CHAPTER
5
Intercompany Bonds, Cash
Flow, EPS, and
Unconsolidated Investments
Fundamentals of Advanced Accounting
1st Edition
Fischer, Taylor, and Cheng
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
Chapter 5, Slide #2
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #3
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Bond Issued at Face Value Example: Facts
Sub (80%) issues to third parties $100,000, 5year, 8% bond on 1/1/20X1 at 100.
 Int. Exp. = $8,000 per year
Parent 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
Chapter 5, Slide #4
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #5
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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
Interest receivable
8,000
(eliminates intercompany accrued interest)
Chapter 5, Slide #6
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
8,000
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
Chapter 5, Slide #7
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Bond Example: Carrying Values
Parent buys 12/31/X3
Date
1/1/X1
12/31/X1
12/31/X2
12/31/X3
12/31/X4
12/31/X5
Sub’s Parent’s
Debt
Asset
96,110
96,888
97,666
98,444 103,600
99,222 101,800
100,000 100,000
$98,444 less $103,600 results in a $5,156 loss.
Chapter 5, Slide #8
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Bond Issued at a Discount Example:
Journal Entries (Years 4–5)
Sub Journal Entries
Year 4
Int. Exp.
8,778
Discount on BP
Cash
Year 5
Int. Exp.
8,778
Discount on BP
Cash
Parent Journal Entries
Year 4
Bond Invest.
Cash
103,600
103,600
778
8,000
Cash.
8,000
Bond investment
Int. Rev.
1,800
6,200
778
8,000
Year 5
Cash
8,000
Bond investment
Int. Rev.
1,800
6,200
Chapter 5, Slide #9
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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%
Chapter 5, Slide #10
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Worksheet 5-3: Eliminations (12/31/X4)
Bonds Issued at a Discount
Investment in bonds
Bonds payable
Discount on bond pay.
Interest expense
Interest revenue
RE - Co. S
RE - Co. P
Trial Balances
Co. P
Co. S
101,800
(100,000)
778
8,778
(6,200)
110,000
160,000
B
B
B
B
Eliminations
Dr
Cr
B
101,800
100,000
B
778
B
8,778
6,200
516
4,640
•Bonds issued at a discount/premium does not change
consolidation entries.
•Bonds issued at a discount/premium does require additional
calculations.
Chapter 5, Slide #11
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Effective Interest Method
• Procedures for elimination do not
change!
• Only dollar values are different…
Chapter 5, Slide #12
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Effective Interest Bond Example: Facts
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
Chapter 5, Slide #13
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Effective Interest Bond Example:
Amortization Tables
Date
1/1/X1
Cash
8,000
Sub
Int.
Sub
Amort.
Sub
Bal.
96,110
Par
Int.
Par
Amort.
Par
Bal.
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
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
103,667
Chapter 5, Slide #14
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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%
Chapter 5, Slide #15
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #16
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #17
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Cash Purchase: Example (continued)
D&D Schedule
Price paid
Interest (80%  $550,000)
Excess
Allocate to building (80%  25,000)
Allocate to equipment (80% x 60,000)
Goodwill
540,000
440,000
100,000
(20,000)
(48,000)
32,000
Chapter 5, Slide #18
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
10-year
5-year
Cash Purchase: Example (continued)
To see cash flow impact, consider additions to
parent balance sheet on purchase date:
Dr
Cr
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
Chapter 5, Slide #19
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #20
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Non-Cash Purchase: Example
Cash
Inventory
Building
Equipment
Total
Balance Sheet of Company Acquired
50,000
Liabilities
60,000
190,000
Common Stock
400,000
Retained Earnings
700,000
Total
1500,000
200,000
350,000
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
Chapter 5, Slide #21
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Stock Issued for Sub: Example (continued)
D&D Schedule
Price paid (10,000 shares x $54)
Interest (80%  $550,000)
Excess
Allocate to building (80%  25,000)
Allocate to equipment (80% x 60,000)
Goodwill
540,000
