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CHAPTER 6

INTERCOMPANY DEBT, CONSOLIDATED STATEMENT OF


CASH FLOWS AND OTHER ISSUES

Chapter Outline
I.

Variable interest entities (VIEs)


A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most
cases a sponsoring firm creates these entities to engage in a limited and well-defined set
of business activities. For example, a business may create a VIE to finance the
acquisition of a large asset. The VIE purchases the asset using debt and equity
financing, and then leases the asset back to the sponsoring firm. If their activities are
strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as
less risky than their sponsoring firms. As a result, such arrangements can allow financing
at lower interest rates than would otherwise be available to the sponsor.
B. Control of VIEs, by design, often does not rest with its equity holders. Instead, control is
exercised through contractual arrangements with the sponsoring firm who becomes the
"primary beneficiary" of the entity. These contracts can take the form of leases,
participation rights, guarantees, or other residual interests. Through contracting, the
primary beneficiary bears a majority of the risks and receives a majority of the rewards of
the entity, often without owning any voting shares.
C. An entity whose control rests a primary beneficiary is referred to by FASB Interpretation
46R "Consolidation of Variable Interest Entities," (FIN 46R) as a variable interest entity.
The following characteristics indicate a controlling financial interest in a variable interest
entity.
1. The direct or indirect ability to make decisions about the entity's activities
2. The obligation to absorb the expected losses of the entity if they occur,
or
3. The right to receive the expected residual returns of the entity if they occur
The primary beneficiary bears the risks and receives the rewards of a variable interest
entity and is considered to have a controlling financial interest.
D. FIN 46R reasons that if a "business enterprise has a controlling financial interest in a
variable interest entity, assets, liabilities, and results of the activities of the variable
interest entity should be included with those of the business enterprise." Therefore,
primary beneficiaries must include their variable interest entities in their consolidated
financial statements consistent with the provisions of SFAS 141R.

II. Intercompany debt transactions


A. No real consolidation problem is created when one member of a business combination
loans money to another. The resulting receivable/payable accounts as well as the
interest income expense balances are identical and can be directly offset in the
consolidation process.
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B. The acquisition of an affiliate's debt instrument from an outside party does require special
handling so that consolidated financial statements can be produced.
1. Because the acquisition price will usually differ from the book value of the liability, a
gain or loss has been created which is not recorded within the individual records of
either company.
2. Because of the amortization of any associated discounts and/or premiums, the
interest income being reported by the buyer will not correspond with the interest
expense of the debtor.
C. In the year of acquisition, all intercompany accounts (the liability, the receivable, interest
income, and interest expense) are eliminated within the consolidation process while the
gain or loss (which produced all of the discrepancies because of the initial difference) is
recognized.
1. Although several alternatives exist, this textbook assigns all income effects resulting
from the retirement to the parent company, the party ultimately responsible for the
decision to reacquire the debt.
2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to
consolidate intercompany debt.
D. Even after the year of retirement, all intercompany accounts must be eliminated again in
each subsequent consolidation; however, the beginning retained earnings of the parent
company is adjusted rather than a gain or loss account.
1. The change in retained earnings is needed because a gain or loss was created in a
prior year by the retirement of the debt, but only interest income and interest expense
were recognized by the two parties.
2. The amount of the change made to retained earnings at any point in time is the
original gain or loss adjusted for the subsequent amortization of discounts or
premiums.
III. Subsidiary preferred stock
A. Subsidiary preferred shares not owned by the parent are a component of the
noncontrolling interest.
B. In an acquisition, the fair value of any subsidiary preferred shares not acquired by the
parent is added to any consideration transferred along with the fair value of the
noncontrolling interest in common shares to compute the acquisition-date fair value of the
subsidiary.
IV. Consolidated statement of cash flows
A. Statement is produced from consolidated balance sheet and income statement and not
from the separate cash flow statements of the component companies.
B. Intercompany cash transfers are omitted from this statement because they do not occur
with an outside, unrelated party.
C. The "Noncontrolling Interest's Share of the Subsidiary's Income'' is not included as a cash
flow although any dividends paid to these outside owners is reported as a financing
activity.
V. Consolidated earnings per share
A. This computation normally follows the pattern described in intermediate accounting
textbooks. For basic EPS, consolidated net income is divided by the weighted-average
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number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for
the parent shares, their weight must be included in computing diluted EPS but only if
earnings per share is reduced.
1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an
earnings figure and (2) a shares figure.
2. The portion of the shares figure belonging to the parent is computed. That
percentage of the subsidiary's diluted earnings is then added to the parent's income
in order to complete the earnings per share computation.
VI. Subsidiary stock transactions
A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury
stock, a change is created in the book value underlying the parent's investment account.
The increase or decrease should be reflected by the parent as an adjustment to this
balance.
B. The book value of the subsidiary that corresponds to the parent's ownership is measured
before and after the transaction with any alteration recorded directly to the investment
account. The parent's additional paid-in capital (or retained earnings) account is normally
adjusted although the recognition of a gain or loss is an alternate accounting treatment.
C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to
the parent's investment account. In addition, any subsidiary treasury stock is eliminated
within the consolidation process.

Learning Objectives
Having completed Chapter 6, students should have fulfilled each of the following learning
objectives:
1. Describe a variable interest entity and primary beneficiary. Also should know when a variable
interest entity is subject to consolidation.
2. Eliminate all intercompany debt accounts and recognize any associated gain or loss created
whenever one company acquires an affiliate's debt instrument from an outside party.
3. Recognize that intercompany debt transactions require a constantly changing consolidation
entry to be prepared for each subsequent period until the debt is formally retired.
4. Compute the appropriate amounts and make the worksheet entry needed in each
subsequent consolidation when one company has purchased the debt of an affiliate directly
from an outside parry.
5. Discuss the various theories as to the appropriate allocation of any income effect created by
intercompany debt transactions and identify the assignment employed in this textbook (and
the rationale for its use).
6. Understand that subsidiary preferred stocks not owned by the parent are initially valued in
consolidated financial reports as noncontrolling interest at acquisition-date fair value.
7. Prepare a consolidated statement of cash flows.
8. Compute basic and diluted earnings per share for a business combination in which the
subsidiary has dilutive convertible securities.
9. Identify subsidiary stock transactions that can impact the underlying book value figure
recorded within the parent's Investment account.
10.

Calculate the effect that a subsidiary stock transaction has on the parent's investment
balance and make the required journal entry to record that impact.

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Answer to Discussion Question


Who Lost the $300,000?
This case is designed to give life to a theoretical accounting issue discussed within the chapter:
If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to
the subsidiary? The case attempts to illustrate that no clear-cut solution to this question can be
found. This lack of an absolute answer makes financial accounting both intriguing and
frustrating. Interesting class discussion can be generated from this issue.
Students should note that the decision as to assignment only becomes necessary because of
the presence of the noncontrolling interest. Regardless of the level of ownership all
intercompany balances are simply eliminated on the worksheet with the gain or loss being
recognized. Not until the time that the noncontrolling interest computations are made does the
identity of the specific party become important.
All financial and operating decisions are assumed to be made in the best interest of the business
entity as a whole. This debt would not have been retired unless corporate officials believed that
Penston/Swansan would benefit from the decision. Thus, a strong argument can be made
against any assignment to either separate party.
Students should be required to pick one method and justify its use. Discussion usually centers
on the following issues:

Parent company officials made the actual choice that created the loss. Therefore, assigning
the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong
party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the
case) so that its financial records should not be affected by the $300,000 loss.
The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the
$300,000 should be attributed to that party. Financial records measure the results of
transactions and the retirement simply culminates an earlier transaction made by the
subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as
indicated in the case). If the subsidiary had acquired its own debt, for example, no question
as to the assignment would have existed. Thus, changing that assignment simply because
the parent was forced to be the acquirer is not justified.
Both parties were involved in the transaction so that some allocation of the loss is required.
If, at the time of repurchase, a discount existed within the subsidiary's accounts, this figure
would have been amortized to interest expense (if the debt had not been retired). Thus, the
$300,000 loss was accepted now in place of the later amortization. This reasoning then
assigns this portion of the loss to the subsidiary. Because the parent was forced to pay more
than face value, that remaining portion is assigned to the buyer.

Answers to Questions
1. A variable interest entity (VIE) is a business structure that is designed to accomplish a
specific purpose. A VIE can take the form of a trust, partnership, joint venture, or corporation
although typically it has neither independent management nor employees. The entity is
frequently sponsored by another firm to achieve favorable financing rates.
2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that
change with changes in the entity's net asset value. Variable interests will absorb portions of
a variable interest entity's expected losses if they occur or receive portions of the entity's
expected residual returns if they occur. Variable interests typically are accompanied by
contractual arrangements that provide decision making power to the owner of the variable
interests. Examples of variable interests include debt guarantees, lease residual value
guarantees, participation rights, and other financial interests.
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3. The following characteristics are indicative of an enterprise qualifying as a primary


