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CHAPTER. Intercompany Bonds, Cash Flow, EPS, and Unconsolidated Investments Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng . 5. 5. Intercompany Bonds. A subsidiary may have debt that is more expensive than if it were issued by the parent

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CHAPTER

Intercompany Bonds, Cash Flow, EPS, andUnconsolidated InvestmentsFundamentals of Advanced Accounting1st EditionFischer, Taylor, and Cheng

5

5


Intercompany bonds l.jpg

Intercompany Bonds

  • A subsidiary may have debt that is more expensive than if it were issued by the parent

  • One member of the affiliated group (usually the subsidiary) has bonds outstanding that are held by outsiders; the other member (usually the parent) purchases the bonds from the outsiders

    • Consolidation treatment (on Worksheet) is retirement with an ordinary gain or loss (no longer extraordinary)

    • The result is the same if the parent loans money to the subsidiary and the subsidiary retires the bonds

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Intercompany bonds eliminations l.jpg

Intercompany Bonds - Eliminations

  • Elimination entry B1:

    • Bonds payable/receivable are eliminated

    • Intercompany interest revenues/expenses are eliminated

  • Elimination entry B2:

    • Intercompany interest receivables/payables are eliminated

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bond issued at face value example facts l.jpg

Bond Issued at Face Value Example: Facts

Sub(80%)issues to third parties $100,000, 5-year, 8% bond on 1/1/20X1 at 100.

Int. Exp. = $8,000 per year

Parentpurchases the bonds from third party for $103,600 on 1/2/20X3

3 remaining years

Discount amortization (st.-line) = $1,200 per year

Int. Rev. = $6,800 per year

Consolidated statements:$103,600 was paid to retire bonds with a book value of $100,000

There is $3,600 loss on the date of purchase

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bond example general ledger journal entries years 1 5 l.jpg

Bond Example: General Ledger Journal Entries (Years 1–5)

Sub Journal Entries

Year 1

Cash100,000

Bond Pay.100,000

Int. Exp.8,000

Int. Pay. 8,000

Year 2

Int. Exp8,000

Int. Pay8,000

Years 3, 4 & 5

Int. Exp.8,000

Int. Pay.8,000

Parent Journal Entries

Year 1

No entry

Year 2

No entry

Years 3, 4 & 5

Int. Rec. 8,000

Invest in Bond 1,200

Int. Pay.6,800

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bonds issued at face value elimination entries at 12 31 x3 l.jpg

Bonds Issued at Face Value – Elimination entries at 12/31/X3

B1Bond payable100,000

Invest. In Bonds 102,400*

Interest income6,800

Interest expense8,000

Loss on Bond retirement3,600

(eliminates intercompany bonds and interest expense)

* Net of $1,200 amortization of bond premium

B2Interest payable8,000

Interest receivable8,000

(eliminates intercompany accrued interest)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bond issued at discount example facts l.jpg

Bond Issued at Discount Example: Facts

Sub(80%)issues to third party $100,000, 5-year, 8% bond on 1/1/20X1 at $96,110.(Discount = $3,890)

  • Discount amortization (straight line) = $778 per year

  • Int. Exp. = $8,778 per year (Interest paid on 12/31)

  • Discount balance $1,556 at 12/31/X3

    Parentpurchases the bonds from third party for $103,600 on 12/31/20X3

  • 2 remaining years

  • Premium amortization (st.-line) = $1,800 per year

  • Int. Rev. = $6,200 per year

    Consolidated statements:$103,600 was paid to retire bonds with a book value of $98,444

  • There is $5,156 loss on the date of purchase

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bond example carrying values l.jpg

Bond Example: Carrying Values

Parent buys 12/31/X3

$98,444 less $103,600 results in a $5,156 loss.

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bond issued at a discount example journal entries years 4 5 l.jpg

Bond Issued at a Discount Example: Journal Entries (Years 4–5)

Sub Journal Entries

Year 4

Int. Exp.8,778

Discount on BP778

Cash8,000

Year 5

Int. Exp.8,778

Discount on BP778

Cash8,000

Parent Journal Entries

Year 4

Bond Invest.103,600

Cash103,600

Cash.8,000

Bond investment1,800

Int. Rev.6,200

Year 5

Cash8,000

Bond investment1,800

Int. Rev.6,200

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Bonds issued at discount elimination entries at 12 31 x4 l.jpg

Bonds Issued at Discount – Elimination entries at 12/31/X4

BBond payable100,000

Discount on Bonds payable778

Invest. In Bonds 101,800*

Interest income6,200

Interest expense8,778

Retained Earnings - P 4,640**

Retained Earnings – S 516^

(eliminates intercompany bonds and interest expense)

* Net of $1,200 amortization of bond premium

**$5,156 loss x 80%

^$5,156 loss x 20%

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Worksheet 5 3 eliminations 12 31 x4 bonds issued at a discount l.jpg

Worksheet 5-3: Eliminations (12/31/X4)Bonds Issued at a Discount

  • Bonds issued at a discount/premium does not change consolidation entries.

