Solution manual advanced accounting 9e by hoyle ch06

Even after the year of retirement, all intercompany accounts must be eliminated again in each subsequent consolidation; however, the beginning retained earnings of the parent company is

CHAPTER 6 INTERCOMPANY DEBT, CONSOLIDATED STATEMENT OF

CASH FLOWS AND OTHER ISSUES

Chapter Outline

I Variable interest entities (VIEs)

A VIEs typically take the form of a trust, partnership, joint venture, or corporation In most cases a sponsoring firm creates these entities to engage in a limited and well-defined set

of business activities For example, a business may create a VIE to finance the acquisition

of a large asset The VIE purchases the asset using debt and equity financing, and then leases the asset back to the sponsoring firm If their activities are strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their sponsoring firms As a result, such arrangements can allow financing at lower interest rates than would otherwise be available to the sponsor

B Control of VIEs, by design, often does not rest with its equity holders Instead, control is exercised through contractual arrangements with the sponsoring firm who becomes the

"primary beneficiary" of the entity These contracts can take the form of leases, participation rights, guarantees, or other residual interests Through contracting, the primary beneficiary bears a majority of the risks and receives a majority of the rewards of the entity, often without owning any voting shares

C An entity whose control rests a primary beneficiary is referred to by FASB Interpretation

46R "Consolidation of Variable Interest Entities," (FIN 46R) as a variable interest entity

The following characteristics indicate a controlling financial interest in a variable interest entity

1 The direct or indirect ability to make decisions about the entity's activities

2 The obligation to absorb the expected losses of the entity if they occur,

3 The right to receive the expected residual returns of the entity if they occur

The primary beneficiary bears the risks and receives the rewards of a variable interest entity and is considered to have a controlling financial interest

D FIN 46R reasons that if a "business enterprise has a controlling financial interest in a

variable interest entity, assets, liabilities, and results of the activities of the variable interest entity should be included with those of the business enterprise." Therefore, primary beneficiaries must include their variable interest entities in their consolidated financial

statements consistent with the provisions of SFAS 141R

II Intercompany debt transactions

A No real consolidation problem is created when one member of a business combination loans money to another The resulting receivable/payable accounts as well as the interest

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income expense balances are identical and can be directly offset in the consolidation process

B The acquisition of an affiliate's debt instrument from an outside party does require special handling so that consolidated financial statements can be produced

1 Because the acquisition price will usually differ from the book value of the liability, a gain or loss has been created which is not recorded within the individual records of either company

2 Because of the amortization of any associated discounts and/or premiums, the interest income being reported by the buyer will not correspond with the interest expense of the debtor

C In the year of acquisition, all intercompany accounts (the liability, the receivable, interest income, and interest expense) are eliminated within the consolidation process while the gain or loss (which produced all of the discrepancies because of the initial difference) is recognized

1 Although several alternatives exist, this textbook assigns all income effects resulting from the retirement to the parent company, the party ultimately responsible for the decision to reacquire the debt

2 Any noncontrolling interest is, therefore, not affected by the adjustments utilized to consolidate intercompany debt

D Even after the year of retirement, all intercompany accounts must be eliminated again in each subsequent consolidation; however, the beginning retained earnings of the parent company is adjusted rather than a gain or loss account

1 The change in retained earnings is needed because a gain or loss was created in a prior year by the retirement of the debt, but only interest income and interest expense were recognized by the two parties

2 The amount of the change made to retained earnings at any point in time is the original gain or loss adjusted for the subsequent amortization of discounts or premiums

III Subsidiary preferred stock

A Subsidiary preferred shares not owned by the parent are a component of the noncontrolling interest

B In an acquisition, the fair value of any subsidiary preferred shares not acquired by the parent is added to any consideration transferred along with the fair value of the noncontrolling interest in common shares to compute the acquisition-date fair value of the subsidiary

