Chapter 7

Intercompany
Profit
Transactions –
Bonds
Intercompany Profits on Bonds:
Objectives
1. Differentiate between intercompany receivables and
payables, and assets or liabilities of the
consolidated reporting entity.
2. Demonstrate how a consolidated reporting entity
constructively retires debt.
3. Defer unrealized gains/losses and later recognize
realized gains/losses on bond transfers between
parent and subsidiary.
4. Adjust calculation of noncontrolling interest share
amounts in the presence of intercompany
gains/losses on debt transfers.

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 Intercompany Profit Transactions – Bonds

1: INTERCOMPANY
RECEIVABLES AND
PAYABLES

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Intercompany Payables and
Receivables

Remove intercompany:
– Payables and interest expense
– Receivables and interest income
Loans directly between affiliates generally
pose no special problems

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Retirement of Debt

– Issuing firm uses own resources to retire its own

bonds – no intercompany (IC) issues
– Issuing firm borrows from unaffiliated entity and
uses funds to retire its own debt – no IC
– Issuing firm borrows from affiliate and uses
funds to retire its own debt – simple IC loan
– Non-issuing firm purchases debt securities of an
affiliate resulting in constructive retirement – IC
constructive retirement

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 Intercompany Profit Transactions – Bonds

2: CONSTRUCTIVE
RETIREMENT OF DEBT

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Constructive Retirement

One company purchases debt instruments of

an affiliate from outside entities
Constructive gains and losses on bonds are:
1. Realized gains and losses from the consolidated
viewpoint
2. That arise when a company purchases the
bonds of an affiliate
3. From other entities
4. At a price other than the book value of the
bonds.

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Agency Theory

Agency theory
– Assigns gain or loss to the issuing firm
– Conceptually superior than other methods
Text:
– Follows agency theory
– Simplifies discussion using straight line
amortization of premiums & discounts
Other methods
– Assign gain or loss to affiliates based on the par
value of the bonds – par value theory
– Assign all gain or loss to the parent
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 Intercompany Profit Transactions – Bonds

3: GAINS AND LOSSES ON

BOND TRANSFERS

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Parent is Issuer

At constructive retirement
– Remove Investment in Bonds
– Remove proportionate share of Bonds payable
and unamortized premium or discount
– Realize a gain or loss
The gain or loss at constructive retirement is
recognized over the life of the bonds
Gain or loss is attributed solely to the parent

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Subsidiary Acquires Parent Bonds

Pam owns 70% of Sue, acquired at book value. Sue's

net income for 2010 is $220.
On 1/1/12, Pam has $10,000 bonds outstanding with
unamortized premium of $100. Bonds mature in 5
years. Straight line amortization. Interest is 10%,
payable semi-annually.
On 1/1/12, Sue acquires $1,000 of Pam's bonds on the
open market at $950. Straight line.
– Portion of bonds retired: 1,000/10,000 = 10%
– Gain on retirement: 10%(10,100) – 950 = $60
– Pam's Investment in Sue: 70%(220) + 60 – 12 = $202
– Noncontrolling interest share: 30%(220) = $66

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Amortizations and Interest

Book Book value Book value

value Fiscal 12/31/ Fiscal 12/31/
PAM’S BOOKS: 1/1/2012 Year 2012 2012 Year 2013 2013
Bonds payable $10,100 -$20 $10,080 -$20 $10,060

Retired 10% $1,010 $1,008 $1,006

500+500-20 500+500-20
Interest expense =$980 =$980
Retired 10% $98 $98

SUE'S BOOKS:
Investment in $950 +$10 $960 +$10 $970
bonds
50+50+10 50+50+10
Interest income =$110 =$110

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Worksheet Entries for Bonds
Entries for 2012 worksheet.

Bonds payable (-L) 1,008

Investment in bonds (-A) 960
Gain on retirement of bonds (Ga, +SE) 48
Interest income (-R, -SE) 110
Interest expense (-E, +SE) 98
Gain on retirement of bonds (Ga, +SE) 12
Interest payable (-L) 50
Interest receivable (-A) 50
Had a consolidated balance sheet been prepared on 1/1/2012,
the date of the retirement, the first entry would have recorded
amounts at $1010, $950, and $60, respectively. There would
be no interest.
One entry could have been used above, with a gain of $60.

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Piecemeal Recognition

– The constructive gain of $60 is recognized in

2012 when the bonds are constructively retired.
– The difference between interest income $98 and
interest expense on the retired bonds $110 is
$12.
– This $12 is an adjustment to investment income.
– Pam is the issuer, so the full $12 is attributed to
Pam.
– If Sue was the issuer, the $12 would be shared
among the controlling and noncontrolling
interests.