440,000
100,000
(20,000)
(48,000)
32,000
Chapter 5, Slide #22
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
10-year
5-year
Non-Cash Purchase: Example (continued)
To see cash flow impact, consider additions to parent
balance sheet on purchase date:
Dr
Cr
Cash
50,000
Inventory
60,000
Building
420,000
Equipment
238,000
Goodwill
32,000
Liabilities
Common Stock – Par
Paid-in Capital in Excess of Par
NCI (20%  550,000)
Chapter 5, Slide #23
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
150,000
100,000
440,000
110,000
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
Common Stock issued,
Liabilities assumed
Non-controlling Interest
Chapter 5, Slide #24
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
$800,000
540,000
150,000
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
Chapter 5, Slide #25
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #26
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Consolidated Diluted EPS Calculation –
Only Sub has Possible Dilution
Consolidated
DEPS
Parent’s
adjusted
internally
Parent’s DEPS
generated +
Income
+
net income
adjustments
Parentowned x
equivalent
Subsidiary
shares
DEPS
= _______________________________________________
Parent’s common
+
Parent’s share
outstanding stock
adjustments
Example on next slide
Chapter 5, Slide #27
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Consolidated Diluted EPS Calculation –
Only Sub has Possible Dilution Example
Subsidiary financial information:
•Net Income (adjusted for interco profits)
•Pref. stock cash dividend
•Interest paid on convertible bonds
•Common stock shares outstanding
•Warrants to purchase one share of common stock
• Warrants held by parent
•Convertible bonds outstanding (conv. to 10 shares cs)
• Convertible bonds held by parent
$22,000
$2,000
$3,000
5,000
1,000
500
200
180
Parent financial information:
•Parent owns 80% of sub
•Net income (internal, adjusted)
•Interest paid on convertible shares
•Common shares outstanding
•Bonds outstanding can convert to shares
$40,000
$5,000
10,000
3,000
Chapter 5, Slide #28
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Consolidated Diluted EPS Calculation –
Only Sub has Possible Dilution
Parent’s
Consolidated
adjusted
DEPS
internally
Parent’s
Parentgenerated +
DEPS
+
owned x
net
Income
equivalent
Subsidiary
income
adjustments
shares
DEPS
= _______________________________________________
Parent’s common
+
Parent’s share
outstanding stock
adjustments
Sub’s
DEPS
Consol
DEPS
$3.07
$22,000 $2,000
+
$3,000
= _________________________________________
5,000
+
2,000
+
500
$4.89
$40,000 +
$5,000
+
$18,574
= _________________________________________
10,000
+
3,000
Chapter 5, Slide #29
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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.
Chapter 5, Slide #30
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #31
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Influential Investment: Example
Excel purchases 25% of Flag’s Stock
D&D of Excess Schedule
Price paid
Equity (25%  $800,000)
Excess of cost over book value
Less Equipment with 5-year life
Goodwill (not amortized)
•
•
•
•
•
$250,000
200,000
50,000
20,000
$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
Chapter 5, Slide #32
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Influential Investment:
20X1 IDS to Calculate Investment Income
20X1 IDS for Flag
Truck. gain
Profit in Excel end. Inv.
4,000
12,000
Reported income
Realized truck gain
Adjusted Income
60,000
1,000
45,000
Ownership interest (25%) 11,250
Less Equip amort.
4,000
Investment income
7,250
Chapter 5, Slide #33
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Influential Investment:
20X2 IDS to Calculate Investment Income
20X2 IDS for Flag
Profit in Excel end. Inv.
18,000
Reported income
Profit in Excel beg. Inv.
70,000
12,000
Realized truck gain
Adjusted Income
1,000
65,000
Ownership interest (25%) 16,250
Less Equip amort.
4,000
Investment income
12,250
Chapter 5, Slide #34
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Influential Investment:
Entries to Record Income & Dividends
20X1 Investment in Flag Company
Investment Income
20X2 Investment in Flag Company
Investment Income
7,250
7,250
12,250
12,250
(to record investment income)
20X2 Cash
12,250
Investment in Flag Company
12,250
(to record dividends received)
Chapter 5, Slide #35
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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 5, Slide #36
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.