beneficiary with a controlling financial interest in a VIE.
The direct or indirect ability to make decisions about the entity's activities
The obligation to absorb the expected losses of the entity if they occur, or
The right to receive the expected residual returns of the entity if they occur
4. Because the bonds were purchased from an outside party, the acquisition price is likely to
differ from the book value of the debt as found on the subsidiary's records. This difference
creates accounting problems in handling the intercompany transaction. From a consolidated
perspective, the debt has been retired; a gain or loss should be reported with no further
interest being recorded. In reality, each company will continue to maintain these bonds on
their individual financial records. Also, because discounts and/or premiums are likely to be
present, both of these account balances as well as the interest income/expense will change
from period to period because of amortization. For reporting purposes, all individual accounts
must be eliminated with the gain or loss being reported so that the events are shown from
the vantage point of the consolidated entity.
5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be
equal in amount. The debt and the receivable will be in agreement so that no gain or loss is
created. Interest income and interest expense should also reflect identical amounts.
Therefore, the consolidation process for this type of intercompany debt requires no more
than the offsetting of the various reciprocal balances.
6. The gain or loss to be reported is the difference between the price paid and the book value
of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be
recognized immediately on the date of acquisition.
7. Because the bonds are still legally outstanding, they will continue to be found on both sets of
financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest
Expense, and Interest Income) must be eliminated within the consolidation process. Any gain
or loss on the retirement as well as later effects on interest caused by amortization are also
included to arrive at an adjustment to the beginning retained earnings of the parent
company.
8. The original gain is never recognized within the financial records of either company. Thus,
within the consolidation process for the year of acquisition, the gain is directly recorded
whereas (for each subsequent year) it is entered as an adjustment to beginning retained
earnings. In addition, because the book value of the debt and the investment are not in
agreement, the interest expense and interest income balances being recorded by the two
companies will differ each year because of the amortization process. This amortization
effectively reduces the difference between the individual retained earnings balances and the
total that is appropriate for the consolidated entity. Consequently, a smaller change is
needed each period to arrive at the balance to be reported. For this reason, the annual
adjustment to beginning retained earnings gradually decreases over the life of the bond.
9. No set rule exists for assigning the income effects that result from intercompany debt
transactions although several different theories have been put forth over the years which
include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire
amount to the buyer, and (3) allocation of the gain or loss between the two parties in some
manner. This textbook attributes the entire income effect (the $45,000 gain in this case) to
the parent company. Assignment to the parent is justified because that party is ultimately
responsible for the decision being made to retire the debt. The answer to the discussion
question included in this chapter analyzes this question in more detail.
10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are
included in the consolidated financial statements at acquisition-date fair value and
subsequently adjusted for their share of subsidiary income and dividends.
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11. The consolidated statement of cash flows is developed from the information found in the
consolidated balance sheet and income statement. Thus, the cash flows generated by
operating, investing, and financing activities are identified only after the consolidation of
these other statements.
12. The noncontrolling interest share of the subsidiarys income is a component of consolidated
net income. Consolidated net income then is adjusted for noncash and other items to arrive
at consolidated cash flows from operations. Any dividends paid by the subsidiary to these
outside owners are listed as a financing activity of the business combination because an
actual cash outflow is created.
13. An alternative to the normal diluted earnings per share calculation is required whenever the
subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the
potential impact of the conversion of subsidiary shares must be factored into the overall
diluted earnings per share computation.
14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect
consolidated basic EPS. Consolidated basic earnings per share is computed by dividing
consolidated net income by the weighted average number of parent shares outstanding.
Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by
including both convertible items. The portion of the parent's controlled shares to the total
shares used in this calculation is then determined. Only this percentage (of the income figure
used in the subsidiary's computation) is added to the parent's income in arriving at the
diluted earnings per share for the business combination.
15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties.
Clearly, additional financing is brought into the company by any such sale. Also, stock
issuance may be used to entice new individuals to join the organization. Additional
management personnel, as an example, might be attracted to the company in this manner.
The company could also be forced to sell shares because of government regulation. Many
countries require some degree of local ownership as a prerequisite for operating within that
country.
16. Because the new stock was issued at a price above book value, the book value per share of
Metcalf's stock has been increased. Consequently, the book value of Washburn's investment
should be increased to reflect this change. To measure the effect, the underlying book value
of Washburn's investment is calculated both before and after the new issuance. Because the
increment is the result of a stock transaction, an increase is made to additional paid -in capital
although recording a gain or loss is currently allowed. Although the subsidiary's shares (both
new and old) are eliminated in the consolidation process, the increase in the parent's APIC
(or gain or loss) does carry into the consolidated figures. In addition, the percentage of the
subsidiary attributed to the noncontrolling interest will have increased.
17. A stock dividend does not alter the book value of the subsidiary company and, thus, creates
no effect on Washburn's investment account or on the consolidated figures. Hence, no entry
is recorded at all by the parent company in connection with the subsidiary's stock dividend.

Answers to Problems
1. D
2. C
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3. A
4. D
5. A
6. D Cash Flow from Operations:
Net income...................................................................
Depreciation.................................................................
Trademark amortization.............................................
Increase in accounts receivable................................
Increase in inventory...................................................
Increase in accounts payable....................................
Cash Flow from Operations.......................................
7. C

$45,000
10,000
15,000
(17,000)
(40,000)
12,000

Cash Flow from Financing Activities:


Dividends to parents interest....................................
Dividends to noncontrolling interest (20% $5,000)
Reduction in long-term notes payable......................
Cash Flow from Financing Activities........................

(20,000)
$25,000
($12,000)
(1,000)
(25,000)
($38,000)

8. C
9. C
10. C Rodgers' Reported Balance.......................................
Ferdinal's reported balance ......................................
Eliminate interest expenseintercompany ............
Eliminate interest incomeintercompany ..............
Recognize gain on retirement of debt ($212,000 $199,000)
Consolidated net income .....................................

$200,000
80,000
21,000
(22,000)
13,000
$292,000

11. B Eliminate interest expenseintercompany ............


Eliminate interest incomeintercompany ..............
Recognize loss on retirement of debt ($206,000 $189,000)
Reduction in retained earnings, 1/1/10 ...............

$21,000
(18,000)
(17,000)
$(14,000)

12. B Ace reported income ..................................................


Remove intercompany dividends (cost method).....
Byrd reported income ................................................
Gain on extinguishment of debt ($48,300 $46,600)
Eliminate interest expense on "retired" debt
($48,300 x 10%) .....................................................
Eliminate interest income on "retired" debt
($46,600 x 12%) .....................................................
Consolidated net income ...............................

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$400,000
(7,000) $393,000
100,000
1,700
4,830
(5,592)
$493,938

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13. D 30% of Byrd's reported income of $100,000; the intercompany debt


transaction is attributed solely to the parent company.
14. A For 2010, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2009 interest
expense, and the elimination of the 2009 interest income.
Gain on Retirement of Bond
Original book value ...............................................................
20062008 amortization ($600,000 20 yrs. x 3 yrs.) ........
Book value, January 1, 2009 ................................................
Percentage of bonds retired ......................................
Book value of retired bonds ................................................
Cash received ($4,000,000 x 96.6%) ....................................
Gain on retirement of bonds ......................................

$10,600,000
(90,000)
$10,510,000
40%
$4,204,000
3,864,000
$340,000

Interest Expense on Intercompany Debt2009


Cash interest expense (9% x $4,000,000) ...........................
Premium amortization ($30,000 per year total x 40%
retired portion of bonds) .................................................
Interest expense on intercompany debt .............................
Interest Income on Intercompany Debt2009
Cash interest income (9% x $4,000,000) .............................
Discount amortization ($136,000 17 yrs.) ........................
Interest income on intercompany debt ...............................
Adjustment to 1/1/10 Retained Earnings
Recognition of 2009 gain on extinguishment of debt (above).....
Elimination of 2009 intercompany interest expense (above).......
Elimination of 2009 intercompany interest income (above).........
Increase in retained earnings, 1/1/10 .........................$320,000

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$360,000
(12,000)
$348,000
$360,000
8,000
$368,000
$340,000
348,000
(368,000)

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15. D Consideration transferred for preferred stock .............................


Consideration transferred for common stock ..............................
Noncontrolling interest fair value for preferred ...........................
Noncontrolling interest fair value for common .............................
Acquisition-date fair value ..............................................................
Acquisition-date book value ...........................................................
Goodwill ............................................................................................

$424,000
3,960,000
1,696,000
400,000
6,480,000
(6,000,000)
$480,000

16. C Consideration transferred for preferred stock ............................. $106,000


Consideration transferred for common stock ..............................
916,400
Noncontrolling interest fair value for common .............................
580,000
Acquisition-date fair value .............................................................. $1,602,400
Acquisition-date book value ........................................................... (1,500,000)
Excess fair value............................................................................... $102,400
to building .......................................................................................
50,000
to goodwill.......................................................................................
$52,400
17. A Parents reported sales .............................................
Subsidiary's reported sales ......................................
Less: intercompany transfers ...................................
Sales to outsiders .................................................
Eliminate increase in receivables (less cash collected)
Cash generated by sales ......................................

$300,000
200,000
(40,000)
$460,000
(30,000)
$430,000

18. B Book value of subsidiary prior to issuing new shares


(12,000 x $40) ........................................................
Parent's ownership ....................................................
Book value acquired ..................................................

$480,000
100%
$480,000

Book value of subsidiary after issuing new shares (above


value plus 3,000 shares at $50 each) ..................
Parent's ownership (12,000 15,000 shares) ..........
Book value acquired ..................................................

$630,000
80%
$504,000

Investment in Nestlum increases by $24,000 ($504,000 less $480,000)


19. A Because the parent acquired 80 percent of the new shares, its proportion of
ownership has remained the same. Because the purchase price will
necessarily equal 80 percent of the increase in the subsidiary's book value,
no separate adjustment by the parent is required.
20. C Adjusted book value of subsidiary ($795,000 + $150,000) ..........
Current parent ownership (32,000 shs. 50,000 shs.) .................
Book value acquired....................................................................
Book value acquired currently recorded in parent's investment account ($795,000 x 80%) .................................................
Required adjustmentdecrease .........................................

$945,000
64%
$604,800

21. D Adjusted book value of subsidiary ($795,000 $192,000) ..........

$603,000

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636,000
$(31,200)

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Current parent ownership (32,000 shs. 32,000 shs.) .................


Book value equivalency of parent's ownership ......................
Book value equivalency currently recorded in parent's investment account ($795,000 x 80%) .................................................
Required adjustmentdecrease..........................................

100%
$603,000
636,000
$(33,000)

22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)


Consolidation of a variable interest entity is required if a parent has a
variable interest that will

Absorb a majority of the entity's expected losses if they occur

Receive a majority of the entity's expected residual returns if they occur

Because (1) HCO Medias losses are limited by contract, and (2)
Hillsborough has the right to receive the residual benefits of the sales
generated on the HCO Media internet site above $500,000, Hillsborough
should consolidate HCO Media.
23.

(40 minutes) (VIE Qualifications for Consolidation)


a. The purpose of consolidated financial statements is to present the financial
position and results of operations of a group of businesses as if they were a
single entity. They are designed to provide information useful for making
business and economic decisionsespecially assessing amounts, timing,
and uncertainty of prospective cash flows. Consolidated statements also
provide more complete information about the resources, obligations, risks,
and opportunities of an enterprise than separate statements.
b. According to FIN 46R, an entity qualifies as a VIE and is subject to
consolidation if either of the following conditions exist.

The total equity at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other
parties. In most cases, if equity at risk is less than 10% of total assets, the
risk is deemed insufficient.

The equity investors in the VIE lack any one of the following three
characteristics of a controlling financial interest.
1. The direct or indirect ability to make decisions about an entity's
activities through voting rights or similar rights.
2. The obligation to absorb the expected losses of the entity if they
occur (e.g., another firm may guarantee a return to the equity
investors)

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23. continued
3. The right to receive the expected residual returns of the entity (e.g.,
the investors' return may be capped by the entity's governing
documents or other arrangements with variable interest holders).
Consolidation is required if a parent has a variable interest that will

Absorb a majority of the entity's expected losses if they occur

Receive a majority of the entity's expected residual returns if they occur

Also, a direct or indirect ability to make decisions that significantly affect the
results of the activities of a variable interest entity is a strong indication that
an enterprise has one or both of the characteristics that would require
consolidation of the variable interest entity.
c. Risks of the construction project that has TecPC has effectively shifted to
the owners of the VIE

At the end of the 1st five-year lease term, if the parent opts to sell the
facility, and the proceeds are insufficient to repay the VIE investors,
TecPC may be required to pay up to 85% of the project's cost. Thus, a
potential 15% risk.

During construction 11.1% of project cost potential termination loss.

Risks that remain with TecPC

Guarantees of return to VIE investors at market rate, if facility does not


perform as expected TecPC is still obligated to pay market rates.

If lease is not renewed, TecPC must either purchase the facility or sell it
on behalf of the VIE with a guarantee of Investors' (debt and equity)
balances representing a risk of decline in market value of asset

Debt guarantees

d. TecPC possesses the following characteristics of a primary beneficiary


Direct decision-making ability (end of five-year lease term)

Absorb a majority of the entity's expected losses if they occur (via debt
guarantees and guaranteed lease payments and residual value)

Receive a majority of the entity's expected residual returns if they occur


(via use of the facility and potential increase in its market value).

