2011$8,800 - ($8,800 3/4 year 50%) $ 5,500

3 Interest receivable and payable

Interest receivable in consolidated balance sheetat December 31, 2011 0

Interest payable in consolidated balance sheet atDecember 31, 2011 $ 1,000

4 Consolidation working paper entries

Loss on constructive retirement of bonds 4,8008% bonds payable 49,100Interest income 2,100

Investment in Pan bonds 52,700Interest expense 3,300

To eliminate reciprocal interest income and expense amounts andreciprocal bond investment and liability amounts and enterunrecognized constructive loss.


To eliminate reciprocal payables and receivables.


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Solution P7-2

Pew Corporation and Sat CorporationSchedule to Determine Pews Net Income and Controlling Share ofConsolidated

Net Income

2011 2012 2013 2014 Total

Pews separate income $250,000 $187,500 $230,000 $255,000 $ 922,500

80% of Sats net income + 40,000 + 48,000 + 44,000 + 48,000 + 180,000

$2,500 unrealized profit inSats December 31, 2011Inventory - 2,500 + 2,500

$5,000 unrealized profit inSats December 31, 2012Inventory - 5,000 + 5,000

$7,500 unrealized profit in2013 on sale of land

upstream 80% - 6,000 - 6,000

$15,000 unrealized profit onsale of equipment in 2013 - 15,000 - 15,000

$3,750 depreciation onunrealized profit onequipment in 2013 and 2014 + 3,750 + 3,750 + 7,500

$4,000 constructive loss onpurchase of Pews bonds

in 2014 - 4,000 - 4,000

$1,000 piecemeal recognition ofconstructive loss in 2014 + 1,000 + 1,000

Pews net income $287,500 $233,000 $261,750 $303,750 $1,086,000


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Solution P7-3(continued)Pad Corporation and SubsidiaryConsolidation Working Paper


Pad Sum 75%Adjustments andEliminations

ConsolidatedStatements

Income StatementSales $ 2,520 $ 2,000 b 200 $4,320

Gain on land 40 f 40

Gain on building 80 f 80

Income from Sum 208 h 208

Gain on bonds g 24 24

Cost of sales 1,400* 1,200* d 60 b 200

c 48 2,412*

Depreciation expense 304* 160* e 16

f 4 444*

Interest expense 80* 80*

Other expenses 184* 240* 424*

Consolidated NI 984

Noncontrolling int. share k 104 104*

Controlling share of NI $ 880 $ 400 $ 880

Retained Earnings

Retained earningsPad $ 600 $ 600

Retained earningsSum $ 400 i 400

Controlling share of NI 880 400 880

Dividends 640* 320* h 240

k 80 640*

Retained earnings, Dec. 31 $ 840 $ 480 $ 840

Balance SheetCash $ 108 $ 324 a 40 $ 472

Bond interest receivable 20 j 20

Other receivables 160 120 a 40 240Inventories 320 200 d 60 460

Land 360 280 f 40 600

Buildingsnet 600 720 f 76 1,244

Equipmentnet 560 360 e 48 872

Investment in Sum stock 1,372 c 48 i 1,500

e 48

h 32

Investment in Pad bonds _______ 376 g 376 ______

$ 3,480 $ 2,400 $3,888

Accounts payable $ 200 $ 320 $ 520

Bond interest payable 40 j 20 20

10% bonds payable 800 g 400 400

Common stock 1,600 1,600 i 1,600 1,600

Retained earnings 840 480 840

$ 3,480 $ 2,400

Noncontrolling interest January 1 e 16 i 500

Noncontrolling interest December 31 _______ k 24 508

3,296 3,296 $3,888


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Solution P7-4(continued)

8 Noncontrolling interest December 31, 2013Beginning noncontrolling interest (($670,000 + $150,000

unamortized excess) 20%) $164,000

Less: Unrealized profit in beginning inventory

($40,000

20%) (8,000)Less: Noncontrolling interest dividends ($30,000 20%) (6,000)

Add: Noncontrolling interest share 11,000Noncontrolling interest December 31 $161,000

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

9 Investment in She stock at December 31, 2012Investment in She stock at cost $640,000

Add: Changes in retained earnings to December 31, 2012($270,000 - $200,000) 80% 56,000

Less: 80% of Excess of ($200,000/8 years) = $20,000 per

year 2 years (40,000)

Less: Unrealized profit in beginning inventory

($40,000 80%) (32,000)

Investment in She stock December 31, 2012 $624,000

Alternative computation:

Investment in She stock December 31, 2013 $640,000Less: 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

10 Income from SheShare of Shes reported net income $ 60,000Less: Depreciation on excess ($200,000/8 years) (25,000)Add: Unrealized profit in beginning inventory 40,000Less: Unrealized profit in ending inventory (20,000)Shes adjusted and realized income $ 55,000Pets 80% controlling share $ 44,000Less: Constructive loss on retirement of bonds($6,000 - $2,000) (4,000)

Pets income from She $ 40,000


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Solution P7-6

Income from Sal for 2012:

Share of reported income of Sal ($100,000 75%) $ 75,000

Add: Unrealized profit in beginning inventory of Sal 12,000

Less: Unrealized profit in ending inventory of Sal (15,000)Add: Piecemeal recognition of gain on sale of equipment

to Par ($24,000/6 years) 75% 3,000

Less: Unrealized gain on sale of land to Sal (10,000)Less: Unrealized gain on sale of building to Sal less

piecemeal recognition through depreciation ($20,000 - $1,000) (19,000)Add: Gain on constructive retirement of Par bonds

($100,000 - $94,000) 6,000Income from Sal for 2012 $ 52,000

Investment in Sal at December 31, 2012:

Underlying equity in Sal ($520,000 75%) $390,000

Less: Unrealized profit in Sals ending inventory (15,000)Less: Unrealized gain on equipment sold to Par

($24,000 - $12,000 recognized) 75% (9,000)

Less: Unrealized gain on sale of land to Sal (10,000)Less: Unrealized gain on sale of building to

Sal ($20,000 - $1,000 recognized) (19,000)Add: Gain on constructive retirement of Pars bonds 6,000

Investment in Sal December 31 $343,000

Noncontrolling interest share:

Net income of Sal $100,000Add: Piecemeal recognition of gain on

equipment ($24,000/6 years) 4,000

Sals realized income 104,000Noncontrolling interest percentage 25%

Noncontrolling interest share $ 26,000


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chapter 7 - 12thedition

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