PPT8-Intercompany Bond Holdings and Miscellaneous Topics

ACCT6381
Advanced Accounting
Week 8
Intercompany Bond Holdings and Miscellaneous
Topics
Intercompany Bond Holdings and Miscellaneous
Topics—Consolidated Financial Statements
2
Learning Objectives
• Describe the term “constructive retirement of debt”.
• Describe how the gain or loss on constructive retirement of intercompany
bond holdings is allocated between the purchasing and issuing companies.
• Explain the impact on the consolidated financial statements when a
company issues a note to an affiliated company, which then discounts the
note with an outside company.
• Determine the effect on the consolidated financial statements when a
subsidiary issues a stock dividend.
• Understand the difference in how stock dividends and cash dividends issued
by a subsidiary company affect the consolidated financial statements.
3
Learning Objectives
• Determine the impact on the investment account when a subsidiary
issues a stock dividend from preacquisition earnings and from
postacquisition earnings.
• Explain how the purchase price is allocated when the subsidiary has
both common and preferred stock outstanding.
• Determine the controlling interest in income when the parent
company owns both common and preferred stock of the subsidiary.
4
Intercompany Bond Holdings
• An affiliate company may purchase bonds issued by another affiliate directly
from the issuing company or from outsiders after the original issue.
• Because the bonds are held within the affiliated group, the intercompany
• bond investments (receivable),
• bonds payable (liability),
• intercompany interest expense and,
• intercompany interest revenue,
must be eliminated.
• Bonds not held by external parties are viewed as being constructively
retired in the consolidated financial statements. This is viewed as early
retirement of debt.
LO 1 Constructive retirement of debt. 5
Accounting for Bonds - A Review
Illustration: Three year bonds with a par value of $100,000 are
issued on Jan. 2, 2013, for $85,000. The bonds pay 7% interest each
December 31. Assume straight-line amortization of the discount.
* $100,000 – 85,000 = 15,000 / 3 years = $5,000

Illustration - Issuing Company
Journal entries for 2013:
Jan. 2 Cash 85,000

Discount on Bonds Payable 15,000
Bonds Payable 100,000
Dec. 31 Interest Expense 7,000

Cash 7,000
Interest Expense 5,000

Illustration - Investor Company
Journal entries for 2013:
Jan. 2 Investment in Bonds 85,000

Cash 85,000
Dec. 31 Cash 7,000

Interest Revenue 7,000
Investment in Bonds 5,000

Constructive Gain or Loss on Intercompany Bond
Holdings
• The purchase of an affiliate’s bonds does not alter the accounting on
the books of the individual companies.
• The acquisition of an affiliate’s outstanding bonds from outsiders is
considered a constructive retirement by the consolidated entity.
• The constructive gain or loss is recognized in the consolidated income
statement prior to the recognition of the gain or loss on the books of
the individual companies.

Constructive Gain or Loss on Intercompany Bond
Holdings
• The constructive gain or loss on the bond retirement is computed as
the difference between the carrying value of the liability and the
purchase price of the bonds.
• In the period the bonds are purchased, workpaper entries are made to
accelerate the recognition of the gain or loss.
• After the bonds are purchased, workpaper entries are needed to eliminate
the portion of the constructive gain or loss recorded during the period on the
books of the individual companies.

Constructive Gain or Loss
Allocation of Constructive Gain or Loss
• Four methods for allocating the constructive gain or loss between the
parent and subsidiary:
1) Entirely to the issuing company.
2) Entirely to the purchasing company.
3) Entirely to the parent company.
4) Allocated between the purchasing and issuing companies.
The authors consider the fourth method to be

the soundest conceptually.
LO 2 Allocating the constructive gain or loss. 11

Computing the Constructive Gain or Loss
• On the date bonds of an affiliate are purchased, a constructive gain or
loss is computed.
• The portion allocated to the issuing company is the difference between the
book value (carrying value) of the bonds issued and their par value.
• The portion allocated to the purchasing company is the difference between
the par value of the bonds and their cost.
• There is no constructive gain or loss if the bonds are issued or purchased at
par value.