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Amortizations and Interest

Book Book value Book value

value Fiscal 12/31/ Fiscal 12/31/
PAM’S BOOKS: 1/1/2012 Year 2012 2012 Year 2013 2013
Bonds payable $10,100 -$20 $10,080 -$20 $10,060

Retired 10% $1,010 $1,008 $1,006

500+500-20 500+500-20
Interest expense =$980 =$980
Retired 10% $98 $98

SUE'S BOOKS:
Investment in $950 +$10 $960 +$10 $970
bonds
50+50+10 50+50+10
Interest income =$110 =$110

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2013 Worksheet Entries

Entries for 2013 worksheet, assuming that Pam has

not yet paid the second interest payment.

Bonds payable (-L) 1,006

Interest income (-R, -SE) 110

Investment in bonds (-A) 970

Interest expense (-E, +SE) 98

Investment in Sue (-A) 48

Interest payable (-L) 50

Interest receivable (-A) 50

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Subsequent Worksheet Entries

– Notice that there is no gain in subsequent years.

– The $60 “gain” is amortized each year by $12, so
the Investment account is increased by $48 in
2013.
– The Investment in Sue account will be credited
by $36 in 2014, by $24 in 2015, and so forth.
– Had Sue been the issuer, the $48 credit for 2012
would be shared between:
• Investment in Sue and
• Noncontrolling Interest

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 Intercompany Profit Transactions – Bonds

4: EFFECT ON
NONCONTROLLING
INTEREST

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Subsidiary Issuer with Gain

Constructive gain
– Purchase price of the debt is less than the book
value
– Share gain between CI and NCI in year of
retirement.
• Increase Income from subsidiary
• Increase Noncontrolling interest share
– In current and subsequent years, use piecemeal
recognition
• Reduce Income from subsidiary
• Reduce Noncontrolling interest share

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Subsidiary Issuer with Loss

Constructive loss
– Purchase price of the debt is greater than the
book value
– Share loss between CI and NCI in year of
retirement.
• Reduce Income from subsidiary
• Reduce Noncontrolling interest share
– In current and subsequent years, use piecemeal
recognition
• Increase Income from subsidiary
• Increase Noncontrolling interest share

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Parent Acquires Subsidiary Bonds
Pine owns 80% of Scent, acquired at book value. Scent's net income
for 2012 is $500.
On 1/1/12, Scent has $5,000, bonds outstanding with unamortized
discount of $200. Bonds mature in 8 years. Straight line amortization.
Interest is 10% payable semi-annually. Interest expense = $525.
On 1/1/12, Pine acquires $2,000 of Scent's bonds on the open market
at $2,040. Straight line. Interest income = $195.
– Portion of bonds retired: 2,000/5,000 = 40%
– Loss on retirement: 40%(4,800) – 2,040 = -$120
– Pine's Investment in Scent: 80%(500 – 120 + 210 - 195) =
$316
– Noncontrolling interest share: 20%(500 – 120 + 210 - 195) = $79

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Amortizations and Interest

Book
value
SCENT'S 1/1/201 Fiscal Year Book value Fiscal Year Book value
BOOKS: 2 2012 12/31/2012 2013 12/31/2013
Bonds payable $4,800 +$25 $4,825 +$25 $4,850

Retired 40% $1,920 $1,930 $1,940

250+250+25 250+250+25
Interest expense =$525 =$525

Retired 40% $210 $210

PINE'S BOOKS:
Investment in $2,040 -$5 $2,035 -$5 $2,030
bonds
100+100-5 100+100-5
Interest income =$195 =$195

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2012 Entries with Loss

Entries for 2012 worksheet, assuming the

second interest payment has not yet been
paid.

Bonds payable (-L) 1,930

Interest income (-R, -SE) 195

Loss on retirement of bonds (Lo, -SE) 120

Interest expense (-E, +SE) 210

Investment in bonds (-A) 2,035

Interest payable (-L) 100

Interest receivable (-A) 100

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Amortizations and Interest

Book Book Book

value Fiscal value Fiscal value
SCENT'S 1/1/20 Year 12/31/201 Year 12/31/201
BOOKS: 12 2012 2 2013 3
Bonds payable $4,800 +$25 $4,825 +$25 $4,850

Retired 40% $1,920 $1,930 $1,940

Interest 250+250+2 250+250+2
expense 5 =$525 5 =$525

Retired 40% $210 $210

PINE'S
BOOKS:
Investment in $2,040 -$5 $2,035 -$5 $2,030
bonds
100+100-5 100+100-5
Interest income =$195 =$195

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2013 Worksheet Entries

Entries for 2013 worksheet, assuming that

Scent has not yet paid the second interest
payment.

Bonds payable (-L) 1,940

Interest income (-R, -SE) 195
Investment in Scent (+A) 105
Investment in bonds (-A) 2,030
Interest expense (-E, +SE) 210
Interest payable (-L) 100
Interest receivable (-A) 100

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