IV Consolidated statement of cash flows

A Statement is produced from consolidated balance sheet and income statement and not from the separate cash flow statements of the component companies

B Intercompany cash transfers are omitted from this statement because they do not occur with an outside, unrelated party

C The "Noncontrolling Interest's Share of the Subsidiary's Income'' is not included as a cash flow although any dividends paid to these outside owners is reported as a financing activity

V Consolidated earnings per share

A This computation normally follows the pattern described in intermediate accounting textbooks For basic EPS, consolidated net income is divided by the weighted-average number of parent shares outstanding If convertibles (such as bonds or warrants) exist for the parent shares, their weight must be included in computing diluted EPS but only if earnings per share is reduced

1 The subsidiary's diluted earnings per share are computed first to arrive at (1) an earnings figure and (2) a shares figure

2 The portion of the shares figure belonging to the parent is computed That percentage

of the subsidiary's diluted earnings is then added to the parent's income in order to complete the earnings per share computation

VI Subsidiary stock transactions

A If the subsidiary issues new shares of stock or reacquires its own shares as treasury stock, a change is created in the book value underlying the parent's investment account The increase or decrease should be reflected by the parent as an adjustment to this balance

B The book value of the subsidiary that corresponds to the parent's ownership is measured before and after the transaction with any alteration recorded directly to the investment account The parent's additional paid-in capital (or retained earnings) account is normally adjusted although the recognition of a gain or loss is an alternate accounting treatment

C Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the parent's investment account In addition, any subsidiary treasury stock is eliminated within the consolidation process

5 Discuss the various theories as to the appropriate allocation of any income effect created by intercompany debt transactions and identify the assignment employed in this textbook (and the rationale for its use)

6 Understand that subsidiary preferred stocks not owned by the parent are initially valued in consolidated financial reports as noncontrolling interest at acquisition-date fair value

7 Prepare a consolidated statement of cash flows

8 Compute basic and diluted earnings per share for a business combination in which the subsidiary has dilutive convertible securities

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9 Identify subsidiary stock transactions that can impact the underlying book value figure recorded within the parent's Investment account

10 Calculate the effect that a subsidiary stock transaction has on the parent's investment balance and make the required journal entry to record that impact

Answer to Discussion Question

Who Lost the $300,000?

This case is designed to give life to a theoretical accounting issue discussed within the chapter: If

a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case attempts to illustrate that no clear-cut solution to this question can be found This lack of an absolute answer makes financial accounting both intriguing and frustrating Interesting class discussion can be generated from this issue

Students should note that the decision as to assignment only becomes necessary because of the presence of the noncontrolling interest Regardless of the level of ownership all intercompany balances are simply eliminated on the worksheet with the gain or loss being recognized Not until the time that the noncontrolling interest computations are made does the identity of the specific party become important

All financial and operating decisions are assumed to be made in the best interest of the business entity as a whole This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision Thus, a strong argument can be made against any assignment to either separate party

Students should be required to pick one method and justify its use Discussion usually centers

on the following issues:

 Parent company officials made the actual choice that created the loss Therefore, assigning the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong party In effect, the subsidiary had nothing to do with this transaction (as indicated in the case)

so that its financial records should not be affected by the $300,000 loss

 The debt was that of the subsidiary Because the subsidiary's debt is being retired, all of the

$300,000 should be attributed to that party Financial records measure the results of

transactions and the retirement simply culminates an earlier transaction made by the

subsidiary The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case) If the subsidiary had acquired its own debt, for example, no question as

to the assignment would have existed Thus, changing that assignment simply because the parent was forced to be the acquirer is not justified

 Both parties were involved in the transaction so that some allocation of the loss is required If,

at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would have been amortized to interest expense (if the debt had not been retired) Thus, the

$300,000 loss was accepted now in place of the later amortization This reasoning then assigns this portion of the loss to the subsidiary Because the parent was forced to pay more than face value, that remaining portion is assigned to the buyer