Computing the Constructive Gain or Loss
If the issue price and purchase price were not equal to par value, there
are four possible combinations that can result:

Computing the Constructive Gain or Loss - Combination 3
+ $10,000 - $15,000
Constructive gain Constructive loss
- $5,000
Net constructive loss

Constructive Gain or Loss -
Computing the Constructive Gain or Loss - Combination 4
- $10,000 + $15,000
Constructive loss Constructive gain
+ $5,000
Net constructive gain

Accounting for Intercompany Bonds Illustrated
• Illustration: P Company acquired an 80% interest in S Company for

$1,200,000 on January 2, 2012, when the retained earnings and common
stock accounts of S Company were $500,000 and $1,000,000, respectively.
On December 31, 2015, P Company acquired $300,000 of S Company’s par
value bonds (60% of S Company’s bonds) on the open market for $310,000
after the semiannual interest payment had been made. At the time of
purchase there were $500,000 par value bonds outstanding with a book
value of $480,000. The bonds mature in four years on December 31, 2019,
and carry an interest rate of 9%. Interest is paid semiannually on June 30
and December 31. Both companies use the straight-line method to amortize
bond discounts and premiums. The fiscal year-end of both companies is
December 31.
Book Entry Related to Bond
Investment
Prepare the entry made by P Company to record the bond investment on
December 31, 2015:
Dec. 31 Investment in S Company Bonds 310,000
Cash 310,000
Note:
 The usual practice of recording a bond investment does not separate the
discount or premium.
 Since the bonds were purchased on the open market, there is no entry
made on the issuing company’s books.

Book Entry Related to Bond
Investment
Compute the Constructive Gain or Loss
- $12,000 - $10,000
Constructive loss Constructive loss
On the books of the The constructive loss is

individual companies, - $22,000 recognized in the
the constructive loss is determination of
not recorded. Net constructive loss combined income.

Consolidated Statements Workpaper—2015
Cost Method
(5)
(2)
(3)
(6) (1)
(5)
* ($125,000 $12,000) x 20% = $22,600

Cost Method
(2)
(4)
(1) (6)
(4)
(3)
(6)
(6)
** $300,000 ($700,000 - $500,000) x 20% = $340,000

Worksheet entries for 2015.
1. Investment in S Company Stock 160,000
Beginning Retained Earnings—P Company 160,000
To establish reciprocity, or convert to equity
Retained earnings balance—January 1, 2015 $ 700,000

Retained earnings balance—date of acquisition 500,000
Increase in retained earnings 200,000
Percentage interest held by P Company 80%
Amount to establish reciprocity $ 160,000

2. Loss on Constructive Retirement of Bonds 10,000
Investment in S Company Bonds 10,000
To recognize the constructive loss not recorded by P Company and adjust the bond
investment to par value.

To recognize the constructive loss not recorded by the subsidiary and adjust the
intercompany bonds to par value.
Entries (2) and (3) recognize the constructive loss allocated to each company and adjust bond
investment and carrying value of the intercompany debt to par value.

4. Bonds Payable 300,000
To eliminate intercompany bond investment and liability.
5. Dividend Income 16,000

Dividends Declared—S Company 16,000
To eliminate intercompany dividends.
6. Beginning Retained Earnings—S Company 700,000
Common Stock—S Company 1,000,000
Investment in S Company Stock 1,360,000
Noncontrolling Interest in Equity 340,000
To eliminate investment account and create NCI.
Complete Equity
Method
If the complete equity method is used, entry (1), the reciprocity entry, is
not needed and the following entry replaces entry (5) above.
Equity in S Company Income 80,400

Dividends Declared 16,000
Investment in S Company Stock 64,400
To eliminate the intercompany income and dividends.

