GLOBAL EDITION. Advanced Accounting TWELFTH EDITION. Floyd A. Beams Joseph H. Anthony Bruce Bettinghaus Kenneth A. Smith

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1 GLOBAL EDITION Advanced Accounting TWELFTH EDITION Floyd A. Beams Joseph H. Anthony Bruce Bettinghaus Kenneth A. Smith

3 Pro s Investment in Sky account at December 31, 2012, has a balance of $10,584,000. This balance equals the underlying book value of Pro s investment in Sky at January 1, 2012, plus $459,000 investment income from Sky for 2012 (in thousands): Investment in Sky January 11$11,250,000 * 90%2 $10,125 Add: Income from Sky 459 Investment in Sky December 31 $10,584 Intercompany Profit Transactions Bonds 249 Exhibit 7-3 presents a consolidated financial statement workpaper for Pro and Subsidiary. The constructive loss of $300,000 on the intercompany bonds appears in the consolidated income statement for Because $5,000,000 par of Sky bonds have been constructively retired, the consolidated balance sheet reports bonds payable of $4,880,000 ($5,000,000 par less the unamortized discount of $120,000) related to the bonds held outside of the consolidated entity. EFFECT OF CONSTRUCTIVE LOSS ON NONCONTROLLING INTEREST SHARE AND CONSOLIDATED NET INCOME Noncontrolling interest share for 2012 is $51,000 31$750,000 - $300,000 + $60,0002 * 10%4. We assign the constructive loss to Sky. We charge the noncontrolling interest for 10 percent of the $300,000 constructive loss and credit it for 10 percent of the $60,000 piecemeal recognition of the constructive loss during Accordingly, noncontrolling interest share for 2012 is 10 percent of Sky s $510,000 realized income, and not 10 percent of Sky s $750,000 reported net income. The constructive retirement of bonds payable reduces the controlling interest share of consolidated net income for 2012 by $216,000. We reflect this reduction in the consolidated income statement through the inclusion of the $300,000 loss on the constructive retirement of the bonds, elimination of interest income of $470,000 and interest expense of $530,000, and reduction of noncontrolling interest share by $24,000 (from $75,000 based on reported net income of Sky to $51,000 noncontrolling interest share for the year). An analysis of the effect follows (in thousands): LEArning objective 4 Controlling Interest Share of Consolidated Net Income 2012 Decreased by: Constructive loss $300 Elimination of interest income 470 Total decreases $770 Increased by: Elimination of interest expense $530 Reduction of noncontrolling interest share 1$75,000 - $51, Total increases $554 Effect on controlling interest share for 2012 $216 The reduction of noncontrolling interest share is similar to the reduction of other expenses. CONSOLIDATION WORKPAPER ENTRIES The entries shown in the consolidation workpaper of Exhibit 7-3 are similar to those in the Pam Sue illustration in Exhibit 7-1 except for the amounts and the shift to a constructive loss situation. As in the previous illustration, workpaper entries a, b, and e are separated for illustrative purposes, but they could be combined into a single entry as follows (in thousands): Loss on retirement of bonds (Lo, SE) 300 Interest payable ( L) 250 Interest income ( R, SE) % bonds payable ( L) 4,880 Investment in Sky bonds ( A) 5,120 Interest receivable ( A) 250 Interest expense ( E, +SE) 530

4 250 CHAPTER 7 Exhibit 7-3 subsidiary Bonds held by parent pro CorporatioN and SubSidiary CoNSolidatioN workpaper For the year ENdEd december 31, 2012 (in thousands) Pro Adjustments and Eliminations 90% sky debits Credits Consolidated statements Income Statement sales $25,750 $14,250 $40,000 income from sky 459 c 459 interest income 470 b 470 Expenses including cost of sales (21,679) (12,440) (34,119) interest expense (1,060) b 530 (530) Loss on retirement of bonds a 240 b 60 noncontrolling interest share ($750 - $300 + $60) * 10% (300) f 51 (51) controlling interest share $ 5,000 $ 750 $ 5,000 Retained Earnings Statement retained earnings Pro $13,000 $13,000 retained earnings sky $ 1,250 d 1,250 add: controlling interest share 5, ,000 retained earnings december 31 $18,000 $ 2,000 $18,000 Balance Sheet other assets $34,046 $25,000 $59,046 interest receivable 250 e 250 investment in sky 10,584 c 459 d 10,125 investment in sky bonds 5,120 a 5,120 $50,000 $25,000 $59,046 other liabilities $12,000 $ 2,740 $14,740 interest payable 500 e % bonds payable 9,760 a 4,880 4,880 Capital stock 20,000 10,000 d 10,000 20,000 retained earnings 18,000 2,000 18,000 $50,000 $25,000 noncontrolling interest f 51 d 1,125 1,176 17,660 17,660 $59,046