Answers to Questions

1 A variable interest entity (VIE) is a business structure that is designed to accomplish a specific purpose A VIE can take the form of a trust, partnership, joint venture, or corporation although typically it has neither independent management nor employees The entity is frequently sponsored by another firm to achieve favorable financing rates

2 Variable interests are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity's net asset value Variable interests will absorb portions of a variable interest entity's expected losses if they occur or receive portions of the entity's expected residual returns if they occur Variable interests typically are accompanied by contractual arrangements that provide decision making power to the owner of the variable interests Examples of variable interests include debt guarantees, lease residual value guarantees, participation rights, and other financial interests

3 The following characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE

 The direct or indirect ability to make decisions about the entity's activities

 The obligation to absorb the expected losses of the entity if they occur, or

 The right to receive the expected residual returns of the entity if they occur

4 Because the bonds were purchased from an outside party, the acquisition price is likely to differ from the book value of the debt as found on the subsidiary's records This difference creates accounting problems in handling the intercompany transaction From a consolidated perspective, the debt has been retired; a gain or loss should be reported with no further

interest being recorded In reality, each company will continue to maintain these bonds on

their individual financial records Also, because discounts and/or premiums are likely to be present, both of these account balances as well as the interest income/expense will change from period to period because of amortization For reporting purposes, all individual accounts must be eliminated with the gain or loss being reported so that the events are shown from the vantage point of the consolidated entity

5 If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be equal in amount The debt and the receivable will be in agreement so that no gain or loss is

created Interest income and interest expense should also reflect identical amounts

Therefore, the consolidation process for this type of intercompany debt requires no more than the offsetting of the various reciprocal balances

6 The gain or loss to be reported is the difference between the price paid and the book value of the debt on the date of acquisition For consolidation purposes, this gain or loss should be recognized immediately on the date of acquisition

7 Because the bonds are still legally outstanding, they will continue to be found on both sets of financial records Thus, each account (Bonds Payable, Investment in Bonds, Interest Expense, and Interest Income) must be eliminated within the consolidation process Any gain

or loss on the retirement as well as later effects on interest caused by amortization are also included to arrive at an adjustment to the beginning retained earnings of the parent company

8 The original gain is never recognized within the financial records of either company Thus, within the consolidation process for the year of acquisition, the gain is directly recorded

whereas (for each subsequent year) it is entered as an adjustment to beginning retained earnings In addition, because the book value of the debt and the investment are not in

agreement, the interest expense and interest income balances being recorded by the two

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companies will differ each year because of the amortization process This amortization effectively reduces the difference between the individual retained earnings balances and the total that is appropriate for the consolidated entity Consequently, a smaller change is needed each period to arrive at the balance to be reported For this reason, the annual adjustment to beginning retained earnings gradually decreases over the life of the bond

9 No set rule exists for assigning the income effects that result from intercompany debt transactions although several different theories have been put forth over the years which include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss between the two parties in some manner This textbook attributes the entire income effect (the $45,000 gain in this case) to the parent company Assignment to the parent is justified because that party is ultimately responsible for the decision being made to retire the debt The answer to the discussion question included in this chapter analyzes this question in more detail

10 Subsidiary outstanding preferred shares are part of the noncontrolling interest and are included in the consolidated financial statements at acquisition-date fair value and subsequently adjusted for their share of subsidiary income and dividends

11 The consolidated statement of cash flows is developed from the information found in the consolidated balance sheet and income statement Thus, the cash flows generated by operating, investing, and financing activities are identified only after the consolidation of these other statements

12 The noncontrolling interest share of the subsidiary’s income is a component of consolidated

net income Consolidated net income then is adjusted for noncash and other items to arrive at

consolidated cash flows from operations Any dividends paid by the subsidiary to these outside owners are listed as a financing activity of the business combination because an actual cash outflow is created