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24. (10 minutes) (Consolidation of variable interest entity.)


a. Implied valuation and excess allocation for Softplus.
Noncontrolling interest fair value
Consideration transferred by Pantech
Total business fair value
Fair value of VIE net assets
Excess net asset value fair value

$ 60,000
20,000
80,000
100,000
$20,000

The $20,000 excess net asset fair value is recognized by PanTech as a


bargain purchase. All SoftPlus assets and liabilities are recognized at their
individual fair values.
Cash
Marketing software
Computer equipment
Long-term debt
Noncontrolling interest
Pantech equity interest
Gain on bargain purchase

$20,000
160,000
40,000
(120,000)
(60,000)
(20,000)
(20,000)
-0-

b. Implied valuation and excess valuation for Softplus.


Noncontrolling interest fair value
Consideration transferred by Pantech
Total business fair value
Fair value of VIE net identifiable assets
Goodwill

60,000
20,000
80,000
60,000
$20,000

When the business fair value of a VIE (that is a business) is greater than
assessed asset values, all identifiable assets and liabilities are reported at
fair values (unless a previously held interest) and the difference is treated
as a goodwill.
Cash
Marketing software
Computer equipment
Goodwill (excess business fair value)
Long-term debt
Noncontrolling interest
Pantech equity interest

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$20,000
120,000
40,000
20,000
(120,000)
(60,000)
(20,000)
-0-

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25.

(25 Minutes) (Consolidation entry for three consecutive years to report


effects of intercompany bond acquisition. Straight-line method used.)
a. Book Value of Bonds Payable, January 1, 2009
Book value, January 1, 2007 ................................................... $1,050,000
Amortization20072008 ($5,000 per year
[$50,000 premium 10 years] for two years) ..................
10,000
Book value of bonds payable, January 1, 2009..................... $1,040,000
Book value of 40% of bonds payable
(intercompany portion), January 1, 2009 .........................
$416,000
Gain on Retirement of Bonds, January 1, 2009
Purchase price ($400,000 x 96%) ...........................................
Book value of liability (computed above) .............................
Gain on retirement of bonds ...................................................

$384,000
416,000
$32,000

Book Value of Bonds Payable, December 31, 2009


Book value, January 1, 2009 (computed above) .................. $1,040,000
Amortization for 2009...............................................................
5,000
Book value of bonds payable, December 31, 2009............... $1,035,000
Book value of 40% of bonds payable (intercompany portion),
December 31, 2009..............................................................
$414,000
Book Value of Investment, December 31, 2009
Book value of investment, January 1, 2009 (purchase price)
Amortization for 2009 ($16,000 discount 8-yr. rem. life) .
Book value of investment, December 31, 2009 ....................
Intercompany Interest Balances for 2009
Interest expense:
Cash payment ($400,000 x 9%) .........................................
Amortization of premium for 2009 ($5,000 per year
multiplied by 40% intercompany portion) ..................
Intercompany interest expense ........................................
Interest income:
Cash collection ($400,000 x 9%) .......................................
Amortization of discount for 2009 (above) ......................
Intercompany interest income ..........................................

$384,000
2,000
$386,000

$36,000
2,000
$34,000
$36,000
2,000
$38,000

CONSOLIDATION ENTRY B (2009)


Bonds Payable ............................................................ 400,000
Premium on Bonds Payable ...................................... 14,000
Interest Income ........................................................... 38,000
Investment in Bonds ..............................................
386,000
Interest Expense .....................................................
34,000
Extraordinary Gain on Retirement of Bonds .......
32,000
(To eliminate accounts stemming from intercompany bonds [balances
computed above] and to recognize gain on the retirement of this debt.)
25. (continued)
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b. In 2010, because straight-line amortization is used, the interest accounts


remain unchanged at $38,000 and $34,000. However, the premium
associated with the bond payable as well as the discount on the
investment are affected by the $2,000 per year amortization. In addition,
the gain now has to be included as a component of beginning retained
earnings. Concurrently, the two interest balances recorded by the
individual companies in 2009 are removed from retained earnings
because they resulted after the intercompany retirement. Gain of $32,000
plus $34,000 expense removal less $38,000 income elimination gives
$28,000 increase in retained earnings.
CONSOLIDATION ENTRY *B (2010)
Bonds Payable .....................................................
400,000
Premium on Bonds Payable ($2,000 amortization)
12,000
Interest Income .....................................................
38,000
Investment in Bonds ($2,000 amortization) ..
388,000
Interest Expense ..............................................
34,000
Retained Earnings, 1/1/10 (Darges) ...............
28,000
(To remove intercompany bond accounts that remain on the individual
records of both companies. Both debt and investment balances have
been adjusted for 200910 amortization. Entry to retained earnings brings
the totals reported by the individual companies [interest income and
expense] to the balance of the original gain.)
c. As with part b, new premium and discount balances must be determined
and then removed. The adjustment made to retained earnings takes into
account that another year of interest expense ($34,000) and income
($38,000) have been closed into this equity account by the separate
companies.
CONSOLIDATION ENTRY *B (2011)
Bonds Payable ......................................................
Premium on Bonds Payable ................................
Interest Income ......................................................
Investment in Bonds .......................................
Interest Expense ..............................................
Retained Earnings, 1/1/11 (Darges) ...............

400,000
10,000
38,000

390,000
34,000
24,000

(To remove intercompany bond accounts that remain on the individual


records of both companies. Both debt and investment balances have
been adjusted for 2009 2011 amortization. Entry to retained earnings
brings the totals reported by the individual companies to the balance of
the original gain.)

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26.

(12 Minutes) (Determine consolidated income statement accounts after


acquisition of intercompany bonds.)

Interest Expense To Be Eliminated = $84,000 x 11% = $9,240

Interest Income To Be Eliminated = $108,000 x 8% = $8,640

Loss To Be Recognized = $108,000 $84,000 = $24,000

CONSOLIDATED TOTALS

27.

Revenues and Interest Income = $1,051,360 (add the two book values and
eliminate interest income on intercompany bond)

Operating and Interest Expense = $751,760 (add the two book values and
eliminate interest expense on intercompany bond)

Other Gains and Losses = $152,000 (add the two book values)

Loss on Retirement of Debt = $24,000 (computed above)

Net Income = $427,600 (consolidated revenues, interest income, and


gains less consolidated operating and interest expense and losses)

(30 Minutes) (Consolidation entry for two years to report effects of


intercompany bond acquisition. Effective rate method applied.)
a. Loss on Repurchase of Bond
Cost of acquisition ..........................................
Book value ($668,778 x 1/8) ............................
Loss on repurchase ........................................

$121,655
83,597
$38,058

Interest Balances for 2009


Interest income:
$121,655 x 6% .............................................

$7,299

Interest expense:
$83,597 (book value [above]) x 10% ........

$8,360

Investment Balance, December 31, 2009


Original cost, 1/1/09.........................................
Amortization of premium:
Cash interest ($100,000 x 8%) ..................
Effective interest income (above) ............
Investment, 12/31/09..............................

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$121,655
$8,000
7,299

701
$120,954

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6-15

27. (continued)
Bonds Payable Balance, December 31, 2009
Book value, 1/1/09 (above) .............................
Amortization of discount:
Cash interest ($100,000 x 8%) ..................
Effective interest expense (above) ..........
Bonds payable, 12/31/09.......................

$83,597
$8,000
8,360

360
$83,957

Entry B12/31/09
Bonds Payable .................................................
83,957
Interest Income ................................................
7,299
Loss on Retirement of Debt ...........................
38,058
Investment in Bonds ..................................
120,954
Interest Expense ........................................
8,360
(To eliminate intercompany debt holdings and recognize loss on
retirement.)
b. Interest Balances for 2010
Interest income: $120,954 (investment
balance for the year) x 6% .........................................

$7,257

Interest expense: $83,957 (liability balance


for the year) x 10% ......................................................

$8,396

Investment Balance, December 31, 2010


Book value, January 1, 2010 (part a) ........................
Amortization of premium:
Cash interest ($100,000 x 8%) .............................
Effective interest income (above) .......................
Investment balance, December 31, 2010.......
Bonds Payable Balance, December 31, 2010
Book value, January 1, 2010 (part a) ........................
Amortization of discount:
Cash interest ($100,000 x 8%) .............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2010 ..........................................
Interest Balances for 2011
Interest income: $120,211 (investment.....................
balance for the year [above]) x 6%
Interest expense: $84,353 (liability balance
for the year [above]) x 10% ..................................

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$120,954
$8,000
7,257

743
$120,211
$83,957

$8,000
8,396

396
$84,353
$7,213

$8,435

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Solutions Manual

27. (continued)
Investment Balance, December 31, 2011
Book value, January 1, 2011 (above) .......................
Amortization of premium:
Cash interest ($100,000 x 8%) .............................
Effective interest income (above) .......................
Investment balance, December 31, 2011.......
Bonds Payable Balance, December 31, 2011
Book value, January 1, 2011 (above) .......................
Amortization of discount:
Cash interest ($100,000 x 8%) .............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2011 .....................................

$120,211
$8,000
7,213

787
$119,424
$84,353

$8,000
8,435

435
$84,788

Adjustment Needed to Retained Earnings, January 1, 2011


Loss on retirement of debt (part a) ..........................
Balances currently in retained earnings:
Interest income:
2009
($7,299)
2010
(7,257)
($14,556)
Interest expense:
2009
$8,360
2010
8,396
16,756
Reduction needed to beginning retained
earnings to arrive at consolidated total ...........................

$38,058

2,200
$35,858

Entry *B12/31/11
Bonds Payable ............................................................
Interest Income ...........................................................
Retained earnings, 1/1/11 (Parent) ...........................
Investment in Bonds .............................................
Interest Expense ...................................................

84,788
7,213
35,858
119,424
8,435

(To eliminate intercompany bond holdings and adjust beginning retained


earnings balance of the parent to amount representing loss on retirement.
Amounts computed above.)

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6-17

28. (35 Minutes) (Consolidation procedures and balances related to intercompany


bonds. Both straight-line and effective interest rate methods are used.)
a. Acquisition price of bonds ................................................................
Book value of bonds payable (see Schedule 1)
($443,497 x 50%) ............................................................................
Loss on retirement ..............................................................................

$283,550
(221,749)
$61,801

SCHEDULE 1Book Value of Bonds Payable

Date
2007
2008
2009

Book
Value
$435,763
$438,055
$440,622

Effective
Interest
(12% Rate)
$52,292
$52,567
$52,875

Cash
Interest
$50,000
$50,000
$50,000

Amortization
$2,292
$2,567
$2,875

b. Investment in Bloom Bonds


Purchase price12/31/09...........................................
Cash interest ($250,000 x 10%) .................................
Effective interest income ($283,550 x 8%) ...............
Amortization ..........................................................
Investment in Bloom bonds, 12/31/10 ......................
Bonds Payable
Book value12/31/09 (computed above) ................
Cash interest ($500,000 x 10%) .................................
Effective interest expense ($443,497 x 12%) ...........
Amortization ..........................................................
Bonds payable, 12/31/10 ............................................

