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CHAPTER. Intercompany Bonds, Cash Flow, EPS, and Unconsolidated Investments Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng . 5. 5. Intercompany Bonds. A subsidiary may have debt that is more expensive than if it were issued by the parent

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  1. CHAPTER Intercompany Bonds, Cash Flow, EPS, andUnconsolidated InvestmentsFundamentals of Advanced Accounting1st EditionFischer, Taylor, and Cheng 5 5

  2. Intercompany Bonds • A subsidiary may have debt that is more expensive than if it were issued by the parent • One member of the affiliated group (usually the subsidiary) has bonds outstanding that are held by outsiders; the other member (usually the parent) purchases the bonds from the outsiders • Consolidation treatment (on Worksheet) is retirement with an ordinary gain or loss (no longer extraordinary) • The result is the same if the parent loans money to the subsidiary and the subsidiary retires the bonds Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  3. Intercompany Bonds - Eliminations • Elimination entry B1: • Bonds payable/receivable are eliminated • Intercompany interest revenues/expenses are eliminated • Elimination entry B2: • Intercompany interest receivables/payables are eliminated Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  4. Bond Issued at Face Value Example: Facts Sub(80%)issues to third parties $100,000, 5-year, 8% bond on 1/1/20X1 at 100. Int. Exp. = $8,000 per year Parentpurchases the bonds from third party for $103,600 on 1/2/20X3 3 remaining years Discount amortization (st.-line) = $1,200 per year Int. Rev. = $6,800 per year Consolidated statements:$103,600 was paid to retire bonds with a book value of $100,000 There is $3,600 loss on the date of purchase Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  5. Bond Example: General Ledger Journal Entries (Years 1–5) Sub Journal Entries Year 1 Cash 100,000 Bond Pay. 100,000 Int. Exp. 8,000 Int. Pay. 8,000 Year 2 Int. Exp 8,000 Int. Pay 8,000 Years 3, 4 & 5 Int. Exp. 8,000 Int. Pay. 8,000 Parent Journal Entries Year 1 No entry Year 2 No entry Years 3, 4 & 5 Int. Rec. 8,000 Invest in Bond 1,200 Int. Pay. 6,800 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  6. Bonds Issued at Face Value – Elimination entries at 12/31/X3 B1 Bond payable 100,000 Invest. In Bonds 102,400* Interest income 6,800 Interest expense 8,000 Loss on Bond retirement 3,600 (eliminates intercompany bonds and interest expense) * Net of $1,200 amortization of bond premium B2 Interest payable 8,000 Interest receivable 8,000 (eliminates intercompany accrued interest) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  7. Bond Issued at Discount Example: Facts Sub(80%)issues to third party $100,000, 5-year, 8% bond on 1/1/20X1 at $96,110.(Discount = $3,890) • Discount amortization (straight line) = $778 per year • Int. Exp. = $8,778 per year (Interest paid on 12/31) • Discount balance $1,556 at 12/31/X3 Parentpurchases the bonds from third party for $103,600 on 12/31/20X3 • 2 remaining years • Premium amortization (st.-line) = $1,800 per year • Int. Rev. = $6,200 per year Consolidated statements:$103,600 was paid to retire bonds with a book value of $98,444 • There is $5,156 loss on the date of purchase Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  8. Bond Example: Carrying Values Parent buys 12/31/X3 $98,444 less $103,600 results in a $5,156 loss. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  9. Bond Issued at a Discount Example: Journal Entries (Years 4–5) Sub Journal Entries Year 4 Int. Exp. 8,778 Discount on BP 778 Cash 8,000 Year 5 Int. Exp. 8,778 Discount on BP 778 Cash 8,000 Parent Journal Entries Year 4 Bond Invest. 103,600 Cash 103,600 Cash. 8,000 Bond investment 1,800 Int. Rev. 6,200 Year 5 Cash 8,000 Bond investment 1,800 Int. Rev. 6,200 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  10. Bonds Issued at Discount – Elimination entries at 12/31/X4 B Bond payable 100,000 Discount on Bonds payable 778 Invest. In Bonds 101,800* Interest income 6,200 Interest expense 8,778 Retained Earnings - P 4,640** Retained Earnings – S 516^ (eliminates intercompany bonds and interest expense) * Net of $1,200 amortization of bond premium **$5,156 loss x 80% ^$5,156 loss x 20% Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  11. Worksheet 5-3: Eliminations (12/31/X4)Bonds Issued at a Discount • Bonds issued at a discount/premium does not change consolidation entries. • Bonds issued at a discount/premium does require additional calculations. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  12. Effective Interest Method • Procedures for elimination do not change! • Only dollar values are different… Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  13. Effective Interest Bond Example: Facts • Subissues to third party a $100,000, 5-year, 8% bond on 1/1/20X1 for $96,110 • Parentpurchases the bonds from outsiders for $103,667 on 12/31/20X3 (2 remaining years) • Consolidated statements:$103,667 was paid to retire bonds with a book value of $98,240. • There is a $5,427 loss Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  14. Effective Interest Bond Example: Amortization Tables Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  15. Bonds Issued at Discount – Elimination entries at 12/31/X4 B Bond payable 100,000 Discount on Bonds payable 918 Invest. In Bonds 101,887* Interest income 6,220 Interest expense 8,842 Retained Earnings - P 4,342** Retained Earnings – S 1,085^ (eliminates intercompany bonds and interest expense) * Net of $1,780 amortization of bond premium **$5,427 loss x 80% ^$5,427 loss x 20% Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  16. Consolidated Cash Flow: The Issues • Consolidated Statement of Cash Flows is required – FASB No. 95 • Use consolidated financial statements to analyze cash flow • Intercompany transactions already eliminated…no effect • Investment and financing activities reported (even if non-cash) • Cash purchase is investing • Stock issue is a noncash transaction • Amortizations are a non-cash adjustment to operations Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  17. Cash Purchase: Example Balance Sheet of Company Acquired Cash 50,000 Liabilities 1500,000 Inventory 60,000 Building 190,000 Common Stock 200,000 Equipment 400,000 Retained Earnings 350,000 Total 700,000 Total 700,000 Building Fair Value = $425,000; Life = 10 years Equipment Fair Value = $250,000; Life = 5 years Goodwill = Excess of price paid over fair value of net assets Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  18. Cash Purchase: Example (continued) D&D Schedule Price paid 540,000 Interest (80%  $550,000) 440,000 Excess 100,000 Allocate to building (80%  25,000) (20,000) 10-year Allocate to equipment (80% x 60,000) (48,000) 5-year Goodwill 32,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  19. Cash Purchase: Example (continued) To see cash flow impact, consider additions to parent balance sheet on purchase date: Inventory 60,000 Building 420,000 Equipment 238,000 Goodwill 32,000 Liabilities 150,000 Cash (540,000 – 50,000 sub cash) 490,000 NCI (20%  550,000) 110,000 Dr Cr Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  20. Cash Purchase Example:Effect on Statement of Cash Flows • Cash operations • +$10,600 depreciation adjustment • Cash flows from investing activities • Payment for purchase of Company S, net of cash acquired $(490,000) • Noncash “investing” is • $150,000 liability • $110,000 NCI Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  21. Non-Cash Purchase: Example Balance Sheet of Company Acquired Cash 50,000 Liabilities 1500,000 Inventory 60,000 Building 190,000 Common Stock 200,000 Equipment 400,000 Retained Earnings 350,000 Total 700,000 Total 700,000 10,000 shares of Stock issued for sub $10 par value $54 market value Building Fair Value = $425,000; Life = 10 years Equipment Fair Value = $250,000; Life = 5 years Goodwill = Excess of price paid over fair value of net assets Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  22. Stock Issued for Sub: Example (continued) D&D Schedule Price paid (10,000 shares x $54) 540,000 Interest (80%  $550,000) 440,000 Excess 100,000 Allocate to building (80%  25,000) (20,000) 10-year Allocate to equipment (80% x 60,000) (48,000) 5-year Goodwill 32,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  23. Non-Cash Purchase: Example (continued) To see cash flow impact, consider additions to parent balance sheet on purchase date: Cash 50,000 Inventory 60,000 Building 420,000 Equipment 238,000 Goodwill 32,000 Liabilities 150,000 Common Stock – Par 100,000 Paid-in Capital in Excess of Par 440,000 NCI (20%  550,000) 110,000 Dr Cr Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  24. Non-Cash Purchase Example:Effect on Statement of Cash Flows • Cash operations • +$10,600 depreciation adjustment • Cash flows from investing activities • Cash acquired in purchase of Company S, $(490,000) • Noncash financing and investing • Adjusted value of assets acquired $800,000 • Common Stock issued, 540,000 • Liabilities assumed 150,000 • Non-controlling Interest 110,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  25. Consolidated