solution manual advanced financial accounting 8th edition baker chap008

8-1 CHAPTER 8 INTERCOMPANY INDEBTEDNESS ANSWERS TO QUESTIONS Q8-1 A gain or loss on bond retirement is reported by the consolidated entity whenever a one of the companies purchases it

8-1

CHAPTER 8 INTERCOMPANY INDEBTEDNESS

ANSWERS TO QUESTIONS

Q8-1 A gain or loss on bond retirement is reported by the consolidated entity whenever (a)

one of the companies purchases its own bonds from a nonaffiliate at an amount other than book value, or (b) a company within the consolidated entity purchases the bonds of an affiliate from a nonaffiliate at an amount other than book value

Q8-2 A constructive retirement occurs when the bonds of a company included in the

consolidated entity are purchased by another company included within the consolidated entity Although the debtor still considers the bonds as outstanding, and the investor views the bonds as an investment, they are constructively retired for consolidation purposes If bonds are actually retired, the debtor purchases its own bonds from a nonaffiliate and they are no longer outstanding

Q8-3 When bonds sold to an affiliate at par value are not eliminated, bonds payable and

bond investment are misstated in the balance sheet accounts and interest income and interest expense are misstated in the income statement accounts There is also a premium

or discount account to be eliminated when the bonds are not issued at par value Unless interest is paid at year-end, there is likely to be some amount of interest receivable and interest payable to be eliminated as well

Q8-4 Both the bond investment and interest income reported by the purchaser will be

improperly included Interest expense, bonds payable, and any premium or discount recorded on the books of the debtor also will be improperly included In addition, the constructive gain or loss on bond retirement will be omitted if no eliminating entries are recorded in connection with the purchase

Q8-5 If the focus is placed on the legal entity, only bonds actually reacquired by the debtor

will be treated as retired This treatment can lead to incorrect reports for the consolidated entity in two dimensions If a company were to repurchase bonds from an affiliate, any retirement gain or loss reported by the debtor is not a gain or loss to the economic entity and must be eliminated in preparing consolidated statements Moreover, although a purchase of debt of any of the other companies in the consolidated entity will not be recognized as a retirement by the debtor, when emphasis is placed on the economic entity the purchase must serve as a basis for recognition of a bond retirement for the consolidated entity

Q8-6 The difference in treatment is due to the effect of the transactions on the consolidated

entity In the case of land sold to another affiliate, a gain has been recorded that is not a gain from the viewpoint of the consolidated entity Thus, it must be eliminated in the consolidation process On the other hand, in a bond repurchase the buyer simply records an investment in bonds and the debtor makes no special entries because of the purchase by an affiliate Neither company records the effect of the transaction on the economic entity Thus, in the consolidation process an entry must be made to show the gain on bond retirement that has occurred from the viewpoint of the economic entity

Q8-7 When there has been a direct sale to an affiliate, the interest income recorded by the

purchaser should equal the interest expense recorded by the seller and the two items should have no net effect on reported income The eliminating entries do not change consolidated net income in this case, but they will result in a more appropriate statement of the relevant income and expense categories in the consolidated income statement

Q8-8 Whenever a loss on bond retirement has been reported in a prior period, the affiliate

that purchased the bonds paid more than the book value of the debt shown by the debtor As

a result, each period the interest income recorded by the buyer will be less than the interest expense reported by the debtor When the two income statement accounts are eliminated in the consolidation process, the effect will be to increase consolidated net income Because the full amount of the loss was recognized for consolidated purposes in the year in which the bonds were purchased by the affiliate, the effect of the elimination process in each of the periods that follow should be to increase consolidated income

Q8-9 The difference between the carrying value of the debt on the debtor's books and the

carrying value of the investment on the purchaser's books indicates the amount of unrecognized gain or loss at the end of the period To determine the amount of the gain or loss on retirement at the start of the period, the difference between interest income recorded

by the purchaser on the bond that has been purchased and interest expense recorded by the debtor during the period is added to the difference between carrying values at the end of the period

Q8-10 Interest income and interest expense must be eliminated and a loss on bond

retirement established in the elimination process Consolidated net income will decrease by the amount of the loss Because the loss is attributed to the subsidiary, income assigned to the controlling and noncontrolling interests will decrease in proportion to their share of common stock held

Q8-11 A constructive gain will be included in the consolidated income statement in this case

and both consolidated net income and income to the controlling interest will increase by the full amount of the gain