Consolidated Statements Workpaper —2015 Complete
Equity Method
(3)
(1)
(4)
(3)
(1)
(2)
(3)
(4)
(2)
(1)
(4)
(4)
25
Year Subsequent to Acquisition of Bonds, Entries on the
Books of Affiliated Companies—2016
P Company’s Books
Entries on June 30 and December 31
Cash 13,500
To record receipt of interest ($300,000 x 9% x 6/12).

To amortize premium on outstanding bonds ($10,000/ 8 periods).

Year Subsequent to Acquisition of Bonds, Entries on the
Books of Companies—2016
S Company’s Books
Entries on June 30 and December 31

Cash 22,500
To record payment of interest ($500,000 x 9% x 6/12).

To amortize discount on outstanding bonds ($20,000 / 8 periods).

Consolidated Statements
Workpaper Entries
Cost Method
Worksheet entries for December 31, 2016.
1. Investment in S Company Stock 244,000
Beginning Retained Earnings—P Company 244,000
To establish reciprocity/convert to equity
($805,000 - $500,000) x 80% = $244,000
2. Beginning Retained Earnings—P Company 10,000

To adjust beginning retained earnings for constructive loss (recorded in prior year as
workpaper entry only; see 2015 entry (2) and to adjust investment to par.

Workpaper Entries
Worksheet entries for December 31, 2016. Cost Method
3. Beginning Retained Earnings—P Company * 9,600

Beginning Noncontrolling Interest ** 2,400
Discount on Bonds Payable ($15,000 x 60%) 12,000
To adjust beginning retained earnings balances for unrecorded constructive loss at
beginning of the year (recorded in 2015 as workpaper entry only; see 2015 entry (3))
and adjust intercompany bonds to par value.
* ($12,000 x 80%)
** ($12,000 x 20%)

Workpaper Entries
4. Investment in S Company Bonds 2,500

Interest Revenue ($1,250 + $1,250)
2,500
To reverse the amortization of premium on investment recorded by P Company
during the current year (and not needed by consolidated entity since the
constructive loss was recorded in its entirety in 2015).

Workpaper Entries
5. Discount on Bonds Payable ($5,000 x 60%) 3,000

Interest Expense
3,000
To reverse amortization of discount on bonds payable recorded by S Company
during current year (and not needed by consolidated entity since the constructive
loss was recorded in its entirety in 2015).
6. Interest Revenue * 27,000
Interest Expense
27,000
To eliminate intercompany interest.
* ($45,000 x 60%) or ($13,500 + $13,500)

Workpaper Entries
7. Bonds Payable ($500,000 x 60%) 300,000

Investment in S Company Bonds
300,000
To eliminate intercompany bond investment and bonds payable.
To eliminate intercompany bond investment and bonds payable.

Workpaper Entries
Cost Method
Worksheet entries for December 31, 2016.
9. Beginning Retained Earnings—S Company 805,000
Common Stock—S Company 1,000,000
Investment in S Company Stock 1,444,000
To eliminate the investment account and recognize NCI in Net Assets.

Consolidated Statements Workpaper—2016 Cost Method
(8)
(6) (4)
(5)
(6)
(2)
(3) (1)
(9)
(1)
(4) (2)
(7)
(1) (9)
(7)
(5) (3)
(9)
(3) (9)
34
Interim Purchase of Intercompany Bonds
Had the bonds been held during 2015, P Company would have amortized a
portion of the premium and S Company would have amortized a part of the
discount.
Assuming that P Company amortized $500 and S Company amortized $600
during 2015, the original workpaper entries (2) and (3) for constructive
losses) are modified as follows:
2. Loss on Constructive Retirement Bonds 10,000
Interest Revenue 500
Interest Expense 600

Interim Purchase of Intercompany Bonds
• Notes:
• The consolidated income statement will still show a total loss on the
constructive retirement of $22,000.
• The credits to interest revenue and interest expense add back the portion of
the loss that was recorded by the individual companies, but which is reported
in total in 2015.
• Failure to add back the $1,100 ($500 + $600) to the reported income of the
individual companies will result in reporting this portion of the loss twice.

