CHAPTER Intercompany Bonds, Cash Flow, EPS, and Unconsolidated Investments Fundamentals of Advanced...

CHAPTER

Intercompany Bonds, Cash Flow, EPS, and

Unconsolidated Investments Fundamentals of Advanced Accounting

1st EditionFischer, Taylor, and Cheng

55

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 5, Slide #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


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


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 yearParent purchases 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


Bond Example: General Ledger Journal Entries (Years 1–5)

Sub Journal Entries Year 1Cash 100,000

Bond Pay. 100,000Int. Exp. 8,000 Int. Pay. 8,000Year 2Int. Exp 8,000 Int. Pay 8,000Years 3, 4 & 5Int. Exp. 8,000

Int. Pay. 8,000

Parent Journal EntriesYear 1 No entry

Year 2No entry

Years 3, 4 & 5Int. Rec. 8,000 Invest in Bond 1,200 Int. Pay. 6,800


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)


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

Parent purchases 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


Bond Example: Carrying Values

Date Sub’s Debt

Parent’s Asset

1/1/X1 96,110 12/31/X1 96,888 12/31/X2 97,666 12/31/X3 98,444 103,600 12/31/X4 99,222 101,800 12/31/X5 100,000 100,000

Parent buys 12/31/X3

$98,444 less $103,600 results in a $5,156 loss.


Bond Issued at a Discount Example: Journal Entries (Years 4–5)

Sub Journal Entries Year 4

Int. Exp. 8,778Discount on BP 778

Cash 8,000

Year 5Int. Exp. 8,778Discount on BP 778

Cash 8,000

Parent Journal Entries Year 4Bond Invest. 103,600

Cash 103,600

Cash. 8,000Bond investment 1,800Int. Rev. 6,200

Year 5Cash 8,000

Bond investment 1,800Int. Rev. 6,200


Bonds Issued at Discount – Elimination entries at 12/31/X4

B Bond payable 100,000Discount on Bonds payable 778Invest. In Bonds 101,800*

Interest income 6,200Interest 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%


Worksheet 5-3: Eliminations (12/31/X4)Bonds Issued at a Discount

Co. P Co. SInvestment in bonds 101,800 B 101,800 Bonds payable (100,000) B 100,000 Discount on bond pay. 778 B 778 Interest expense 8,778 B 8,778 Interest revenue (6,200) B 6,200 RE - Co. S 110,000 B 516 RE - Co. P 160,000 B 4,640

Dr CrEliminationsTrial Balances

•Bonds issued at a discount/premium does not change consolidation entries.

•Bonds issued at a discount/premium does require additional calculations.


Effective Interest Method

• Procedures for elimination do not change!

• Only dollar values are different…


Sub issues to third party a $100,000, 5-year, 8% bond on 1/1/20X1 for $96,110

Parent purchases 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

Effective Interest Bond Example: Facts


Effective Interest Bond Example: Amortization Tables

Date

Cash

Sub Int.

Sub Amort.

Sub Bal.

Par Int.

Par Amort.

Par Bal.

1/1/X1 8,000 96,110

12/31/X1 8,000 8,650 650 96,760

12/31/X2 8,000 8,708 708 97,468

12/31/X3 8,000 8,772 772 98,240 103,667

12/31/X4 8,000 8,842 842 99,082 6,620 1,780 101,887

12/31/X5 8,000 8,918 918 100,000 6113 1,887 100,000


Bonds Issued at Discount – Elimination entries at 12/31/X4

B Bond payable 100,000Discount on Bonds payable 918Invest. In Bonds 101,887*

Interest income 6,220Interest 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%


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


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


Cash Purchase: Example (continued)

D&D SchedulePrice paid 540,000Interest (80% $550,000) 440,000Excess 100,000Allocate to building (80% 25,000) (20,000) 10-yearAllocate to equipment (80% x 60,000) (48,000) 5-yearGoodwill 32,000


Cash Purchase: Example (continued)

To see cash flow impact, consider additions to parent balance sheet on purchase date:

Inventory 60,000Building 420,000Equipment 238,000Goodwill 32,000

Liabilities 150,000Cash (540,000 – 50,000 sub cash) 490,000NCI (20% 550,000) 110,000

Dr Cr


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


Non-Cash Purchase: Example

Balance Sheet of Company AcquiredCash 50,000 Liabilities 1500,000Inventory 60,000Building 190,000 Common Stock 200,000Equipment 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


Stock Issued for Sub: Example (continued)

D&D SchedulePrice paid (10,000 shares x $54) 540,000Interest (80% $550,000) 440,000Excess 100,000Allocate to building (80% 25,000) (20,000) 10-yearAllocate to equipment (80% x 60,000) (48,000) 5-yearGoodwill 32,000


Non-Cash Purchase: Example (continued)

To see cash flow impact, consider additions to parent balance sheet on purchase date:

Cash 50,000Inventory 60,000Building 420,000Equipment 238,000Goodwill 32,000Liabilities 150,000

Common Stock – Par 100,000Paid-in Capital in Excess of Par 440,000NCI (20% 550,000) 110,000

Dr Cr


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


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


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


Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution

Parent’s adjusted internally generated net income

+

Parent’s DEPS Income

adjustments

+

Parent- owned

equivalent shares

x

Subsidiary DEPS

= _______________________________________________

Consolidated

DEPS

Parent’s common outstanding stock

+ Parent’s share adjustments

Example on next slide


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


Consolidated Diluted EPS Calculation – Only Sub has Possible Dilution

Parent’s adjusted internally generated

net income

+

Parent’s DEPS

Income adjustments

+

Parent- owned

equivalent shares

x

Subsidiary DEPS

= _______________________________________________

Consolidated

DEPS

Parent’s common outstanding stock

+ Parent’s share adjustments

$22,000

-

$2,000

+

$3,000

= _________________________________________

$3.07

5,000 + 2,000 + 500

Sub’s DEPS

Consol DEPS

$40,000

+

$5,000

+

$18,574

= _________________________________________

$4.89

10,000 + 3,000


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.


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


Influential Investment: ExampleExcel purchases 25% of Flag’s Stock

D&D of Excess SchedulePrice paid $250,000Equity (25% $800,000) 200,000Excess of cost over book value 50,000Less Equipment with 5-year life 20,000Goodwill (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


Influential Investment:20X1 IDS to Calculate Investment Income

20X1 IDS for Flag

Truck. gain 4,000 Reported income60,000

Profit in Excel end. Inv. 12,000 Realized truck gain1,000

Adjusted Income45,000

Ownership interest (25%) 11,250

Less Equip amort.4,000

Investment income7,250


Influential Investment:20X2 IDS to Calculate Investment Income

20X2 IDS for Flag

Profit in Excel end. Inv. 18,000 Reported income70,000

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 income12,250


Influential Investment: Entries to Record Income & Dividends

20X1 Investment in Flag Company 7,250Investment Income 7,250

20X2 Investment in Flag Company 12,250Investment Income 12,250

(to record investment income)

20X2 Cash 12,250Investment in Flag Company 12,250

(to record dividends received)


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

CHAPTER Intercompany Bonds, Cash Flow, EPS, and Unconsolidated Investments Fundamentals of Advanced...

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