13 An alternative to the normal diluted earnings per share calculation is required whenever the subsidiary has dilutive convertible securities such as bonds or warrants In this case, the potential impact of the conversion of subsidiary shares must be factored into the overall diluted earnings per share computation

14 Basic Earnings per Share The existence of subsidiary convertible securities does not affect

consolidated basic EPS Consolidated basic earnings per share is computed by dividing consolidated net income by the weighted average number of parent shares outstanding

Diluted Earnings per Share The subsidiary's diluted earnings per share is computed by

including both convertible items The portion of the parent's controlled shares to the total shares used in this calculation is then determined Only this percentage (of the income figure used in the subsidiary's computation) is added to the parent's income in arriving at the diluted earnings per share for the business combination

15 Several reasons could exist for a subsidiary to issue new shares of stock to outside parties Clearly, additional financing is brought into the company by any such sale Also, stock issuance may be used to entice new individuals to join the organization Additional management personnel, as an example, might be attracted to the company in this manner The company could also be forced to sell shares because of government regulation Many countries require some degree of local ownership as a prerequisite for operating within that country

16 Because the new stock was issued at a price above book value, the book value per share of Metcalf's stock has been increased Consequently, the book value of Washburn's investment should be increased to reflect this change To measure the effect, the underlying book value

of Washburn's investment is calculated both before and after the new issuance Because the increment is the result of a stock transaction, an increase is made to additional paid-in capital although recording a gain or loss is currently allowed Although the subsidiary's shares (both new and old) are eliminated in the consolidation process, the increase in the parent's APIC (or gain or loss) does carry into the consolidated figures In addition, the percentage of the subsidiary attributed to the noncontrolling interest will have increased

17 A stock dividend does not alter the book value of the subsidiary company and, thus, creates

no effect on Washburn's investment account or on the consolidated figures Hence, no entry

is recorded at all by the parent company in connection with the subsidiary's stock dividend

7 C Cash Flow from Financing Activities:

Dividends to parent’s interest ($12,000) Dividends to noncontrolling interest (20%  $5,000) (1,000) Reduction in long-term notes payable (25,000) Cash Flow from Financing Activities ($38,000)

8 C

9 C

10 C Rodgers' Reported Balance $200,000

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Ferdinal's reported balance 80,000 Eliminate interest expense—intercompany 21,000 Eliminate interest income—intercompany (22,000) Recognize gain on retirement of debt ($212,000 – $199,000) 13,000 Consolidated net income $292,000

11 B Eliminate interest expense—intercompany $21,000

Eliminate interest income—intercompany (18,000) Recognize loss on retirement of debt ($206,000 – $189,000) (17,000) Reduction in retained earnings, 1/1/10 $(14,000)

12 B Ace reported income $400,000

Remove intercompany dividends (cost method) (7,000) $393,000 Byrd reported income 100,000 Gain on extinguishment of debt ($48,300 – $46,600) 1,700 Eliminate interest expense on "retired" debt

($48,300 x 10%) 4,830 Eliminate interest income on "retired" debt

($46,600 x 12%) (5,592) Consolidated net income $493,938

13 D 30% of Byrd's reported income of $100,000; the intercompany debt

transaction is attributed solely to the parent company

14 A For 2010, the adjustment to beginning retained earnings should recognize

the gain on the retirement of the debt, the elimination of the 2009 interest expense, and the elimination of the 2009 interest income

Gain on Retirement of Bond

Original book value $10,600,000 2006–2008 amortization ($600,000 ÷ 20 yrs x 3 yrs.) (90,000) Book value, January 1, 2009 $10,510,000 Percentage of bonds retired 40% Book value of retired bonds $4,204,000 Cash received ($4,000,000 x 96.6%) 3,864,000 Gain on retirement of bonds $340,000

Interest Expense on Intercompany Debt—2009

Cash interest expense (9% x $4,000,000) $360,000 Premium amortization ($30,000 per year total x 40%

retired portion of bonds) (12,000) Interest expense on intercompany debt $348,000