5 effect on consolidated statements in subsequent years The loss on the retirement of bonds only appears in the consolidated income statement in the year in which we constructively retire the bonds. In subsequent years, we allocate the unrecognized portion of the constructive loss between the investment account (the controlling interest) and noncontrolling interest. For example, the combined workpaper entry to eliminate the bond investment and bonds payable and the interest income and interest expense amounts at December 31, 2013, would be as follows (in thousands): Intercompany Profit Transactions Bonds 251 Investment in Sky (+A) 216 Noncontrolling interest ( SE) 24 Interest income ( R, SE) % bonds payable ( L) 4,910 Investment in Sky bonds ( A) 5,090 Interest expense ( E, +SE) 530 The assignment of the constructive loss to Sky dictates allocation of the unrecognized loss between the investment in Sky ($216,000) and noncontrolling interest ($24,000). The loss is a subsidiary loss, so noncontrolling interest must share in the loss. In computing noncontrolling interest share for 2013, we add 10 percent of the $60,000 constructive loss recognized in 2013 to the noncontrolling interest share of income reported by Sky. We require this adjustment of noncontrolling interest share each year through By December 31, 2016, the bond investment will decrease to $5,000,000 through premium amortization, and the intercompany bond liability will increase to $5,000,000 through discount amortization. The intercompany bond holdings increase the controlling share of consolidated net income by $54,000 each year for 2013 through Under the equity method, Pro s income from Sky and net income also increase by $54,000 in each of the years. Computations of the controlling share of consolidated net income effect follow (in thousands): Controlling Share of Consolidated Net Income 2013 through 2016 Increased by: Elimination of interest expense $530 Decreased by: Elimination of interest income $470 Increase in noncontrolling interest share ($60,000 piecemeal recognition * 10%) 6 Total decreases $476 Annual effect on controlling share $ 54 Exhibit 7-4 summarizes the intercompany bond account balances that appear on the books of Pro and Sky at year-end 2013 through The exhibit also summarizes the required workpaper adjustments to consolidate the financial statements of Pro and Sky for years subsequent to the year of intercompany purchase of Sky bonds. Because the Investment in Sky account is involved, we make the workpaper entries shown in Exhibit 7-4 before eliminating reciprocal investment and subsidiary equity amounts. The workpaper entries shown in Exhibit 7-4 eliminate those amounts that would have been eliminated from the separate statements of Pro and Sky if the bonds had in fact been retired in The objective is to produce the consolidated financial statements as if Sky had purchased and retired its own bonds.

6 252 CHAPTER 7 Exhibit 7-4 subsidiary Bonds held by parent years subsequent to year of intercompany purchase Summary of intercompany bond account balances on SEparatE books december 31, pro s Books (in thousands) investment in sky bonds $5,090 $5,060 $5,030 $ 5,000 interest income interest receivable sky s Books (in thousands) 10% bonds payable $9,820 $9,880 $9,940 $10,000 interest expense 1,060 1,060 1,060 1,060 interest payable Summary of CoNSolidatioN workpaper adjustments december 31, Debits (in Thousands) investment in sky (90%)* $ 216 $ 162 $ 108 $ 54 noncontrolling interest (10%)* interest income % bonds payable** 4,910 4,940 4,970 5,000 interest payable Credits (in Thousands) investment in sky bonds 5,090 5,060 5,030 5,000 interest expense** interest receivable *The unrecognized portion of the constructive loss at the beginning of the year is charged 90% to the investment in sky account and 10% to noncontrolling interest. **Elimination of 50% of sky s bonds (including 50% of the unamortized discount on the bonds) and 50% of the current interest expense on the bonds. summary Transactions in which a corporation acquires the outstanding bonds of an affiliate on the open market result in constructive gains and losses except when an affiliate purchases bonds at book value. The consolidated entity realizes constructive gains and losses when an affiliate purchases another affiliate s bonds. The constructive gains and losses should be reflected in the income of the parent (under the equity method) and consolidated net income in the year of purchase. Constructive gains and losses on parent bonds purchased by a subsidiary are similar to unrealized gains and losses on downstream sales and do not require allocation between noncontrolling and controlling interests. However, constructive gains and losses on subsidiary bonds purchased by the parent company should be allocated between the controlling and noncontrolling interests. Constructive gains or losses on intercompany bonds are recognized on the books of the purchaser and issuer as they amortize differences between the book value and par value of bonds. A summary illustration comparing effects of constructive gains and losses from intercompany bond transactions on parent and consolidated net incomes is presented in Exhibit 7-5. questions 1. What reciprocal accounts arise when one company borrows from an affiliate? 2. Do direct lending and borrowing transactions between affiliates give rise to unrealized gains or losses and unrecognized gains or losses?