Q8-12 A direct placement of subsidiary bonds with the parent should have no effect on

consolidated income or on income assigned to the noncontrolling shareholders

Q8-13 When subsidiary bonds are purchased from a nonaffiliate by the parent and there is a

constructive gain or loss for consolidated purposes, the gain or loss is assigned to the subsidiary and included in computing income to the noncontrolling shareholders

Q8-14 Interest income recorded by the subsidiary and interest expense recorded by the

parent should be equal in the direct placement case When the subsidiary purchases parent company bonds from a nonaffiliate, interest income and interest expense will not be the same unless the bonds are purchased from the nonaffiliate at an amount equal to the liability reported by the parent

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Q8-15 A gain on constructive bond retirement recorded in a prior period means the bonds

were purchased for less than book value and the interest income recorded by the subsidiary each period will be greater than the interest expense recorded by the parent Consolidated net income for the current period will decrease by the difference between interest income and interest expense as these amounts are eliminated in preparing the consolidated statements Income to the noncontrolling interest will be unaffected since the constructive gain is assigned to parent company

Q8-16 A constructive loss recorded on the subsidiary's bonds in a prior period means the

interest income recorded by the parent is less than the interest expense recorded by the subsidiary in each of the following periods Consolidated net income will increase when interest income and expense are eliminated Income assigned to the noncontrolling interest will be based on the reported net income of the subsidiary plus the difference between interest income and interest expense each period following the retirement As a result, the amount assigned will be greater than if the bond had not been constructively retired

Q8-17 On the date the parent sells the bonds to a nonaffiliate they are issued for the first

time from a consolidated perspective While the parent will record a gain or loss on sale of the bonds on its books, none is recognized from a consolidated viewpoint The difference between the sale price received by the parent and par value is a premium or discount Each period there will be a need to establish the correct amount for the premium or discount account and to adjust interest expense recorded by the subsidiary to bring the reported amounts into conformity with the sale price to the nonaffiliate

Q8-18 The retirement gain or loss reported by the subsidiary when it repurchases the bonds

held by the parent must be eliminated in the consolidation process From the viewpoint of the consolidated entity the bonds were retired at the point they were purchased by the parent and a gain or loss should have been recognized at that point

SOLUTIONS TO CASES

C8-1 Recognition of Retirement Gains and Losses

a When Flood purchases the bonds it establishes an investment account on its books and Bradley establishes a bond liability and discount account on its books No entry is made by Century When Century purchases the bonds, Century records an investment and Flood removes the balance in the investment account and records a gain on the sale Bradley makes no entry When Bradley retires the issue, Bradley removes its liability and unamortized discount and records a loss on bond retirement Century removes the bond investment account and records a loss on the sale of bonds Flood makes no entry

b A constructive loss on bond retirement is reported by the consolidated entity at the time Century purchases the bonds from Flood The exact amount of the loss cannot be ascertained without knowing the maturity date of the bonds, the date of initial sale, and the date of purchase by Century

c The initial sale of bonds by Bradley is treated as a normal transaction with no need for an adjustment to income assigned to the noncontrolling shareholders Income assigned to noncontrolling shareholders will be reduced by a proportionate share of the loss reported in the consolidated income statement in the period in which Century purchases the bonds from Flood In the years before the bonds are retired by Bradley, income assigned to the noncontrolling interest (assuming no differential) will be greater than a pro rata portion of the reported net income of Bradley In the period in which the bonds are retired by Bradley, reported net income of Bradley must be adjusted to remove its loss on bond retirement before assigning income to the noncontrolling interest No adjustment is made in the years following the repurchase by Bradley

From: , Accounting Staff

Re: Consolidation of Joint Venture

Hydro Corporation and Rich Corner Bank established a joint venture which borrowed

$30,000,000 and built a new production facility That facility is now leased to Hydro on a 10 year operating lease Hydro currently reports the annual lease payment as an operating expense and in the notes to its financial statements must report a contingent liability for its guarantee of the debt of the joint venture I have been asked to review the current financial reporting standards and determine whether Hydro’s current reporting is appropriate