Year- End
Book Value
$438,055
$440,622
$443,497
$283,550

$25,000
22,684
2,316
$281,234
$443,497
$50,000
53,220
3,220
$446,717

Although not required, the consolidation entry as of 12/31/10 is as follows. The


reduction in retained earnings represents the loss only; no intercompany
interest was recognized in the previous year because the purchase was made
on December 31.
Entry *B (2010)
Bonds Payable ($446,717 x 50%) ..............................
Interest Income ...........................................................
Retained Earnings, 1/1/10 ..........................................
Interest Expense ($53,220 x 50%) .......................
Investment in Bloom Bonds ................................

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223,359
22,684
61,801
26,610
281,234

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Solutions Manual

28. continued
c. Loss on Retirement of Bond
Because Bloom uses the straight-line method of amortization, the loss on
retirement must be computed again.
Original issue price1/1/07 .........................................................
Discount amortization (20072009) ([$64,237 11] x 3 years).
Book value 12/31/09 ......................................................................

$435,763
17,519
$453,282

Intercompany portion of bonds payable (50%) ..........................


Purchase price ...............................................................................
Loss on retirement ........................................................................

$226,641
283,550
$56,909

Investment in Bloom Bonds


Purchase price12/31/09 .............................................................
Premium amortization (2010) ($33,550 8) ................................
Book value 12/31/10 .................................................................

$283,550
(4,194)
$279,356

Interest Income
Cash interest ($250,000 x 10%) ....................................................
Premium amortization (above) .....................................................
Intercompany interest income2010 ....................................

$25,000
(4,194)
$20,806

Bonds Payable
Original issue price 1/1/07.............................................................
Discount amortization (20072010) [($64,237 11) x 4 years] .
Book value 12/31/10 .................................................................
Opus ownership .......................................................................
Intercompany portion12/31/10 .......................................

$435,763
23,359
$459,122
50%
$229,561

Interest Expense
Cash interest ($250,000 x 10%) ....................................................
Discount amortization ([$64,237 11] x 1/2) ..............................
Intercompany interest expense2010 ..................................

$25,000
2,920
$27,920

The reduction in retained earnings represents the loss only; no intercompany


interest was recognized in the previous year because the purchase was made
on December 31.
Entry *B (2010)
Bonds Payable ............................................................
Interest Income ...........................................................
Retained Earnings, 1/1/10 .........................................
Interest Expense ..................................................
Investment in Bloom Bonds ................................

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229,561
20,806
56,909

27,920
279,356

The McGraw-Hill Companies, Inc., 2009


6-19

29. (8 Minutes) (Determine goodwill for a purchase in which subsidiary has both
common stock and preferred stock)
Consideration transferred for common stock
Consideration transferred for preferred stock
Noncontrolling interest in common stock
Noncontrolling interest in preferred stock
Hepners acquisition-date fair value
Book value of Hepner
Goodwill

$1,600,000
630,000
400,000
270,000
$2,900,000
2,500,000
$400,000

30. (30 Minutes) (Consolidation entries for a purchase where subsidiary has
outstanding cumulative preferred stock.)
a. The preferred shares are entitled to the specified cumulative dividend. Thus, the
noncontrolling interest's share of the subsidiary's income equals $160,000 or 8
percent of the preferred stock's par value.
b. Acquisition-Date Fair Value Allocation and Amortization
Consideration transferred ............................................................ $14,040,000
Noncontrolling interest fair value (preferred shares).................
2,000,000
Acquisition-date fair value of Smith............................................. 16,040,000
Book value ..................................................................................... (16,000,000)
Franchises ......................................................................................
$40,000
Period of amortization ..................................................................
40 years
Annual amortization ......................................................................
$1,000
Investment in Smith Account, December 31, 2009
Consideration transferred, January 1, 2009 ............................... $14,040,000
Equity accrual (income remaining for common stock
after preferred stock dividend) ...............................................
290,000
Dividends collected ($360,000 total less $160,000
paid to preferred shareholders) .............................................
(200,000)
Amortization for 2009 (above) ..........................................................
(1,000)
Investment in Smith account, December 31, 2009...................... $14,129,000
c. Consolidation Entries
Entry S and A combined
Preferred Stock (Smith) ............................................. 2,000,000
Common Stock (Smith) .............................................. 4,000,000
Retained Earnings, 1/1/09 (Smith) ............................ 10,000,000
Franchises ...................................................................
40,000
Investment in Smith..........................................
14,040,000
Noncontrolling Interest in Smith, Inc.............
2,000,000
(To eliminate subsidiary stockholders equity, record excess fair values, and
record outside ownership of subsidiary's preferred stock at fair value)

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30. c. (continued)
Entry I

Equity Income of Subsidiary ................................


285,000
Investment in Smith .........................................
285,000
(To eliminate equity accrual made in connection with common stock
[$290,000] along with excess amortization recorded by parent.)

Entry D Investment in Smith ..............................................


200,000
Dividends Paid .................................................
200,000
(To remove intercompany dividend payments made on common stock [see
computation above].)
Entry E

Amortization Expense ..........................................


1,000
Franchises ........................................................
1,000
(To recognize amortization of franchises for current year [see computation
above].)

31. (30 Minutes) (Prepare consolidation entries for a purchase where subsidiary
has outstanding preferred stock)
Consideration transferred for common stock
$ 7,368,000
Consideration transferred for preferred stock
3,100,000
Noncontrolling interest in common stock
4,912,000
Acquisition-date fair value for Young
$15,380,000
Youngs book value
15,000,000
Excess fair over book value
380,000
to building (5-year life)
$200,000
to equipment (10-year life)
(100,000)
100,000
to brand name (20-year life)
$280,000
CONSOLIDATION ENTRIES
Entries S and A combined
Preferred Stock (Young) ............................................ 1,000,000
Common Stock (Young) ............................................ 4,000,000
Retained Earnings (Young) ....................................... 10,000,000
Brand name..................................................................
280,000
Building ......................................................................
200,000
Equipment ..............................................................
Investment in Young's Preferred Stock (100%) .
Investment in Young's Common Stock (60%) ....
Noncontrolling interest ........................................

100,000
3,100,000
7,368,000
4,912,000

(To eliminate subsidiary stockholders equity, record excess acquisitiondate fair values, and record outside ownership of subsidiary's preferred
stock at acquisition-date fair value)
31. (continued)
Entry I1
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Dividend Income .........................................................


80,000
Dividends Paid ......................................................
80,000
(To offset intercompany preferred stock dividend payments recognized as
income by parent$1,000,000 par value x 8% dividend rate.)
Entry I2
Dividend Income .........................................................
192,000
Dividends Paid ......................................................
192,000
(To eliminate intercompany dividend payments [60% of $320,000] on
common stock. Because the $320,000 in dividends remaining after Entry I1
equals exactly 8 percent of the common stock par value, the participation
factor does not affect the distribution.)
Entry E
Amortization Expense ................................................
44,000
Equipment ...................................................................
10,000
Building ..................................................................
Brand name ...........................................................
(To record 2009 amortization of specific accounts
recognized within acquisition price of preferred stock.)

40,000
14,000

32. (15 Minutes) (The effect that various events have on a consolidated statement
of cash flows.)

Sale of building. The $44,000 in cash received from the sale is listed as a
cash inflow within the company's investing activities. If the company is
using the direct approach in presenting cash flows from operations, the
$12,000 gain is merely omitted. However, if the indirect approach is in use,
the gain (a positive) must be eliminated from net income by a subtraction.

Intercompany inventory transfers. Because these transactions do not occur


with any parties outside of the business combination, they are not reflected
in the consolidated statement of cash flows.

Dividend paid by the subsidiary. The $27,000 payment to the parent is


eliminated in consolidated statements and is not a cash outflow from the
consolidated entity. The remaining $3,000 payment to the noncontrolling
interest is reported as a cash outflow from a financing activity.

Amortization of intangible asset. This $16,000 noncash expense appears in


the consolidated income statement. If the combined companies are using
the direct approach to present cash flows from operations, this expense is
omitted. If the indirect approach is used, the expense must be removed from
consolidated net income by an addition.

Decrease in accounts payable. Cash payments have been used to reduce


this liability balance during the period. If the direct approach is used to
present cash flows from operations, the change is added to cost of goods
sold as one step in deriving the cash paid during the period for inventory (an
outflow). If the indirect approach is applied, the decrease is subtracted from

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Solutions Manual

net income in arriving at the net cash generated from operations during the
period.
33. (20 Minutes) (Determine cash flows from operations for a consolidated entity.)
NOTECORRECTION TO PROBLEM: The noncontrolling interests share of the
subsidiarys income is $9,800 (not $12,000 as listed on page 285 of text).
DIRECT APPROACH
Cash revenues (add book values, eliminate intercompany transfers,
and add decrease in accounts receivable) ...................................
$648,000
Cash inventory purchases (add book values, eliminate
intercompany transfers, eliminate unrealized gains, add increase in
inventory, and add decrease in accounts payable)......................
(370,000)
Depreciation and amortization (omit as noncash expenses)............
-0Other expenses (add book values) ......................................................
(40,000)
Gain on sale of equipment (omit because this is an investing activity)
-0Equity in earnings of Wallace (not an operating cash flow) .............
-0Cash generated from operations ..............................................
$238,000
INDIRECT APPROACH
Consolidated net income (computed below) .....................................
Adjustments:
Depreciation and amortization ..................................................
Gain on sale of equipment .........................................................
Increase in inventory ..................................................................
Decrease in accounts receivable ..............................................
Decrease in accounts payable ..................................................
Cash generated from operations .........................................

$216,000
61,000
(30,000)
(11,000)
8,000
(6,000)
$238,000

Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below:


Revenues (add book values and subtract intercompany transfers) $640,000
Cost of goods sold (add book values, less intercompany
transfers and beginning unrealized gain, plus ending
unrealized gain) ..........................................................................
(353,000)
Depreciation and amortization (add book values plus
amortization from excess fair value allocations) ....................
(61,000)
Other expenses (add book value) ..................................................
(40,000)
Gain on sale of equipment ..............................................................
30,000
Consolidated net income ...........................................................
$216,000

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The McGraw-Hill Companies, Inc., 2009


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34. (30 Minutes) (Compute basic and diluted earnings per share for a business
combination.)
(Note: This question may require students to review earnings per share
fundamentals analyzed in intermediate accounting.)
The following computations assume that Parent acquired its interest in Sub's
bonds directly from Sub. Therefore, no gain or loss was created and interest
income will exactly offset interest expense.
BASIC EARNINGS PER SHAREBUSINESS COMBINATION
CONSOLIDATED NET INCOME
- Parent's reported income ........................................
$150,000
- Sub's reported income ............................................
130,000
- Amortization expense ..............................................
(10,000)
Consolidated net income .....................................
$270,000
Parent shares outstanding ..................................
60,000
Basic earnings per share ($270,000 60,000) .........
$4.50
FULLY DILUTED EARNINGS PER SHARESUBSIDIARY
Reported earnings ...........................................................
$130,000
Shares outstanding .........................................................
30,000
Basic earnings per share (130,000 30,000) ................
$4.33
Sub's earnings assuming conversion of Sub's bonds
($130,000 plus $24,000 in interest
saved net of taxes) .....................................................
$154,000
Sub's shares assuming conversion of Sub's bonds
(30,000 + 12,000) .........................................................
42,000
Diluted earnings per share
(154,000 42,000) .......................................................
$3.67

(rounded)

(rounded)

Because diluted earnings per share is below basic earnings per share, the
convertible bonds have a dilutive impact on the computation and should be
included.
PARENT'S SHARE OF SUBSIDIARY'S DILUTED EARNINGS
Total shares used in computation above .....................
42,000
Parent's ownership (30,000 plus 20% of 12,000) ..........
32,400
Parent's portion of shares (32,400 42,000) ...........
77%
Sub's earnings used in diluted computation
(above) ......................................................................
$154,000
Parent's portion of shares ..............................................
77%
Earnings attributed to business combination ..............
$118,580

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Solutions Manual

34. (continued)
DILUTED EARNINGS PER SHAREBUSINESS COMBINATION
Parent's reported income ..........................................
$150,000
Subs income applicable to computation
(see above) ..................................................................
118,580
Amortization expense ................................................
(10,000)
Interest saved (net of taxes) on assumed
conversion of Parent's bonds ...................................
32,000
Diluted earnings ...............................................................
$290,580
Parent shares outstanding ........................................
Additional shares from assumed conversion
of Parent's bonds .......................................................
Diluted shares ..................................................................
Diluted earnings per share
($290,580 70,000) .....................................................