Stock Dividends Issued by a Subsidiary Company
• A subsidiary may issue stock dividends in the same class of stock that
is held by the parent company.
• Parent company records receipt of shares in a memorandum entry
only.
• Subsidiary records the declaration of a stock dividend as a transfer
from retained earnings to one or more paid-in capital accounts.
• Amount transferred is dependent on whether the dividend is a large or small
stock dividend.
• For consolidated purposes, the stock dividend does not alter the
investor’s proportionate interest in the subsidiary.
LO 4 Stock dividends issued by a subsidiary. 37
Illustration: Assume that P Company purchased 4,000 shares of S

Company’s $100 par value common stock on January 2, 2015, for
$560,000. At the time of purchase, S Company reported common
stock and retained earnings balances of $500,000 and $200,000,
respectively. If consolidated statements were prepared on January 2,
2015, the investment eliminating entry would be:
Capital Stock—S Company 500,000

1/1 Retained Earnings—S Company 200,000
Investment in S Company 560,000

Illustration: Now assume that S Company reports net income of
$50,000 and declares a 30% stock dividend (1,500 shares) on
December 31, 2015. S Company would record the dividend as follows
(par value):
Stock Dividend Declared (or R/E) 150,000
Capital Stock (1,500 shares $100) 150,000
The only entry made by P Company in 2015 is a memorandum

entry to record the receipt of 1,200 shares from S Company.

Cost Method
Consolidated Statement Workpaper December 31, 2015
(2)
(1)
(2)
(1)
(2)
(2)

Worksheet Entries – Year Stock Dividends Are Declared
1. Capital Stock—S Company 120,000
Stock Dividends Declared—S Company 120,000
To reverse effects of stock dividend ($150,000 x 80%).
2. 1/1 Retained Earnings—S Company 200,000

To eliminate investment account and recognize noncontrolling interest.

Stock Dividends Issued from Postacquisition Earnings
• If the stock dividend had been more than retained
earnings balance ($200,000), some of the
postacquisition earnings of the subsidiary would have
been capitalized.
• FASB ASC paragraph 810-10-45-9: Occasionally,
subsidiary companies capitalize earned surplus
[retained earnings] arising since acquisition, by means
of a stock dividend or otherwise. This does not
require a transfer to capital surplus on consolidation.
LO 6 Subsidiary stock dividends issued from postacquisition earnings. 42

Dividends from Preacquisition Earnings
Effects of a liquidating dividend on the consolidated
statements workpaper entries:
Assume that P Company acquired an 80% interest in S
Company on January 2, 2015, for $560,000. At the
time of purchase, S Company had capital stock and
retained earnings in the amounts of $500,000 and
$200,000, respectively. During the first year that the
investment was held, S Company reported net income
of $200,000. On December 31, 2015, the subsidiary
declared and paid a cash dividend of $250,000.
LO 6 Subsidiary stock dividends issued from preacquisition earnings. 43
Liquidating dividends are accounted for as a return of part of
the original investment.
P Company’s Books
Cash 200,000
Dividend Income ($200,000 x 80%) 160,000
Investment in S Company ($50,000 x 80%) 40,000
To record receipt of a cash dividend from S Company.
This entry reduces the investment account to $520,000.

The December 31, 2015, eliminating entries are as follows:
To eliminate intercompany dividends.
2. Investment in S Company 40,000

To reverse the liquidating dividend.

The December 31, 2015, eliminating entries are as follows:
3. Beginning Retained Earnings—S Co. 200,000
To eliminate investment account and create noncontrolling interest.