  • Bonds issued at a discount/premium does require additional calculations.

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Effective interest method l.jpg

Effective Interest Method

  • Procedures for elimination do not change!

  • Only dollar values are different…

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Effective interest bond example facts l.jpg

Effective Interest Bond Example: Facts

  • Subissues to third party a $100,000, 5-year, 8% bond on 1/1/20X1 for $96,110

  • Parentpurchases the bonds from outsiders for $103,667 on 12/31/20X3 (2 remaining years)

  • Consolidated statements:$103,667 was paid to retire bonds with a book value of $98,240.

    • There is a $5,427 loss

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Effective interest bond example amortization tables l.jpg

Effective Interest Bond Example: Amortization Tables

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Bonds issued at discount elimination entries at 12 31 x415 l.jpg

Bonds Issued at Discount – Elimination entries at 12/31/X4

BBond payable100,000

Discount on Bonds payable918

Invest. In Bonds 101,887*

Interest income6,220

Interest expense8,842

Retained Earnings - P 4,342**

Retained Earnings – S 1,085^

(eliminates intercompany bonds and interest expense)

* Net of $1,780 amortization of bond premium

**$5,427 loss x 80%

^$5,427 loss x 20%

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


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Consolidated Cash Flow: The Issues

  • Consolidated Statement of Cash Flows is required – FASB No. 95

  • Use consolidated financial statements to analyze cash flow

    • Intercompany transactions already eliminated…no effect

  • Investment and financing activities reported (even if non-cash)

    • Cash purchase is investing

    • Stock issue is a noncash transaction

  • Amortizations are a non-cash adjustment to operations

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Cash purchase example l.jpg

Cash Purchase: Example

Balance Sheet of Company Acquired

Cash50,000Liabilities1500,000

Inventory60,000

Building190,000Common Stock200,000

Equipment400,000Retained Earnings350,000

Total700,000 Total700,000

Building Fair Value = $425,000; Life = 10 years

Equipment Fair Value = $250,000; Life = 5 years

Goodwill = Excess of price paid over fair value of net assets

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Cash purchase example continued l.jpg

Cash Purchase: Example (continued)

D&D Schedule

Price paid540,000

Interest (80%  $550,000) 440,000

Excess100,000

Allocate to building (80%  25,000)(20,000)10-year

Allocate to equipment (80% x 60,000)(48,000) 5-year

Goodwill32,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Cash purchase example continued19 l.jpg

Cash Purchase: Example (continued)

To see cash flow impact, consider additions to parent balance sheet on purchase date:

Inventory60,000

Building420,000

Equipment238,000

Goodwill32,000

Liabilities150,000

Cash (540,000 – 50,000 sub cash)490,000

NCI (20%  550,000)110,000

Dr Cr

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Cash purchase example effect on statement of cash flows l.jpg

Cash Purchase Example:Effect on Statement of Cash Flows

  • Cash operations

    • +$10,600 depreciation adjustment

  • Cash flows from investing activities

    • Payment for purchase of Company S,

      net of cash acquired $(490,000)

  • Noncash “investing” is

    • $150,000 liability

    • $110,000 NCI

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Non cash purchase example l.jpg

Non-Cash Purchase: Example

Balance Sheet of Company Acquired

Cash50,000Liabilities1500,000

Inventory60,000

Building190,000Common Stock200,000

Equipment400,000Retained Earnings350,000

Total700,000 Total700,000

10,000 shares of Stock issued for sub

$10 par value

$54 market value

Building Fair Value = $425,000; Life = 10 years

Equipment Fair Value = $250,000; Life = 5 years

Goodwill = Excess of price paid over fair value of net assets

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Stock issued for sub example continued l.jpg

Stock Issued for Sub: Example (continued)

D&D Schedule

Price paid (10,000 shares x $54)540,000

Interest (80%  $550,000) 440,000

Excess100,000

Allocate to building (80%  25,000)(20,000)10-year

Allocate to equipment (80% x 60,000)(48,000) 5-year

Goodwill32,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Non cash purchase example continued l.jpg

Non-Cash Purchase: Example (continued)

To see cash flow impact, consider additions to parent balance sheet on purchase date:

Cash50,000

Inventory60,000

Building420,000

Equipment238,000

Goodwill32,000

Liabilities150,000

Common Stock – Par100,000

Paid-in Capital in Excess of Par440,000

NCI (20%  550,000)110,000

Dr Cr

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Non cash purchase example effect on statement of cash flows l.jpg