60,000
10,000
70,000
$4.15

(rounded)

35. (10 Minutes) (Compute consolidated diluted earnings per share. Subsidiary has
stock warrants outstanding.)
Figures For Sonston's Basic Earnings Per Share
Net Income ......................................................................
Shares outstanding .........................................................
Assumed Conversion of Stock Warrants ......................
Repurchase of Treasury Stock with Proceeds of Stock
Warrants (10,000 x $10 = $100,000 $20) .....................
Shares for Basic Earnings Per Share Computation......
Shares Controlled by Primus: 40,000 + (20% of 5,000) =
Percentage of Total Held by Primus: 41,000 45,000 =
(rounded)
Income to be Included in Consolidated Diluted Earnings
Per Share $200,000 x 91% = $182,000
Earnings Consolidated Diluted Earnings Per Share:
Net Income Primus .......................................................
Net Income included from Sonston ...............................
Earnings ......................................................................
Outstanding Shares of Primus .......................................

$200,000
40,000
10,000
(5,000)

5,000
45,000

41,000
91%

$600,000
182,000
$782,000
100,000

CONSOLIDATED DILUTED EARNINGS PER SHARE = $782,000 100,000 = $7.82

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The McGraw-Hill Companies, Inc., 2009


6-25

36. (15 Minutes) (Compute consolidated diluted earnings per share. Subsidiary has
convertible bonds outstanding.)
Figures For Simon's Diluted Earnings Per Share
Earnings:
Net Income ......................................................................
Interest Saved if Bonds Are Converted .........................
Tax on Saved Interest (30%) ...........................................
Earnings for Diluted Earnings Per Share ......................

$290,000
$80,000
(24,000)

56,000
$346,000

Shares:
Outstanding ......................................................................
Assumed Conversion of Bonds .....................................
Shares For Diluted Earnings Per Share Computation. .

80,000
30,000
110,000

Shares Controlled by Garfun = 80,000 110,000 = 73%


(rounded)
Income to be Included in Consolidated Diluted Earnings
Per Share = $346,000 x 73% = $252,580
Earnings for Consolidated Diluted Earnings Per Share:
Net IncomeGarfun ........................................................
Dividends to Garfun's Preferred Stock .........................
Net Income included from Simon (above) ....................
Earnings ......................................................................

$480,000
(15,000)
252,580
$717,580

Shares:
Outstanding Shares of Garfun .......................................

80,000

CONSOLIDATED DILUTED EARNINGS PER SHARE = $717,580 80,000 = $8.97


(rounded)
37. (35 Minutes) (Compute basic and diluted earnings per share for a business
combination. Subsidiary has stock warrants and convertible bonds.)
(Note: This question may require students to review earnings per share
fundamentals analyzed in intermediate accounting.)
The following computations assume that Mason acquired its interest in Dixon's
bonds directly from Dixon. Thus, no gain or loss was created and interest
income and interest expense will exactly offset.

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Solutions Manual

37. (continued)
BASIC EARNINGS PER SHAREBUSINESS COMBINATION
Reported income (separate)Mason ......................
$110,000
Income of Dixon (80%) ...............................................
52,000
Preferred stock dividends (5,000 x $4) ....................
(20,000)
Earnings applicable to basic EPS .......................
$142,000
Mason's outstanding shares .....................................
50,000
Basic earnings per share ($142,000 50,000) .........
$2.84
DILUTED EARNINGS PER SHARE SUBSIDIARY (DIXON)
Net income ..................................................................
$90,000
Interest (net of tax) saved assuming bond conversion
30,000
Income applicable to diluted EPS .................
$120,000
Shares outstanding ....................................................
Assumed conversion of warrants ............................
Assumed acquisition of treasury stock with
proceeds of conversion [(10,000 x $20) $25] ..
Assumed conversion of bonds .................................
Shares applicable to diluted EPS ........................
Diluted EPSsubsidiary ($120,000 52,000) .........

30,000
10,000
(8,000)
20,000
52,000
$2.31 (rounded)

INCOME APPLICABLE TO PARENTDILUTED EARNINGS PER SHARE


Shares used in diluted EPS computation ................
52,000
Shares controlled by Parent
(30,000 x 80% plus 15% x 20,000) ........................
27,000
Portion owned by Parent (27,000 52,000) . .
52% (rounded)
Income used in diluted EPS computation ...............
$120,000
Income applicable to Parentdiluted EPS .............
$62,400
DILUTED EARNINGS PER SHAREBUSINESS COMBINATION
Reported income (separate)Mason ......................
$110,000
Income of Dixon (above) ...........................................
62,400
Amortization expense ................................................
(20,000)
Because of assumed conversion, preferred stock
dividends would not be paid ...............................
-0Earnings applicable to diluted EPS ...............
$152,400
Mason's outstanding shares .....................................
Assumed conversion of preferred stock
(5,000 x 4) ...............................................................
Shares applicable to diluted EPS ..................
Diluted earnings per share
($152,400 70,000) ...............................................

50,000
20,000
70,000
$2.18

(rounded)

38. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above book
value per share)
Book Value of Subsidiary Prior to Issuing New Shares
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(40,000 x $12) ..............................................................


Parent's Ownership .........................................................
Book Value Equivalency of Ownership .........................
Book Value of Subsidiary After Issuing New Shares
(above value plus 10,000 shares at $15.75 each) ...
Parent's Ownership (40,000 50,000 shares) ...............
Book Value Equivalency of Ownership .........................

$480,000
100%
$480,000
$637,500
80%
$510,000

Investment in Rughty should be increased by $30,000 ($510,000 less $480,000)


39. (20 Minutes) (Effects of two different stock issuances by subsidiary.)
The assumption will be made here that subsidiary stock transactions will affect
the parent's capital accounts rather than being reflected as either a gain or loss.
a. Prior to the issuance of the new shares, Davis owns an 80% interest in Maxwell
(16,000 shares out of 20,000 shares). The underlying book value of this
investment is $640,000 ($800,000 x 80%). Subsequent to the issuance, total
book value of the subsidiary will have risen by $250,000 (the price of the stock)
to $1,050,000. Davis' ownership, however, will only be 64% (16,000 25,000).
The book value underlying Davis' investment is now $672,000 (64% of
$1,050,000) so that a $32,000 increase must be recorded by the parent.
Financial RecordsDavis, Incorporated
Investment in Maxwell ................................................
Additional Paid-in Capital ....................................

32,000
32,000

b. The book value underlying Davis' investment is $640,000 (see above) prior to
the issuance of the new shares. The 4,000 additional shares increase
subsidiary's total book value by $100,000 (the price of the stock) to $900,000.
Davis' ownership will have decreased to 2/3 (16,000 shares out of a total of
24,000) for a book value equivalency of just $600,000. Reducing the $640,000
(see a) to $600,000 requires a $40,000 decrease.
Financial RecordsDavis, Incorporated
Additional Paid-in Capital ..........................................
Investment in Maxwell ..........................................

McGraw-Hill/Irwin
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40,000
40,000

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Solutions Manual

40. (45 Minutes) (Prepare consolidation entries following the subsidiary's issuance
of shares to outside parties.)
Initially, Abraham owns 18,000 shares (or 90%) of Sparks' outstanding
shares (the total number of shares can be determined by dividing the
subsidiary's Common Stock account by the $10 par value attributed to each
share). After the issuance of the additional 4,000 shares, an adjustment must
be prepared by the parent company to reflect the change in the underlying
book value of the subsidiary. Because that entry has not yet been recorded,
it is included on the consolidation worksheet as Entry C (labeled in this
manner because it is a correction). The remainder of the consolidation
procedures follow the normal pattern described in previous chapters.
Adjustment for Stock Transaction
Adjusted book value of subsidiary on date of transaction
($480,000 + $100,000 + $161,000) ..............................................
Adjusted parent ownership (18,000 shares 24,000 shares) .....
Book value equivalency of parent ownership .........................
Book value equivalency of parent's investment
account before new issuance ($580,000 x 90%) .....................
Required increase (Entry C) .................................................

$741,000
75%
$555,750
522,000
$33,750

Excess Acquisition-Date Fair Value Allocation and Amortization


Fair value (consideration transferred plus NCI fair value) .......... $649,000
Book value.........................................................................................
(480,000)
Payment in excess of book value .................................................. $169,000
Allocated to land based on fair value.............................................
89,000
Copyrights ........................................................................................
$80,000
Life of Copyrights ............................................................................
20 years
Annual amortization .........................................................................
$4,000
CONSOLIDATION ENTRIES
Entry C
Investment in Sparks .................................................
Additional Paid-in Capital (Abraham) .................
(To record adjustment necessitated by subsidiary
stock transaction, computation shown above.)

33,750

Entry *C
Investment in Sparks .................................................
82,800
Retained Earnings, 1/1/11 (Abraham) .................
(Because initial value method is applied, equity accrual
for 20092010 is needed [$100,000 less the
two years amortization expense $4,000 x 2] x 90%)

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33,750

82,800

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6-29

40. a. (continued)
Entry S
Common Stock (Sparks) ...........................................
240,000
Additional Paid-in Capital (Sparks) ..........................
104,000
Retained Earnings, 1/1/11 (Sparks) ..........................
380,000
Investment in Sparks (75%) .................................
Noncontrolling Interest in Sparks, 1/1/11 (25%).
(To eliminate subsidiary stockholders' equity accounts
against corresponding balance in Investment account
and to recognize noncontrolling interest. Stockholders
equity balances have been adjusted for increase in
book value during 20092010 and the issuance by the
subsidiary of 4,000 shares of stock on January 1, 2011.
Entry A
Land ............................................................................
Copyrights ...................................................................
Investment in Sparks ............................................
Noncontrolling interest ........................................
(To recognize amounts within acquisition price
allocated to land and copyrights. Copyrights balance
has been reduced for 20092010 amortization to arrive
at 1/1/10 balance.)
Entry I
Dividend Income .........................................................
Dividends Paid ......................................................
(To eliminate intercompany dividends recorded by
parent as income [75% x $20,000].)
Entry E
Amortization Expense ................................................
Copyrights..............................................................
(To recognize current year amortization.)