Interest Income on Intercompany Debt—2009

Cash interest income (9% x $4,000,000) $360,000 Discount amortization ($136,000 ÷ 17 yrs.) 8,000 Interest income on intercompany debt $368,000

Adjustment to 1/1/10 Retained Earnings

Recognition of 2009 gain on extinguishment of debt (above) $340,000 Elimination of 2009 intercompany interest expense (above) 348,000 Elimination of 2009 intercompany interest income (above) (368,000) Increase in retained earnings, 1/1/10 $320,000

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15 D Consideration transferred for preferred stock $424,000

Consideration transferred for common stock 3,960,000 Noncontrolling interest fair value for preferred 1,696,000 Noncontrolling interest fair value for common 400,000 Acquisition-date fair value 6,480,000 Acquisition-date book value (6,000,000) Goodwill $480,000

16 C Consideration transferred for preferred stock $106,000

Consideration transferred for common stock 916,400 Noncontrolling interest fair value for common 580,000 Acquisition-date fair value $1,602,400 Acquisition-date book value (1,500,000) Excess fair value $102,400

to building 50,000

to goodwill $52,400

17 A Parent’s reported sales $300,000

Subsidiary's reported sales 200,000 Less: intercompany transfers (40,000) Sales to outsiders $460,000 Eliminate increase in receivables (less cash collected) (30,000) Cash generated by sales $430,000

18 B Book value of subsidiary prior to issuing new shares

(12,000 x $40) $480,000 Parent's ownership 100% Book value acquired $480,000

Book value of subsidiary after issuing new shares (above

value plus 3,000 shares at $50 each) $630,000 Parent's ownership (12,000 ÷ 15,000 shares) 80% Book value acquired $504,000

Investment in Nestlum increases by $24,000 ($504,000 less $480,000)

19 A Because the parent acquired 80 percent of the new shares, its proportion of

ownership has remained the same Because the purchase price will

necessarily equal 80 percent of the increase in the subsidiary's book value,

no separate adjustment by the parent is required

20 C Adjusted book value of subsidiary ($795,000 + $150,000) $945,000

Current parent ownership (32,000 shs ÷ 50,000 shs.) 64% Book value acquired $604,800 Book value acquired currently recorded in parent's invest-

ment account ($795,000 x 80%) 636,000

Required adjustment—decrease $(31,200)

21 D Adjusted book value of subsidiary ($795,000 – $192,000) $603,000

Current parent ownership (32,000 shs ÷ 32,000 shs.) 100% Book value equivalency of parent's ownership $603,000 Book value equivalency currently recorded in parent's invest-

ment account ($795,000 x 80%) 636,000 Required adjustment—decrease $(33,000)

22 (10 minutes) (Qualification of Primary Beneficiary of a VIE)

Consolidation of a variable interest entity is required if a parent has a

variable interest that will

 Absorb a majority of the entity's expected losses if they occur

 Receive a majority of the entity's expected residual returns if they occur

Because (1) HCO Media’s losses are limited by contract, and (2) Hillsborough has the right to receive the residual benefits of the sales generated on the HCO Media internet site above $500,000, Hillsborough should consolidate HCO Media

23 (40 minutes) (VIE Qualifications for Consolidation)

a The purpose of consolidated financial statements is to present the financial position and results of operations of a group of businesses as if they were a single entity They are designed to provide information useful for making business and economic decisions—especially assessing amounts, timing, and uncertainty of prospective cash flows Consolidated statements also provide more complete information about the resources, obligations, risks, and opportunities of an enterprise than separate statements

b According to FIN 46R, an entity qualifies as a VIE and is subject to

consolidation if either of the following conditions exist

 The total equity at risk is not sufficient to permit the entity to finance its

activities without additional subordinated financial support from other parties In most cases, if equity at risk is less than 10% of total assets, the risk is deemed insufficient