Non-Cash Purchase Example:Effect on Statement of Cash Flows

  • Cash operations

    • +$10,600 depreciation adjustment

  • Cash flows from investing activities

    • Cash acquired in purchase

      of Company S, $(490,000)

  • Noncash financing and investing

    • Adjusted value of assets acquired $800,000

    • Common Stock issued, 540,000

    • Liabilities assumed150,000

    • Non-controlling Interest110,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Consolidated diluted eps l.jpg

Consolidated Diluted EPS

Subsidiary has no dilutive shares

  • Calculated by dividing controlling interest in consolidated net income by parent company outstanding stock

  • Parent dilutive shares cause numerator and denominator adjustments just as in a single entity calculation

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Consolidated diluted eps continued l.jpg

Consolidated Diluted EPS - continued

Subsidiary has dilutive shares – Two step process

  • Step 1 – Calculate sub’s Diluted Earnings per Share (DEPS)

  • Step 2 – Calculate consolidated DEPS

    • Uses sub’s DEPS calculation as part of this calculation.

      Additional complication:

      Sub may have outstanding securities that may require the parent to issue additional shares

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


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Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution

Example on next slide

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Consolidated diluted eps calculation only sub has possible dilution example l.jpg

Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution Example

  • Subsidiary financial information:

  • Net Income (adjusted for interco profits)$22,000

  • Pref. stock cash dividend$2,000

  • Interest paid on convertible bonds$3,000

  • Common stock shares outstanding5,000

  • Warrants to purchase one share of common stock1,000

  • Warrants held by parent500

  • Convertible bonds outstanding (conv. to 10 shares cs)200

  • Convertible bonds held by parent180

  • Parent financial information:

  • Parent owns 80% of sub

  • Net income (internal, adjusted)$40,000

  • Interest paid on convertible shares$5,000

  • Common shares outstanding10,000

  • Bonds outstanding can convert to shares3,000

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Consolidated diluted eps calculation only sub has possible dilution29 l.jpg

Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution

Sub’s DEPS

Consol DEPS

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Consolidated diluted eps calculation parent possible dilution from sub s securities l.jpg

Consolidated Diluted EPS Calculation – Parent Possible Dilution from Sub’s Securities

If sub has dilutive securities that affect Parent’s stock:

  • These securities are not included in sub’s DEPS calculation

  • These securities must be included in the parent’s share adjustment for consolidated DEPS.

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


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Equity Method for Unconsolidated Investments

  • Income on investment is recorded as earned

    • Investor records income when the company invested in reports net income

    • Investor reduces the investment account when the company invested in declares dividends

  • Required for certain types of investments

    • Influential investments

    • Corporate joint ventures

    • Unconsolidated subsidiaries

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Influential investment example excel purchases 25 of flag s stock l.jpg

Influential Investment: ExampleExcel purchases 25% of Flag’s Stock

D&D of Excess Schedule

Price paid$250,000

Equity (25%  $800,000)200,000

Excess of cost over book value50,000

Less Equipment with 5-year life 20,000

Goodwill (not amortized)$30,000

Purchase date 1/1/20X1

Flag sells inventory to Excel:

$30,000 goods in ending inventory with 40% GP – 12/31/X1

$40,000 goods in ending inventory with 45% GP – 12/31/X2

Flag sold Excel a truck (4 year life) on 1/1/20X1

NBV $16,000, Sell price $20,000

Investee reports income of $60,000 (before tax) in 20X1 and $70,000 in 20X2

Flag declared and paid $10,000 in dividends in 20X2

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Influential investment 20x1 ids to calculate investment income l.jpg

Influential Investment:20X1 IDS to Calculate Investment Income

20X1 IDS for Flag

Truck. gain4,000Reported income60,000

Profit in Excel end. Inv.12,000Realized truck gain1,000

Adjusted Income45,000

Ownership interest (25%) 11,250

Less Equip amort.4,000

Investment income7,250

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.


Influential investment 20x2 ids to calculate investment income l.jpg

Influential Investment:20X2 IDS to Calculate Investment Income

20X2 IDS for Flag

Profit in Excel end. Inv.18,000Reported income70,000

Profit in Excel beg. Inv.12,000

Realized truck gain1,000

Adjusted Income65,000

Ownership interest (25%) 16,250

Less Equip amort.4,000

Investment income12,250

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Influential investment entries to record income dividends l.jpg

Influential Investment: Entries to Record Income & Dividends

20X1Investment in Flag Company7,250

Investment Income7,250

20X2Investment in Flag Company12,250

Investment Income12,250

(to record investment income)

20X2Cash 12,250

Investment in Flag Company 12,250

(to record dividends received)

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Influential investment special issues l.jpg

Influential Investment: Special Issues

  • Investee with Preferred Stock

  • Investee stock transactions

  • Write-down to market value

  • Zero investment balance

  • Intercompany transactions by investor

  • Gain or loss of influence

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