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543,000
181,000

89,000
72,000
144,900
16,100

15,000
15,000

4,000
4,000

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Solutions Manual

41. (50 Minutes) (Prepare consolidation worksheet for business combination.


Intercompany bond acquisition is made during the current year.)
Acquisition-date fair-value allocation and amortization:
Equipment
Trademarks

$30,000
$40,000

10-year life
20-year life

$3,000 annual amortization


$2,000 annual amortization

As indicated in the problem, the parent is applying the partial equity method.
Hence an Entry *C must be recorded on the worksheet to convert the recorded
figures (amortization is needed for the three years prior to 2012) to equity
balances:
Amortization expense ($5,000 3 years) = .............
$15,000 (Entry *C)
Unrealized gain in ending inventory (downstream):
Ending balance ...........................................................
Markup ($20,000 $100,000) .....................................
Unrealized gain to be eliminated ..............................

$10,000
20%
$2,000

(Entry G)

Loss on extinguishment of bonds:


Book value at date of repurchase ..................................
Percentage repurchased .................................................
Equivalent book value .....................................................
Amount paid .................................................................
Loss on extinguishment of bonds .................................

$282,000
50%
$141,000
145,500
$4,500

(Entry B)

Amortization during 2012 changed the carrying value of the bond payable from
$282,000 to $288,000 (found in the balance sheet) and the investment from
$145,500 to $147,000. This amortization also affects interest income and
expense accounts.
Entry A reflects remaining values after three years of amortizations.

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The McGraw-Hill Companies, Inc., 2009


6-31

41. continued

Pavin and Stabler


Consolidation Worksheet
Year Ending December 31, 2012

Accounts
Revenues...............................................
Cost of goods sold...............................
Expenses...............................................
Interest expensebonds ....................
Interest incomebond investment.....
Loss on extinguishment of bonds......
Equity in income of Stabler.................
Net income.........................................

Pavin
$(740,000)
455,000
125,000
36,000
-0-0(123,000)
$(247,000)

Retained earnings, 1/1/12.....................


Retained earnings, 1/1/12.....................
Net income (above)...............................
Dividends paid......................................
Retained earnings, 12/31/12.................

$(345,000)
(247,000)
155,000
$(437,000)

$(361,000)
(123,000)
61,000
$(423,000)

Cash and receivables...........................


Inventory................................................
Investment in Stabler...........................

$217,000
175,000
613,000

$35,000
87,000
-0-

Investment in Pavin bonds..................


Land, buildings, and equipment (net)
Trademarks...........................................
Total assets........................................
Accounts payable.................................
Bonds payable......................................
Discount on bonds...............................
Common stock......................................
Retained earnings (above)...................
Total liabilities and stockholders equity

McGraw-Hill/Irwin
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Stabler
$(505,000)
240,000
158,500
-0(16,500)
-0-0$(123,000)

-0245,000
-0$1,250,000

147,000
541,000
-0$810,000

$(225,000)
(300,000)
12,000
(300,000)
(437,000)
$(1,250,000)

$(167,000)
(100,000)
-0(120,000)
(423,000)
$(810,000)

Consolidation Entries
Debit
Credit
(TI)100,000
(G) 2,000
(TI) 100,000
(E) 5,000
(B)
18,000
(B) 16,500
(B) 4,500
(I) 123,000
(*C) 15,000
(S) 361,000
(D)

(D) 61,000

(A) 21,000
(A) 34,000

61,000

(P)
33,000
(G)
2,000
(*C) 15,000
(S) 481,000
(A)
55,000
(I)
123,000
(B) 147,000
(E)
3,000
(E)
2,000

(P) 33,000
(B) 150,000
(S) 120,000
1,046,000

The McGraw-Hill Companies, Inc., 2009


Solutions Manual

(B)

6,000

1,046,000

Consolidated
Totals
$(1,145,000)
597,000
288,500
18,000
-04,500
-0$(237,000)
$(330,000)
-0(237,000)
155,000
$(412,000)
$219,000
260,000
-0-0804,000
32,000
$1,315,000
$(359,000)
(200,000)
6,000
(300,000)
(412,000)
$(1,315,000)

42. (40 Minutes) (Prepare consolidation entries after intercompany bond


acquisition.)
a. Allocation of Acquisition-date Excess Fair Value
Consideration transferred ......................$312,000
Noncontrolling interest fair value..............208,000
Acquisition-date fair value.......................$520,000
Book value acquired ..................................300,000
Fair value in excess of book value .........$220,000
Excess allocated to patents based
on fair value............................................. 90,000
Customer List...........................................$130,000

Annual Excess
Life Amortizations
12 years
$7,500
10 years
13,000
Total
$20,500

CONSOLIDATION ENTRIES
Entry *TL
Investment in Herman ................................................
7,000
Land ......................................................................
7,000
(To eliminate unrealized gain created by previous intercompany transfer.
Investment is adjusted here because transfer was downstream and equity
method has been applied by parent. Thus, retained earnings have already
been corrected.)
Entry *G
Retained Earnings 1/1/11 (Herman) ..........................
8,000
Cost of Goods Sold ..............................................
8,000
(To remove unrealized inventory gain from prior year so that it can be
properly realized in current year. Amount is computed as shown below.)
Intercompany profit2010 ........................................
Transfer price2010 ..................................................
Markup ($25,000 $125,000) .....................................
Unrealized gain in 1/1/11 inventory
($40,000 x 20%) .....................................................

$25,000
$125,000
20%
$8,000

Entry S
Common Stock (Herman) ..........................................
100,000
Retained Earnings, 1/1/11 (Herman)
(adjusted for Entry *G) .........................................
292,000
Investment in Herman (60%) ..........................
235,200
Noncontrolling Interest in Herman (40%) ......
156,800
(To eliminate Herman's stockholders' equity accounts and to record
beginning of year balance for noncontrolling interest.)

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6-33

42. a. (continued)
Entry A
Patents ......................................................................
75,000
Customer List..............................................................
104,000
Investment in Herman ...........................................
107,400
Noncontrolling interest ........................................
71,600
(To recognize unamortized balances as of 1/1/11 of amounts allocated within
original acquisition price. Allocations have been reduced by two years of
amortizations.)
Entry I
Equity Income of Herman...........................................
3,000
Investment in Herman......................................
(To eliminate intercompany equity income accrual)
Hermans income.............................................................. $25,000
Excess amortizations....................................................... (20,500)
2010 intercompany inventory gross profit.....................
8,000
2011 intercompany inventory gross profit.....................
(7,500)
Accrual-based income..................................................... $5,000
Freds ownership percentage..........................................
60%
Equity in earnings of Herman.......................................... $3,000
Entry D
Investment in Herman ................................................
Dividends Paid ......................................................
(To eliminate intercompany dividend payments.)
Entry E
Amortization Expense ................................................
Patents....................................................................
Customer List.........................................................
(To recognize current year amortization expense.)

2,400
2,400

20,500

Entry P
Accounts Payable ......................................................
60,000
Accounts Receivable ............................................
(To remove intercompany debt created by inventory transfers.)

McGraw-Hill/Irwin
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3,000

7,500
13,000

60,000

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Solutions Manual

42. a. (continued)
Entry B
Bonds Payable ............................................................
20,000
Premium on Bonds Payable ......................................
1,069
Interest Income ...........................................................
1,873
Investment in Parent Bonds ................................
19,005
Interest Expense ...................................................
1,283
Gain on Retirement of Bond.................................
2,654
(To eliminate effect created by bond acquisition and recognize the related
retirement gain [$21,386 $18,732]. Amounts are calculated below.)

Investment
Liability

Book
Value
(given)

Effective
Interest

$18,732
21,386

$1,873 (10%)
1,283 (6%)

Cash
Interest
(8%)

$1,600
1,600

Excess
Amortizations

$273
317

Entry Tl
Sales ............................................................................
120,000
Cost of Goods Sold (or Purchases) ....................
(To eliminate intercompany transfers made during current year.)

Year- End
Book
Value

$19,005
21,069

120,000

Entry G
Cost of Goods Sold ....................................................
7,500
Inventory.................................................................
7,500
(To defer recognition of inventory transfer gains until subsequent year.
Amount calculated as follows.)
Intercompany profit ..............................................
$30,000
Transfer price 2011 ...............................................
$120,000
Markup ($30,000 $120,000) ...............................
25%
Unrealized gain in ending inventory
($30,000 x 25%) ...................................................
$7,500
b. Herman's reported income for 2011 .........................................
Excess fair value amortization ..................................................
2010 unrealized gain recognized in 2011 (Entry *G) ...............
2011 unrealized gain (Entry G) ..................................................
Herman's realized income for 2011...........................................
Noncontrolling interest ownership ...........................................
Noncontrolling interest's share of the subsidiary's income...
Noncontrolling interest, 1/1/11 (Entry S) ..................................
Noncontrolling interest's share of Herman's income (above)
Noncontrolling interest's share of Herman's dividends
($4,000 x 40%) ........................................................................
Noncontrolling interest, 12/31/11...............................................

McGraw-Hill/Irwin
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$25,000
(20,500)
8,000
(7,500)
$5,000
40%
$2,000
$156,800
2,000
(1,600)
$157,200

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6-35

42. (continued)
c. The balances in the individual records as of December 31, 2012 pertaining to
the Intercompany bonds are as follows:

Investment
Liability

Beginning
Book
Value
(see part a.)

Effective
Interest

$19,005
21,069

$1,901 (10%)
1,264 (6%)

Cash
Interest
(8%)

$1,600
1,600

Excess
Amortizations

$301
336

Year- End
Book
Value

$19,306
20,733

The adjustment to recognize the original gain by the parent can be computed as
follows:
Original gain on retirement (see part a) ........................
Interest income recorded on investment in 2011
(see part a) ..................................................................
Interest expense recorded on liability in 2011
(see part a) .................................................................
Required increase as of January 1, 2012 ......................

$2,654
$1,873
1,283

590
$2,064

Entry *B (as of December 31, 2012)


Bonds Payable.............................................................
20,000
Premium on Bonds Payable ......................................
733
Interest Income ...........................................................
1,901
Investment in Herman ...........................................
2,064
Investment in Parent Bonds ................................
19,306
Interest Expense ...................................................
1,264
(To remove accounts pertaining to intercompany bonds. "Investment in
Herman" is adjusted here rather than retained earnings because equity
method is being applied and gain is attributed to the parent.)

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Solutions Manual

43. (50 Minutes) (Prepare consolidation entries for intercompany preferred stock
and bonds. Determine specified account balances. Preferred stock is a debt
instrument.)
a. Consideration transferred for common stock...................
Consideration transferred for preferred stock..................
Noncontrolling interest in common stock.........................
Noncontrolling interest in preferred stock........................
Lisas acquisition-date fair value........................................
Book value of Lisa................................................................
Excess assigned to franchises...........................................