-The circumstances surrounding the creation of the joint venture and the lease arrangement with Hydro appear to point to the need for Hydro to consolidate the joint venture with its own operations Although Rich Corner Bank holds 100 percent of the equity of the joint venture, it has contributed less than 1 percent of the total assets of the joint venture ($200,000 of equity versus $30,000,000 of total borrowings) Under normal circumstances, less than a 10 percent investment in the entity’s total assets is considered insufficient to permit the entity to

finance its activities [FASB INT 46, Par 9]

In this situation, Hydro has guaranteed the $30,000,000 borrowed by the joint venture and has guaranteed a 20 percent annual return on the equity investment of Rich Corner Bank These conditions will result in Hydro Corporation absorbing any losses incurred by the joint venture and establish Hydro Corporation as the primary beneficiary of the entity The FASB requires consolidation by the entity that will absorb a majority of the entity’s expected losses

if they occur [FASB INT 46, Par 14]

Consolidation of the joint venture will result in including the production facility among Hydro’s assets and the debt as part of its long-term liabilities The claim on the net assets of the joint venture held by Rich Corner Bank will be reported as part of noncontrolling interest Hydro’s consolidated income statement will not include the lease payment as an operating expense, but will include depreciation expense on the production facility and interest expense for the interest payment made on the borrowing of the joint venture

Primary citation:

FASB INT 46

Case 8-3 Subsidiary Bond Holdings

MEMO

To: Financial Vice-President

Farflung Corporation

From: , Accounting Staff

Re: Investment in Bonds Issued by Subsidiary

The consolidated financial statements of Farflung Corporation should include both Micro Company and Eagle Corporation The purpose of the consolidated statements is to present the financial position and results of operations for a parent and one or more subsidiaries as if

the individual entities actually were a single company or entity [ARB 51, Par 1]

When one subsidiary purchases the bonds of another, the investment reported by the purchasing affiliate and the liability reported by the debtor must be eliminated and a gain or loss reported on the difference between the purchase price and the carrying value of the debt

at the time of purchase

In preparing Farflung’s consolidated statements at December 31, 20X4, the following eliminating entry should have been included in the workpaper:

The $24,000 loss should have been included in the consolidated income statement, leading

to a reduction of $15,600 ($24,000 x 65) in income assigned to the controlling interest and a reduction of $8,400 ($24,000 x 35) in income assigned to noncontrolling shareholders This error should be corrected by restating the financial statements of the consolidated entity for 20X4

While omission of the eliminating entry resulted in incorrect financial statements for the consolidated entity, it should have no impact on the financial statements of the individual subsidiaries Assuming (1) the bonds had 15 years remaining until maturity when purchased

by Eagle and pay 8 percent interest annually, (2) straight-line amortization of the premium paid by Eagle is appropriate, and (3) the consolidated financial statements as of December

31, 20X4, are corrected, the eliminating entry at December 31, 20X5, is:

8-7

C8-3 (continued)

C8-4 Interest Income and Expense

a Snerd apparently paid more than par value for the bonds and is amortizing the premium against interest income over the life of the bonds Thus, the cash received is greater than the amount of interest income recorded

b With the information given, the following appears to be true:

(1) When purchasing the bonds, Snerd apparently paid less than the current carrying amount of the bonds on the subsidiary’s books because a constructive gain on bond retirement is included in the 20X3 consolidated income statement Since Snerd paid par value for the bonds, they must have been sold at a premium by the subsidiary

(2) Because the bonds were sold at a premium, interest expense recorded by the subsidiary will be less than the annual interest payment made to the parent

(3) Interest income recorded each period by Snerd will exceed interest expense recorded by the subsidiary When the two balances are eliminated, the effect will be to reduce income to both the controlling and noncontrolling shareholders

C8-5 Intercompany Debt

Answers to this case can be found in the SEC Form 10-K filed by Hershey Foods and its annual report

a When intercompany loans are made between affiliates in different countries, the problem

of changing currency exchange rates may arise, especially if any of the loans are denominated in a currency that rapidly changes in value against the dollar Hershey Foods and many other companies in the same situation hedge their intercompany receivables/payables through foreign currency forward contracts and swaps

b Hershey's intercompany receivables/payables appear to come primarily from intercompany purchases and sales of goods

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SOLUTIONS TO EXERCISES

E8-1 Bond Sale from Parent to Subsidiary

a Journal entries recorded by Humbolt Corporation:

b Journal entries recorded by Lamar Corporation:

c Eliminating entries, December 31, 20X2:

E8-2 Computation of Transfer Price

a $105,000 = $100,000 par value + ($250 x 20 periods) premium

c Eliminating entries, December 31, 20X4:

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E8-4 Evaluation of Intercorporate Bond Holdings

a The bonds were originally sold at a discount Stellar purchased the bonds at par value and a constructive loss was reported

b The annual interest payment received by Stellar will be less than the interest expense recorded by the subsidiary When bonds are sold at a discount, the issue price of the bonds is adjusted downward because the annual interest payment is less than is needed to issue the bonds at par value

c In 20X6, consolidated net income was decreased as a result of the loss on constructive retirement of bonds Each period following the purchase, the amount of interest expense recorded by the subsidiary will exceed the interest income recorded by the parent When these two amounts are eliminated, consolidated net income will be increased Thus, consolidated net income for 20X7 will be increased

E8-5 Multiple-Choice Questions

1 a A constructive gain of $100,000 is included in consolidated net income for the period

ended March 31, 20X8, and consolidated retained earnings at March 31, 20X8 Because the bonds of the parent are constructively retired, there is no effect on the amounts assigned to the noncontrolling interest [AICPA Adapted]

2 a The loss on bond retirement will result in a reduction in consolidated retained

earnings [AICPA Adapted]

3 b $4,700 = ($50,000 x 10) - ($3,000 / 10 years)

4 a $4,000 = ($50,000 x 10) - ($8,000 / 8 years)

5 c $5,600 loss = $58,000 purchase price

- [$53,000 - ($3,000 / 10 years) x 2 years]

E8-6 Multiple-Choice Questions

1 a $14,000 = [($300,000 x 09) - ($60,000 / 10 years)]

x ($200,000 / $300,000)

2 c $12,000 = [$120,000 - ($20,000 / 10 years) x 2 years] - $104,000

Unrecognized portion of gain

on bond retirement ($12,000 - $1,500) 10,500

$40,500 Proportion of stock held by

E8-7 Constructive Retirement at End of Year

a Eliminating entries, December 31, 20X5:

$9,000 = [($400,000 x 1.03) - $400,000] x 15/20

$12,000 = $9,000 + $400,000 - $397,000

b Eliminating entries, December 31, 20X6:

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E8-8 Constructive Retirement at Beginning of Year

a Eliminating entries, December 31, 20X5:

b Eliminating entries, December 31, 20X6:

E8-9 Retirement of Bonds Sold at a Discount

Elimination of bond investment at December 31, 20X8:

Eliminate intercorporate bond holdings:

Computation of book value of liability at constructive retirement

Amortization of discount

[($300,000 - $291,0000) / 20 years] x 7 years 3,150

E8-10 Loss on Constructive Retirement

Eliminating entries, December 31, 20X8:

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E8-11 Determining the Amount of Retirement Gain or Loss

Amortization of bond premium

Less: Interest on bond purchased by Online Enterprises

[($18,000 x 1/2) x (4 months / 12 months)] (3,000) Interest expense included in consolidated

Amortization of premium [($15,000 / 5) x 2 2/3 years] (8,000)

c Eliminating entries, December 31, 20X3:

E8-12 Evaluation of Bond Retirement

a No gain or loss will be reported by Bundle

b A gain of $13,000 will be reported:

Book value of liability reported by Bundle:

Unamortized premium

c Consolidated net income for 20X6 will increase by $12,000:

Adjustment for excess of interest income

over interest expense:

d Eliminating entries, December 31, 20X6:

Eliminate intercorporate bond holdings:

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E8-12 (continued)

e Eliminating entries, December 31, 20X7:

Eliminate intercompany receivable/payable

f Income assigned to noncontrolling interest in 20X7 is $14,400:

Adjustment for excess of interest income

over interest expense:

E8-13 Elimination of Intercorporate Bond Holdings

a Eliminating entries, December 31, 20X8:

Eliminate intercompany receivable/payable

b Income assigned to noncontrolling interest in 20X8 is $6,580:

Adjustment for excess of interest expense

over interest income:

c Eliminating entries, December 31, 20X9:

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SOLUTIONS TO PROBLEMS

P8-14 Consolidation Workpaper with Sale of Bonds to Subsidiary

a Entries recorded by Porter on its investment in Temple:

Record dividends from Temple:

$10,000 x 60

Record equity-method income:

P8-14 (continued)

d Eliminating entries, December 31, 20X2:

