Chapter 7: Intercompany Profit

Transactions – Bonds
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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 Intercompany Profits on Bonds:
Objectives
1. Differentiate between intercompany receivables
and payables, and assets or liabilities of the
consolidated reporting entity.
2. Defer unrealized profits and later recognize
realized profits on bond transfers between
parent and subsidiary companies.
3. Demonstrate how a consolidated reporting entity
constructively retires debt.
4. Adjust calculation of noncontrolling interest
amounts in the presence of intercompany profits
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
1. Issuing firm uses own resources to retire its
own bonds – no intercompany (IC) issues
2. Issuing firm borrows from unaffiliated entity
and uses funds to retire its own debt – no IC
3. Issuing firm borrows from affiliate and uses
funds to retire its own debt – simple IC loan
4. Non-issuing firm purchases debt securities of
an affiliate resulting in constructive retirement
– IC constructive retirement

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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 a superior than other methods
• Text:
– Follows agency theory
– Simplifies discussion using straight line
amortization of premiums & discounts
• Other methods
– Par value theory or assign all gain or loss to the
parent
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Intercompany Profit Transactions – Bonds
2: Profits on Bonds

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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 1/1/10, Pam has $10,000 bonds outstanding with
unamortized premium of $100. Bonds mature in 5
years. Straight line amortization.
On 1/1/10, 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
value During Book value During Book value
Pam's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011
Bonds payable $10,100 -$20 $10,080 -$20 $10,060
10% retired $1,010 $1,008 $1,006
500+500-20 500+500-20
Interest expense =$980 =$980
10% retired $98 $98

Sue's books:
Investment in
bonds $950 +$10 $960 +$10 $970
50+50+10 50+50+10
Interest income =$110 =$110

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 Worksheet Entries for Bonds
Entries for 2010 worksheet.
Bonds payable 1,008
Investment in bonds 960
Gain on retirement of bonds 48
Interest income 110
Interest expense 98
Gain on retirement of bonds 12
• Had a consolidated balance sheet been prepared on
1/1/2010, 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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Intercompany Profit Transactions – Bonds
3: Constructive Retirement of Debt

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 Piecemeal Recognition
The constructive gain of $60 is recognized in 2010
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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 2011 Worksheet Entries
Entries for 2011 worksheet, assuming that Pam
has not yet paid the second interest payment.
Bonds payable 1,006
Interest income 110
Investment in bonds 970
Interest expense 98
Investment in Sue 48
Interest payable 50
Interest receivable 50

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 Subsequent Worksheet Entries
Notice that there is no gain in subsequent years.
The $60 is reduced each year by $12 and is a
credit to the Investment in Sue account.

Had Sue been the issuer, the $48 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 2010 is $500.
On 1/1/10, Scent has $5,000 bonds outstanding with
unamortized discount of $200. Bonds mature in 8 years.
Straight line amortization.
On 1/1/10, Pine acquires $2,000 of Scent's bonds on the
open market at $2,040. Straight line.

• 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 + 15) = $316
• Noncontrolling interest share: 20%(500 – 120 + 15) = $79
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 Amortizations and Interest
Book
value During Book value During Book value
Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011
Bonds payable $4,800 +$25 $4,825 +$25 $4,850
40% retired $1,920 $1,930 $1,940
250+250+25 250+250+25
Interest expense =$525 =$525
40% retired $210 $210

Pine's books:
Investment in
bonds $2,040 -$5 $2,035 -$5 $2,030
100+100-5 100+100-5
Interest income =$195 =$195

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 2010 Entries with Loss
Entries for 2010 worksheet.
Bonds payable 1,930
Interest income 195
Loss on retirement of bonds 120
Interest expense 210
Investment in bonds 2,035

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 Amortizations and Interest
Book
value During Book value During Book value
Scent's books: 1/1/2010 2010 12/31/2010 2011 12/31/2011
Bonds payable $4,800 +$25 $4,825 +$25 $4,850
40% retired $1,920 $1,930 $1,940
250+250+25 250+250+25
Interest expense =$525 =$525
40% retired $210 $210

Pine's books:
Investment in
bonds $2,040 -$5 $2,035 -$5 $2,030
100+100-5 100+100-5
Interest income =$195 =$195

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 2011 Worksheet Entries
Entries for 2011 worksheet, assuming that Scent
has not yet paid the second interest payment.
Bonds payable 1,940
Interest income 195
Investment in Scent 105
Investment in bonds 2,030
Interest expense 210
Interest payable 100
Interest receivable 100

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