$552,800
65,000
138,200
34,000
$790,000
750,000
$40,000

CONSOLIDATION ENTRIES 1/1/09


Entry S and A combined
Preferred Stock (Lisa) ................................................
Common Stock (Lisa) ................................................
Retained Earnings, 1/1/09 (Lisa) ...............................
Franchises ...................................................................
Investment in Lisa-common stock.................
Investment in Lisa-preferred stock................
Noncontrolling Interest in Lisa, Inc................

100,000
200,000
450,000
40,000
552,800
65,000
172,200

(To eliminate subsidiary stockholders equity, record excess acquisitiondate fair values, and record outside ownership of subsidiary's preferred and
common stock at acquisition-date fair values.)
b. Acquisition price of bonds, 1/2/09 ............................
Book value of bonds payable ( acquired) ............
Loss on extinguishment of debt .........................
Interest incomeMona ($53,310 x 8%) ....................
Interest expenseLisa ($44,175 x 14%) ..................
Investment in Lisabonds (book value)
Book valuedate of acquisition, 1/2/09 .............
Cash interest ($50,000 x 10%) .............................
Effective interest (above) .....................................
Investment in Lisabonds
(book value as of 12/31/09) ............................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

(rounded)
(rounded)

$53,310
(44,175)
$9,135
$4,265
$6,185
$53,310

$5,000
4,265

735
$52,575

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6-37

43. b. (continued)
Bonds payable (book value)
Book valuedate of acquisition, 1/2/09 .............
Cash interest ($50,000 x 10%) .............................
Effective interest (above) .....................................
Bonds payable (book value as of 12/31/09). .
CONSOLIDATION ENTRY BDecember 31, 2009
(all figures computed above)
Bonds Payable ............................................................
Interest Income (or Other Revenues) .......................
Extraordinary Loss on Retirement of Debt .............
Discount on Bonds Payable ($50,000 $45,360)
Interest Expense....................................................
Investment in LisaBonds ..................................

$44,175
$5,000
6,185

1,185
$45,360

50,000
4,265
9,135
4,640
6,185
52,575

c. December 31, 2009 book values based on historical cost figures:


Cost of fixed assets ...................................................
$100,000
Depreciation expense ($40,000 book value over
a 10-year life) .........................................................
4,000
Accumulated depreciation (including current
expense) ................................................................
64,000
December 31, 2009 book values based on transfer price:
Cost of fixed assets ...................................................
$120,000
Depreciation expense (10-year life) .........................
12,000
Accumulated depreciation ........................................
12,000
Gain on transfer of fixed assets
($120,000 $40,000) book value .........................
80,000
CONSOLIDATION ENTRY TADecember 31, 2009
Gain on Transfer of Fixed Assets (to remove) ........
Accumulated Depreciation ($64,000 $12,000).
Depreciation Expense ($12,000 $4,000) .........
Fixed Assets ($120,000 $100,000) ....................

McGraw-Hill/Irwin
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80,000
52,000
8,000
20,000

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Solutions Manual

43. (continued)
d. Original allocation to franchises (given) .......................
Amortization at $1,000/year (20092010) .................
Consolidated franchises12/31/10 .........................

$40,000
(2,000)
$38,000

Fixed assets (book values):


Mona, Inc. .................................................................... $1,100,000
Lisa Co. ......................................................................
800,000
Reduction necessitated by intercompany sale
($120,000 transfer price reduced to $100,000
original cost) (see part c) .....................................
(20,000)
Consolidated fixed assets12/31/10 ....................... $1,880,000
Accumulated depreciation (book values):
Mona, Inc......................................................................
Lisa Co. ......................................................................
Increase needed to eliminate intercompany
sale ($60,000 accumulated depreciation at time
of transfer less excess depreciation expense
[$12,000 - $4,000] for 2009 and 2010) .......................
Consolidated Acc. Depr.12/31/10..........................

$300,000
200,000

44,000
$544,000

Expenses (book values):


Mona, Inc.................................................................
$220,000
Lisa Co. ..................................................................
120,000
Recognition of amortization on Franchises ............
1,000
Elimination of interest expense on intercompany debt ($45,360 [see part b] x 14%) (rounded)
(6,350)
Elimination of excess depreciation from
intercompany transfer of fixed assets
($12,000 $4,000) ..................................................
(8,000)
Consolidated expenses ...........................................
$326,650

44. (35 Minutes) (Prepare statement of cash flows for a business combination.)
McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

The McGraw-Hill Companies, Inc., 2009


6-39

(Note: before working this problem, students may wish to review the statement
of cash flows in an intermediate accounting textbook.)
Development of Cash Flow Balances
OPERATING ACTIVITIES2009
Revenues (the consolidated balance plus the decrease in
accounts receivable) ........................................................................
Cost of goods sold (cash purchases) (the consolidated
balance plus the increase in inventory plus the
decrease in accounts payable) .......................................................
Depreciation and amortization (not cash expenses) .........................
Gain on sale of building (sales price is shown below as
an investing activity) ........................................................................
Interest expense (the consolidated balance) .....................................
Noncontrolling interest in subsidiary's income (does not
represent a cash flow although dividends paid to these
outside owners is shown below as a financing activity) ............
INVESTING ACTIVITIES2009
Sale of building ($30,000 book value sold at a $20,000 gain)...........
Purchase of equipment (Buildings and Equipment account
increased by $50,000. Building with a $30,000 book value
was sold [a decrease]. Depreciation [without Databases
amortization] was $95,000 [a decrease]. Only a purchase
of $175,000 would turn these two decreases of $125,000 into
an increase of $50,000) ....................................................................
FINANCING ACTIVITIES2009
Dividends paid by parent (the consolidated balance) ......................
Dividends paid by subsidiary (amount paid to
noncontrolling interest20%) ........................................................
Issuance of bonds .................................................................................
Issuance of common stock by the parent (increase in
common stock and additional paid-in capital) .............................

McGraw-Hill/Irwin
6-40

$890,000
720,000
-0-030,000
-0$50,000

175,000
$100,000
2,000
100,000
47,000

The McGraw-Hill Companies, Inc., 2009


Solutions Manual

44. (continued)
ROGERS COMPANY AND CONSOLIDATED SUBSIDIARY
Statement of Cash Flows
Year Ending December 31, 2009
CASH FROM OPERATIONS
Revenues .....................................................................
Purchases ...................................................................
Expenses .....................................................................
Cash from operations ...........................................
CASH FLOWSINVESTING ACTIVITIES
Sale of building ...........................................................
Purchase of equipment ..............................................
Cash from investing activities..............................
CASH FLOWSFINANCING ACTIVITIES
Dividends paid ............................................................
Issuance of bonds ......................................................
Issuance of common stock .......................................
Cash from financing activities .............................
Net increase in cash during 2009 ...................................
Cash, January 1, 2009 .....................................................
Cash, December 31, 2009 ...............................................

$890,000
(720,000)
(30,000)
140,000
$50,000
(175,000)
(125,000)
$(102,000)
100,000
47,000
45,000
60,000
80,000
$140,000

The above statement uses the direct approach for computing cash flows from
operations. If the indirect approach were to be used, the following computation
would be appropriate.
CASH FROM OPERATIONS
Consolidated net income.................................................
Adjustment from accrual to cash:
Depreciation and amortization .................................
Gain on sale of building ............................................
Decrease in accounts receivable .............................
Increase in inventory ..................................................
Decrease in accounts payable ..................................
Cash from operations ...........................................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

$230,000
100,000
(20,000)
10,000
(140,000)
(40,000)
$140,000

The McGraw-Hill Companies, Inc., 2009


6-41

45. (40 Minutes) (Compute basic and diluted earnings per share. Subsidiary has
stock warrants outstanding and convertible debt.)
(Note: This question may require students to review earnings per share
fundamentals analyzed in intermediate accounting.)
The subsidiary has two convertibles: warrants and bonds. Thus the
subsidiarys diluted earnings per share must be computed as a preliminary step
to the calculations made for the business combination as a whole.
Based on the amount of the "noncontrolling interest in Raleigh's income,"
outside ownership must be 20 percent so that the parent, Alexander, holds an
80 percent interest in Raleigh (or 24,000 shares).
BASIC EARNINGS PER SHAREBUSINESS COMBINATION
Reported income (partial equity)Alexander ..............
$304,000
Adjust for impact of intercompany transfers (consolidated gross profit is $5,000 higher than the individual
figures; thus, deferred figure being recognized is that
much higher than the amount being deferred) .......
5,000
Amortization expense (increase in consolidated
expenses parents 80% ownership).......................
(20,000)
Preferred stock dividends ..............................................
(40,000)
Earnings applicable to basic EPS ............................
$249,000
Alexander's outstanding common shares ....................
Basic earnings per share ($249,000 50,000) ..............

50,000
$4.98

DILUTED EARNINGS PER SHARESUBSIDIARY (RALEIGH)


Net income ......................................................................
$130,000
Interest saved assuming conversion of bonds
(net of taxes) ...............................................................
22,000
Income applicable to diluted EPS ..................................
$152,000
Shares outstanding .........................................................
30,000
Assumed conversion of warrants ..................................
5,000
Assumed acquisition of treasury stock with proceeds
of conversion ([5,000 x $10] $20) ..........................
(2,500)
Assumed conversion of bonds ......................................
10,000
Shares applicable to diluted EPS .............................
42,500
Diluted earnings per sharesubsidiary
($152,000 42,500) .....................................................
$3.58 (rounded)

McGraw-Hill/Irwin
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The McGraw-Hill Companies, Inc., 2009


Solutions Manual

45. (continued)
INCOME APPLICABLE TO PARENTDILUTED EARNINGS PER SHARE
Shares used in diluted EPS computation .....................
Shares controlled by parent (24,000 plus 50% of increment created by warrants [or 1,250]) .......................

42,500

Portion owned by parent (25,250 42,500) ........


Income applicable to parentdiluted EPS (59.4% of
$152,000) .....................................................................

59.4%

25,250
(rounded)

$90,288

DILUTED EARNINGS PER SHAREBUSINESS COMBINATION


Reported income Alexander ...........................................
$304,000
Eliminate equity in earnings of Raleigh ........................
(104,000)
Adjust for impact of intercompany transfers (consolidated gross profit is $5,000 higher than the individual
figures; thus, the deferred figure being recognized is
that much higher than the amount being deferred).
5,000
Amortization expense (increase in consolidated
expenses parents 80% ownership) ......................
(20,000)
Income of Raleigh (computed above) ...........................
90,288
Because of assumed conversion, preferred stock dividends would not be paid ...........................................
-0Earnings applicable to diluted EPS ...............................
$275,288
Alexander's outstanding common shares ....................
Assumed conversion of preferred stock
(10,000 x 2 shares) .....................................................
Shares applicable to diluted EPS ..................................
Diluted earnings per share
($275,288 70,000) .....................................................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

50,000
20,000
70,000
$3.93

(rounded)

The McGraw-Hill Companies, Inc., 2009


6-43

46. (50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares
outstanding that are equity instruments.)
Consideration transferred for common and preferred stock
Skylers book value
Excess fair value assigned to intangible asset (10-year life)
Annual amortization

$11,000

Ending Unrealized Gain


Ending inventory (at transfer price) ...............................
Markup ($30,000 $90,000) .......................................
Ending unrealized gain (increase made to cost
of goods sold to defer gain) ................................