Subsidiary with Preferred and Common Stock
Outstanding
Determining Equity Interest of Each Class of Stockholders
• Subsidiary preferred shares, not held by the parent company,
are considered part of the noncontrolling interest.
• In consolidation, each class of stockholders has an interest in
the net assets of the firm, thus it is necessary to allocate:
• Subsidiary’s stockholders’ equity between preferred and common
stock interests.
• Operating results of the subsidiary to determine the interest of the
two classes of stockholders in the changes in the retained earnings
balance.
• The dividend preference of the preferred stock issue will determine
the amounts allocated to each class of stockholders..
LO 7 Allocating the purchase price between common
and preferred stockholders. 47
Consolidating with Preferred Stock Outstanding
Illustration: Assume the following information concerning the capital
accounts of S Company as of January 2, 2015:
8%, $100 par value preferred stock, cumulative, nonparticipating,
dividends in arrears for 2014, call price is $103,5,000 shares
outstanding $ 500,000
Common stock, $10 par value 1,000,000
Other contributed capital-excess on issue of common stock
over par 305,000
Retained earnings 200,000
Total stockholders’ equity $2,005,000
LO 7 Allocating the purchase price between common and preferred stockholders.

48
On January 2, 2015, P Company acquired 80% of the outstanding
common stock for $1,160,000 and 30% of the outstanding preferred
stock for $180,000. During the year, S Company reported net income of
$200,000 and declared no cash dividends. The entry to record the
purchase is:
P Company’s Books
Investment in S Co. Preferred stock 180,000
Investment in S Co. Common Stock 1,160,000
Cash 1,340,000

Computation and Allocation of Difference Between Implied and Book Value Acquired
—Preferred Stock
Date of Acquisition - 1/2/ 2015
* Noncontrolling interest after adjustment $420,000 - $31,500 = $388,500

** ($103 call + $8 dividends in arrears - $100 par) x 5,000 shares = $11 x 5,000 = $55,000
LO 7 Allocating the purchase price between common and preferred stockholders.
50
Consolidated Statements Workpaper Entries—2015
Cost Method or Partial Equity Method
1a. Beginning Retained Earnings—S Co. 55,000
Preferred Stock—S Co. 500,000
Difference Between Implied and BV 45,000
Investment in S Co. Preferred Stock 180,000
To eliminate the preferred stock investment account and recognize the
noncontrolling interest in equity.

1b. Other Contributed Capital—P Company 13,500

Difference Between Implied and Book Value 45,000
To allocate the difference between implied and book values of preferred stock to
equity.

Computation and Allocation of Difference Between Implied and Book
Value Acquired—Common Stock
Date of Acquisition - 1/2/2015
* $200,000 - $55,000 = $145,000

2. Beginning Retained Earnings—S Co. 145,000
Common Stock—S Co. 1,000,000
Other Contributed Capital—S Co. 305,000
Investment in S Co. Common Stock 1,160,000
NCI in Equity 290,000
To eliminate the common stock investment account and recognize NCI.

and preferred stockholders.
54
Noncontrolling interest in the consolidated income for 2015 is
computed as follows:

Consolidated Statement Workpaper December 31, 2015 Cost Method Page 1
(1a)
(2)
56
P S Eliminations Consolidated
Balance Sheet
Investment in S Company
Preferred stock 180,000 180,000 -
Common stock 1,160,000 1,160,000 -
Difference Implied and BV 45,000 45,000 -
Other assets 5,410,000 2,805,000 8,215,000
Total assets 6,750,000 2,805,000 8,215,000
Total liabilities 1,600,000 600,000 2,200,000
Preferred stock S Co. 500,000 500,000 -
Common stock 3,000,000 1,000,000 1,000,000 3,000,000
Other contributed capital
P Company 400,000 13,500 386,500
S Company 305,000 305,000 -
Retained earnings 1,750,000 400,000 200,000 60,000 1,890,000
NCI in net assets 1/1 31,500 420,000 678,500 -
290,000
NCI in net assets 12/31 738,500 738,500
Total liab. & equity 6,750,000 2,805,000 2,095,000 2,095,000 8,215,000
57
P S Eliminations Consolidated
Company Company Debit Credit NCI Balances
Balance Sheet
Investment in S Company
Preferred stock 180,000 180,000 -
Common stock 1,160,000 1,160,000 -
Difference Implied and BV 45,000 45,000 -
Other assets 5,410,000 2,805,000 8,215,000
Total assets 6,750,000 2,805,000 8,215,000
Total liabilities 1,600,000 600,000 2,200,000
Preferred stock S Co. 500,000 500,000 -
Common stock 3,000,000 1,000,000 1,000,000 3,000,000
Other contributed capital
P Company 400,000 13,500 386,500
S Company 305,000 305,000 -
Retained earnings 1,750,000 400,000 200,000 60,000 1,890,000
NCI in net assets 1/1 31,500 420,000 678,500 -
290,000
NCI in net assets 12/31 738,500 738,500
Total liab. & equity 6,750,000 2,805,000 2,095,000 2,095,000 8,215,000
58
59