Diluted EPS Subsidiary has no dilutive shares • Calculated by dividing controlling interest in consolidated net income by parent company outstanding stock • Parent dilutive shares cause numerator and denominator adjustments just as in a single entity calculation Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  26. Consolidated Diluted EPS - continued Subsidiary has dilutive shares – Two step process • Step 1 – Calculate sub’s Diluted Earnings per Share (DEPS) • Step 2 – Calculate consolidated DEPS • Uses sub’s DEPS calculation as part of this calculation. Additional complication: Sub may have outstanding securities that may require the parent to issue additional shares Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  27. Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution Example on next slide Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  28. Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution Example • Subsidiary financial information: • Net Income (adjusted for interco profits) $22,000 • Pref. stock cash dividend $2,000 • Interest paid on convertible bonds $3,000 • Common stock shares outstanding 5,000 • Warrants to purchase one share of common stock 1,000 • Warrants held by parent 500 • Convertible bonds outstanding (conv. to 10 shares cs) 200 • Convertible bonds held by parent 180 • Parent financial information: • Parent owns 80% of sub • Net income (internal, adjusted) $40,000 • Interest paid on convertible shares $5,000 • Common shares outstanding 10,000 • Bonds outstanding can convert to shares 3,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  29. Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution Sub’s DEPS Consol DEPS Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  30. Consolidated Diluted EPS Calculation – Parent Possible Dilution from Sub’s Securities If sub has dilutive securities that affect Parent’s stock: • These securities are not included in sub’s DEPS calculation • These securities must be included in the parent’s share adjustment for consolidated DEPS. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  31. Equity Method for Unconsolidated Investments • Income on investment is recorded as earned • Investor records income when the company invested in reports net income • Investor reduces the investment account when the company invested in declares dividends • Required for certain types of investments • Influential investments • Corporate joint ventures • Unconsolidated subsidiaries Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  32. Influential Investment: ExampleExcel purchases 25% of Flag’s Stock D&D of Excess Schedule Price paid $250,000 Equity (25%  $800,000) 200,000 Excess of cost over book value 50,000 Less Equipment with 5-year life 20,000 Goodwill (not amortized) $30,000 Purchase date 1/1/20X1 Flag sells inventory to Excel: $30,000 goods in ending inventory with 40% GP – 12/31/X1 $40,000 goods in ending inventory with 45% GP – 12/31/X2 Flag sold Excel a truck (4 year life) on 1/1/20X1 NBV $16,000, Sell price $20,000 Investee reports income of $60,000 (before tax) in 20X1 and $70,000 in 20X2 Flag declared and paid $10,000 in dividends in 20X2 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  33. Influential Investment:20X1 IDS to Calculate Investment Income 20X1 IDS for Flag Truck. gain 4,000 Reported income 60,000 Profit in Excel end. Inv. 12,000 Realized truck gain 1,000 Adjusted Income 45,000 Ownership interest (25%) 11,250 Less Equip amort. 4,000 Investment income 7,250 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  34. Influential Investment:20X2 IDS to Calculate Investment Income 20X2 IDS for Flag Profit in Excel end. Inv. 18,000 Reported income 70,000 Profit in Excel beg. Inv. 12,000 Realized truck gain 1,000 Adjusted Income 65,000 Ownership interest (25%) 16,250 Less Equip amort. 4,000 Investment income 12,250 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  35. Influential Investment: Entries to Record Income & Dividends 20X1 Investment in Flag Company 7,250 Investment Income 7,250 20X2 Investment in Flag Company 12,250 Investment Income 12,250 (to record investment income) 20X2 Cash 12,250 Investment in Flag Company 12,250 (to record dividends received) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

  36. Influential Investment: Special Issues • Investee with Preferred Stock • Investee stock transactions • Write-down to market value • Zero investment balance • Intercompany transactions by investor • Gain or loss of influence Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

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