McGraw-Hill/Irwin
6-44

$560,000
450,000
$110,000

$18,000
33%
$6,000

The McGraw-Hill Companies, Inc., 2009


Solutions Manual

46. (continued)

Accounts
Sales................................................
Cost of goods sold..........................
Expenses.........................................
Gain on sale of equipment.............
Net income....................................

Paisley, Inc. and Skyler Corp.


Consolidation Worksheet
Year Ending December 31, 2009
Consolidation Entries
Paisley, Inc.
Skyler Corp.
Debit
Credit
$(800,000)
$(400,000)
(TI) 90,000
528,000
260,000
(G)
6,000 (TI) 90,000
180,000
130,000
(E) 11,000
(ED) 2,000
(8,000)
-0(TA) 8,000
$(100,000)
$(10,000)

Retained earnings, 1/1/09...............


Net income.......................................
Dividends paid................................
Retained earnings, 12/31/09........

$(400,000)
(100,000)
60,000
$(440,000)

$(150,000)
(10,000)
-0$(160,000)

Cash.................................................
Accounts receivable.......................
Inventory..........................................
Investment in Skyler Corp..............

$30,000
300,000
260,000
560,000

$40,000
100,000
180,000
-0-

Land, buildings, and equipment....


Accumulated depreciation.............
Intangible Asset..............................
Total assets..................................

680,000
(180,000)
-0$1,650,000

500,000
(90,000)
-0$730,000

$(140,000)
(240,000)
-0(620,000)
(210,000)
(440,000)
Total liabilities and stockholders equity $(1,650,000)

$(90,000)
(180,000)
(100,000)
(200,000)
-0(160,000)
$(730,000)

Accounts payable...........................
Long-term liabilities........................
Preferred stock...............................
Common stock................................
Additional paid-in capital................
Retained earnings, 12/31/09...........

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

(S) 150,000

$(400,000)
(87,000)
60,000
$(427,000)
(P) 28,000
(G)
6,000
(S) 450,000
(A) 110,000

(TA) 10,000
(ED) 2,000
(A) 110,000
(P)

Consolidated
Totals
$(1,110,000)
704,000
319,000
-0$(87,000)

(TA) 18,000
(E) 11,000

28,000

(S) 100,000
(S) 200,000

The McGraw-Hill Companies, Inc., 2009


6-45

$70,000
372,000
434,000
-01,190,000
(286,000)
99,000
$1,879,000
$(202,000)
(420,000)
-0(620,000)
(210,000)
(427,000)
$(1,879,000)

46. (continued)
Effect of Intercompany Equipment Transfer
Transfer price
Recorded value.................................................................................
Depreciation expense ($20,000 4)................................................
Accumulated depreciation...............................................................
Gain on sale ($20,000 $12,000).....................................................
Historical cost
Recorded value.................................................................................
Depreciation expense ($12,000 4)................................................
Accumulated depreciation ($18,000 + $3,000)...............................

$20,000
5,000
5,000
8,000
$30,000
3,000
21,000

CONSOLIDATED TOTALS

Sales = $1,110,000 (add book values and eliminate intercompany transfers)


Cost of Goods Sold = $704,000 (add book values, eliminate intercompany
transfers, and eliminate ending unrealized gain [computed above])
Expenses = $319,000 (add book values and include amortization of
intangibles and eliminate $2,000 excess equipment depreciation)
Gain on Sale of Equipment = $0 (intercompany balance is eliminated)
Net Income = $87,000 (consolidated revenues less consolidated expenses)
Retained Earnings, 1/1/09 = $400,000 (parent company figure only because
subsidiary was not acquired until current year)
Dividends Paid = $60,000 (parent balance only)
Retained Earnings, 12/31/09 = $427,000 (consolidated beginning retained
earnings plus net income less dividends paid)
Cash = $70,000 (add book values)
Accounts Receivable = $372,000 (add book values after eliminating intercompany balance)
Inventory = $434,000 (add book values after eliminating unrealized gain)
Investment in Skyler Corporation = $0 (intercompany account is eliminated
so that individual asset and liability accounts of subsidiary can be included)
Land, Buildings, and Equipment = $1,190,000 (add book values and increase
transferred asset from transfer price to historical cost [see above])
Accumulated Depreciation = $286,000 (add book values and adjust balance
for transferred asset from transfer price figure to historical cost (see above])
Intangible Asset = $99,000 (original allocations less one year amortization)
Total Assets = $1,879,000 (summation of consolidated accounts)
Accounts Payable = $202,000 (add book values and remove intercompany
balance)
Long-Term Liabilities = $420,000 (add book values)
Preferred Stock = $0 (subsidiary outstanding shares are eliminated)

McGraw-Hill/Irwin
6-46

The McGraw-Hill Companies, Inc., 2009


Solutions Manual

46. (continued)
Common Stock = $620,000 (parent balance only)
Additional Paid-in Capital = $210,000 (parent balance only)
Retained Earnings, 12/31/09 = $427,000 (computed above)
Total Liabilities and Equities = $1,879,000 (summation of consolidated
accounts)
Many students may choose to prepare a worksheet for this problem. Thus, the
following is an explanation of that approach.
CONSOLIDATED ENTRIES
Entry S
Preferred Stock (Skyler).............................................
100,000
Common Stock (Skyler)..............................................
200,000
Retained Earnings, 1/1/09...........................................
150,000
Investment in Skyler Corp.....................................
450,000
(To eliminate stockholders equity of subsidiary allocable to common and
preferred stockholdings.)
Entry A
Intangible Asset ..........................................................
110,000
Investment in Skyler Corp.....................................
110,000
(To recognize amounts paid within acquisition prices that are attributed to
Intangible Asset.)
Entry E
Amortization Expense.................................................
11,000
Intangible Asset.....................................................
(To record current years amortization of intangible asset.)

11,000

Entry P
Accounts Payable........................................................
Accounts Receivable.............................................
(To eliminate intercompany debt.)

28,000

28,000

Entry TA
Equipment....................................................................
10,000
Gain on Sale of Equipment........................................
8,000
Accumulated Depreciation...................................
18,000
(To eliminate financial effects as of 1/1/09 created by intercompany transfer
of equipment.)
Entry TI
Sales ............................................................................
90,000
Cost of Goods Sold...............................................
90,000
(To eliminate intercompany inventory transfers for the current year.)
46. (continued)
McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

The McGraw-Hill Companies, Inc., 2009


6-47

Entry G
Cost of Goods Sold.....................................................
6,000
Inventory.................................................................
6,000
(To defer unrealized intercompany gain remaining at the end of the current
year. Markup is 33% [$30,000 gross profit $90,000 transfer price]
indicating that the ending inventory of $18,000 contains an unrealized profit
of $6,000 [$18,000 x 33%].)
Entry ED
Accumulated Depreciation.........................................
2,000
Depreciation Expense...........................................
2,000
(To eliminate excess depreciation resulting from intercompany gain of
$8,000 on transfer of equipment [see Entry TA]. Equipment is being
depreciated over a remaining life of four years.)
47. (30 minutes) (Consolidated Cash Flow Statement with current year business
combination)
Plaster Inc. and Subsidiary Stucco Company
Consolidated Statement of Cash Flows
For the year ended 12/31/09
Consolidated net income
Depreciation expense
Amortization expense
Decrease in accounts receivable (net of acquisition)
Increase in inventory (net of acquisition)
Decrease in accounts payable (net of acquisition)
Net cash provided by operations

$274,000
$187,500
8,750
3,600
(102,000)
(8,000)

Purchase of Stucco Company assets (net of cash acquired)


Net cash used in investing activities
Issue long-term debt
Dividends
Net cash provided by financing activities
Increase in cash 1/1/09 to 12/31/09
Beginning Cash, 1/1/09
Ending cash, 12/31/09

McGraw-Hill/Irwin
6-48

89,850
$363,850
(856,000)

$800,000
(108,000)
692,000
199,850
43,000
$242,850

The McGraw-Hill Companies, Inc., 2009


Solutions Manual

Excel CaseIntercompany Bonds


Bonds with a stated rate of 11% sold to yield 12%
Eff. Yield
12%

2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

1,000,000.00
110,000.00
943,497.77
946,717.50
950,323.60
954,362.43
958,885.93
963,952.24
969,626.51
975,981.69
983,099.49
991,071.43
1,000,000.00

0.32197
5.65022

321,973.24
621,524.53
943,497.77

113,219.73
113,606.10
114,038.83
114,523.49
115,066.31
115,674.27
116,355.18
117,117.80
117,971.94
118,928.57

110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00

Consolidated Worksheet Entry 12/31/10


Bonds Payable
954,362.43
Interest Revenue
117,523.20
Loss on retirement
0.00
Gain on retirement
Investment in Bonds
Interest Expense

46,299.01
911,547.79
114,038.83

Bonds retired by affiliate on 1/1/10 at


Eff. Yield
13%
1,000,000.00
0.37616
110,000.00
4.79877
2010
2011
2012
2013
2014
2015
2016
2017

904,024.59
911,547.79
920,049.00
929,655.37
940,510.57
952,776.95
966,637.95
982,300.88
1,000,000.00

117,523.20
118,501.21
119,606.37
120,855.20
122,266.37
123,861.00
125,662.93
127,699.12

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

56,502.23
3,219.73
3,606.10
4,038.83
4,523.49
5,066.31
5,674.27
6,355.18
7,117.80
7,971.94
8,928.57
56,502.23

904,024.59
376,159.86
527,864.73
904,024.59
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00
110,000.00

95,975.41
7,523.20
8,501.21
9,606.37
10,855.20
12,266.37
13,861.00
15,662.93
17,699.12
95,975.41

The McGraw-Hill Companies, Inc., 2009


6-49

Financial Reporting Research and Analysis Case


The number of potential solutions is large. Searches in Lexis-Nexis, Edgar, etc. will
produce numerous examples of consolidations of VIEs. For example, Walt Disney
Company prepares a before and after disclosure of its newly consolidated VIEs
Euro Disney and Hong Kong Disneyland as follows (12-31-04):

Cash and cash equivalents


Other current assets
Total current assets
Investments
Fixed assets
Intangible assets
Goodwill
Other assets
Total assets
Current portion of borrowings
Other current liabilities
Total current liabilities

Before Euro
Disney and Hong
Kong Disneyland
Consolidation
$1,730
7,103
8,833
1,991
12,529
2,815
16,966
6,843
$49,977
$1,872
6,349
8,221

Borrowings
8,850
Deferred income taxes
2,950
Other long term liabilities
3,394
Minority interests
487
Shareholders' equity
26,075
Total liabilities and shareholders' equity $49,977

McGraw-Hill/Irwin
6-50

Euro Disney, Hong


Kong Disneyland
and Adjustments
$312
224
536
(699)
3,953
--135
$3,925
$2,221
617
2,838
545
-225
311
6
$3,925

Total
$2,042
7,327
9,369
1,292
16,482
2,815
16,966
6,978
$53,902
$4,093
6,966
11,059
9,395
2,950
3,619
798
26,081
$53,902

The McGraw-Hill Companies, Inc., 2009


Solutions Manual