PPT8-Intercompany Bond Holdings and Miscellaneous Topics

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ACCT6381

* $100,000 – 85,000 = 15,000 / 3 years = $5,000

LO 1 Constructive retirement of debt. 6

Jan. 2 Cash 85,000

Dec. 31 Interest Expense 7,000

LO 1 Constructive retirement of debt. 7

Jan. 2 Investment in Bonds 85,000

Dec. 31 Cash 7,000

LO 1 Constructive retirement of debt. 8

LO 1 Constructive retirement of debt. 9

LO 1 Constructive retirement of debt. 10

The authors consider the fourth method to be

LO 2 Allocating the constructive gain or loss. 11

LO 2 Allocating the constructive gain or loss. 12

LO 2 Allocating the constructive gain or loss. 13

LO 2 Allocating the constructive gain or loss. 14

LO 2 Allocating the constructive gain or loss. 15

• Illustration: P Company acquired an 80% interest in S Company for

LO 2 Allocating the constructive gain or loss. 17

On the books of the The constructive loss is

LO 2 Allocating the constructive gain or loss. 18

* ($125,000 $12,000) x 20% = $22,600

** $300,000 ($700,000 - $500,000) x 20% = $340,000

LO 2 Allocating the constructive gain or loss. 20

Retained earnings balance—January 1, 2015 $ 700,000

LO 2 Allocating the constructive gain or loss. 21

3. Loss on Constructive Retirement of Bonds 12,000

LO 2 Allocating the constructive gain or loss. 22

5. Dividend Income 16,000

Equity in S Company Income 80,400

LO 2 Allocating the constructive gain or loss. 24

Interest Revenue 1,250

LO 2 Allocating the constructive gain or loss. 26

Interest Expense 22,500

Interest Expense 2,500

LO 2 Allocating the constructive gain or loss. 27

2. Beginning Retained Earnings—P Company 10,000

LO 2 Allocating the constructive gain or loss. 28

3. Beginning Retained Earnings—P Company * 9,600

LO 2 Allocating the constructive gain or loss. 29

4. Investment in S Company Bonds 2,500

LO 2 Allocating the constructive gain or loss. 30

5. Discount on Bonds Payable ($5,000 x 60%) 3,000

LO 2 Allocating the constructive gain or loss. 31

7. Bonds Payable ($500,000 x 60%) 300,000

LO 2 Allocating the constructive gain or loss. 32

LO 2 Allocating the constructive gain or loss. 33

LO 2 Allocating the constructive gain or loss. 35

LO 2 Allocating the constructive gain or loss. 36

Illustration: Assume that P Company purchased 4,000 shares of S

Capital Stock—S Company 500,000

LO 4 Stock dividends issued by a subsidiary. 38

The only entry made by P Company in 2015 is a memorandum

LO 4 Stock dividends issued by a subsidiary. 39

LO 4 Stock dividends issued by a subsidiary. 40

2. 1/1 Retained Earnings—S Company 200,000

LO 4 Stock dividends issued by a subsidiary. 41

LO 6 Subsidiary stock dividends issued from postacquisition earnings. 42

LO 6 Subsidiary stock dividends issued from preacquisition earnings. 44

2. Investment in S Company 40,000

LO 6 Subsidiary stock dividends issued from preacquisition earnings. 45

LO 6 Subsidiary stock dividends issued from preacquisition earnings. 46

LO 7 Allocating the purchase price between common and preferred stockholders.