7 Intercompany Profit Transactions Bonds 253 assumptions 1. Parent (P) Company s net income, excluding income from subsidiary (s), was $100,000 for %-owned subsidiary reported net income of $50,000 for $100,000 of 10% bonds payable are outstanding with $6,000 unamortized premium as of january 1, $50,000 par of the bonds were purchased for $51,500 on january 2, The bonds mature on january 1, p s Net income equity method s Acquires P s bonds (similar to downstream) P Acquires s s bonds (similar to upstream) P s separate income $100,000 $100,000 P s share of s s reported net income 45,000 45,000 Add: Constructive gain on bonds ($53,000 - $51,500) * 100% 1,500 ($53,000 - $51,500) * 90% 1,350 deduct: Piecemeal recognition of constructive gain ($1,500 gain, 3 years) * 100% (500) ($1,500 gain, 3 years) * 90% (450) P s net income $146,000 $145,900 Exhibit 7-5 summary illustration constructive gains and losses on intercompany Bonds controlling interest share of consolidated Net income P s separate income plus s s net income $150,000 $150,000 Add: Constructive gain on bonds 1,500 1,500 Eliminate: interest expense (increase) 4,000 4,000 interest income (decrease) (4,500) (4,500) Total realized income 151, ,000 Less: noncontrolling interest share ($50,000 * 10%) (5,000) ($50,000 + $1,500 - $500) * 10% (5,100) Controlling interest share of consolidated net income $146,000 $145,900 P s net income and controlling share of consolidated net income of $146,000 when s acquires P s bonds are the same as if the bonds were retired by P at the end of in that case, P s separate income would have been $101,000 ($100,000 plus $1,000 constructive gain), and s s net income would be unchanged. P s $101,000 plus P s $45,000 share of s s reported net income equals $146,000. An assumption of retirement at year-end is necessary because interest expense of P and interest income of s are both realized and recognized during The amount of the gain is $1,000 ($1,500 less $500 realized and recognized during the current year). P s net income and controlling share of consolidated net income of $145,900 when P acquires s s bonds are the same as if the bonds were retired by s at the end of in that case, P s separate income would be unchanged at $100,000, and s s reported net income would be $51,000 ($50,000 plus $1,000 constructive gain). P s $100,000 separate income plus P s $45,900 share of s s reported income ($51,000 * 90%) equals $145,900. Again, the assumption of retirement at year-end is necessary because interest income of P and interest expense of s are realized and recognized during the current year. 3. What conditions result in an actual retirement of bonds? 4. A company has a $1,000,000 bond issue outstanding with unamortized premium of $10,000 and unamortized issuance cost of $5,300. What is the book value of its liability? If an affiliate purchases half the bonds in the market at 98, what is the gain or loss? Is the gain or loss actual or constructive? 5. Compare a constructive gain on intercompany bonds with an unrealized gain on the intercompany sale of land. 6. Describe the process by which constructive gains on intercompany bonds are realized and recognized on the books of the affiliates. Does recognition of a constructive gain in consolidated financial statements precede or succeed recognition on the books of affiliates? 7. If a subsidiary purchases parent bonds at a price in excess of recorded book value, is the gain or loss attributed to the parent or the subsidiary? Explain.

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This page intentionally left blank 246 Chapter 7 Parent Acquisition of Subsidiary Bonds Assume that Son sold $2,000,000 par of 10 percent, 10-year bonds to the public at par on December 30, 2015, and that