Eliminate income from subsidiary

Assign income to noncontrolling interest:

$12,000 = $30,000 x 40

Eliminate beginning investment balance:

$90,000 = $102,000 - $12,000 $60,000 = ($100,000 + $50,000) x 40

8-21

P8-14 (continued)

Consolidation Workpaper December 31, 20X2

Porter Temple Eliminations Consol- Item Co Corp Debit Credit idated

(2) 4,000 (40,000) Retained Earnings, Dec 31,

P8-15 Consolidation Workpaper with Sale of Bonds to Parent

a Entries recorded by Mega Corporation on its investment in Tarp Company:

Record dividends from Temple:

$20,000 x 90

Record equity-method income:

$25,000 x 90

b Entry recorded by Mega Corporation on its investment in Tarp Company bonds:

Record interest payment:

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P8-15 (continued)

d Eliminating entries, December 31, 20X4:

Eliminate income from subsidiary

Assign income to noncontrolling interest:

$2,500 = $25,000 x 10

Eliminate beginning investment balance:

$117,000 = $121,500 - $4,500 $13,000 = ($80,000 + $50,000) x 10

P8-15 (continued)

Consolidation Workpaper December 31, 20X4

Item Corp Co Debit Credit idated

(2) 2,000 (30,000) Retained Earnings, Dec 31,

8-25

P8-16 Direct Sale of Bonds to Parent

a Journal entries recorded by Fern Corporation:

Record dividends for Vincent:

$7,000 = $10,000 x 70

Interest Receivable (Current Receivables) 2,000

Accrue interest income at year-end

Record equity-method income:

$21,000 = $30,000 x 70

Record amortization of differential:

P8-16 (continued)

December 31, 20X3

Accrue interest expense at year-end

c Elimination entries, December 31, 20X3:

Eliminate income from subsidiary

Assign income to noncontrolling interest:

$7,800 = [$30,000 – ($56,000 / 14 years)] x 30

Eliminate intercorporate bond holdings:

$46,500 = $45,000 + ($250 x 6 periods) $3,500 = $7,000 / 2

Eliminate intercompany receivable/payable

Eliminate profit on intercompany sale of land

8-27

P8-16 (continued)

Consolidation Workpaper December 31, 20X3 Fern Vincent Eliminations Consol- Item Corp Company Debit Credit idated

Retained Earnings, Jan 1 244,400 100,000 (3)100,000

P8-17 Information Provided in Eliminating Entry

a Rupp Corporation is the parent company In the eliminating entry, noncontrolling interest is credited with a portion of the constructive gain on bond retirement

b Rupp holds 75 percent ownership of Gross [$4,200 / ($4,200 + $1,400)]

c Amount paid to acquire bonds:

Amortization of discount following purchase

d A gain of $7,700 was reported:

Book value of liability reported by Gross:

Unamortized premium

$8,000 - [($8,000 / 10 years) x 4.5 years] 4,400

e Consolidated net income for 20X7 after adjustment for bond retirement:

Adjustment for excess of interest income

over interest expense:

(1,400)

f Income assigned to the noncontrolling interest will decrease by $350

($1,400 x 25) as a result of the eliminating entry

g Eliminating entry prepared at December 31, 20X8:

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a Amount paid by Amazing Corporation for bonds:

Amortization of premium during 20X6

Eliminate intercorporate bond holdings:

$6,300 = $102,800 - [$97,000 - ($3,000 / 6 years)]

$102,800 = computed above $3,500 = [$3,000 + ($3,000 / 6 years)]

e Consolidated net Income and income to controlling

interest for 20X5 and 20X6:

20X5 20X6

Adjustment for excess of interest expense

($9,500) over interest income ($8,600) 900

Income to noncontrolling interest:

a Purchase price of bonds:

Balance reported in bond investment account in excess of par value, December 31, 20X4

b Carrying amount of liability on date of purchase:

c Income to noncontrolling interest in 20X5:

Adjustment for excess of interest expense

$ 30,500 Proportion of stock held by noncontrolling interest x .30

Excess of interest expense over interest income Interest expense:

($100,000 x 12) - ($10,000 / 10) $11,000 Interest income:

($100,000 x 12) – ($10,500 / 7) (10,500)

8-31

a Eliminating entries, December 31, 20X4:

Eliminate balance in investment account

Proportion of stock held by

Gain assigned to noncontrolling

Interest Receivable (Cash and