 The equity investors in the VIE lack any one of the following three

characteristics of a controlling financial interest

1 The direct or indirect ability to make decisions about an entity's

activities through voting rights or similar rights

2 The obligation to absorb the expected losses of the entity if they occur (e.g., another firm may guarantee a return to the equity investors)

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 Absorb a majority of the entity's expected losses if they occur

 Receive a majority of the entity's expected residual returns if they occur

Also, a direct or indirect ability to make decisions that significantly affect the results of the activities of a variable interest entity is a strong indication that

an enterprise has one or both of the characteristics that would require

consolidation of the variable interest entity

c Risks of the construction project that has TecPC has effectively shifted to the owners of the VIE

 At the end of the 1st five-year lease term, if the parent opts to sell the

facility, and the proceeds are insufficient to repay the VIE investors, TecPC may be required to pay up to 85% of the project's cost Thus, a potential 15% risk

 During construction 11.1% of project cost potential termination loss

Risks that remain with TecPC

 Guarantees of return to VIE investors at market rate, if facility does not

perform as expected TecPC is still obligated to pay market rates

 If lease is not renewed, TecPC must either purchase the facility or sell it

on behalf of the VIE with a guarantee of Investors' (debt and equity)

balances representing a risk of decline in market value of asset

 Debt guarantees

d TecPC possesses the following characteristics of a primary beneficiary Direct decision-making ability (end of five-year lease term)

 Absorb a majority of the entity's expected losses if they occur (via debt

guarantees and guaranteed lease payments and residual value)

 Receive a majority of the entity's expected residual returns if they occur

(via use of the facility and potential increase in its market value)

24 (10 minutes) (Consolidation of variable interest entity.)

a Implied valuation and excess allocation for Softplus

Noncontrolling interest fair value $ 60,000

Consideration transferred by Pantech 20,000

Excess net asset value fair value $20,000

The $20,000 excess net asset fair value is recognized by PanTech as a bargain purchase All SoftPlus’ assets and liabilities are recognized at their individual fair values

-0-

b Implied valuation and excess valuation for Softplus

Noncontrolling interest fair value 60,000

Consideration transferred by Pantech 20,000

Fair value of VIE net identifiable assets 60,000

When the business fair value of a VIE (that is a business) is greater than assessed asset values, all identifiable assets and liabilities are reported at fair values (unless a previously held interest) and the difference is treated

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25 (25 Minutes) (Consolidation entry for three consecutive years to report

effects of intercompany bond acquisition Straight-line method used.)

a Book Value of Bonds Payable, January 1, 2009

Book value, January 1, 2007 $1,050,000 Amortization—2007–2008 ($5,000 per year

[$50,000 premium ÷ 10 years] for two years) 10,000 Book value of bonds payable, January 1, 2009 $1,040,000 Book value of 40% of bonds payable

(intercompany portion), January 1, 2009 $416,000

Gain on Retirement of Bonds, January 1, 2009

Purchase price ($400,000 x 96%) $384,000 Book value of liability (computed above) 416,000 Gain on retirement of bonds $32,000

Book Value of Bonds Payable, December 31, 2009

Book value, January 1, 2009 (computed above) $1,040,000 Amortization for 2009 5,000 Book value of bonds payable, December 31, 2009 $1,035,000 Book value of 40% of bonds payable (intercompany portion),

December 31, 2009 $414,000

Book Value of Investment, December 31, 2009

Book value of investment, January 1, 2009 (purchase price) $384,000 Amortization for 2009 ($16,000 discount ÷ 8-yr rem life) 2,000 Book value of investment, December 31, 2009 $386,000

Intercompany Interest Balances for 2009

Interest expense:

Cash payment ($400,000 x 9%) $36,000 Amortization of premium for 2009 ($5,000 per year

multiplied by 40% intercompany portion) 2,000 Intercompany interest expense $34,000

Interest income:

Cash collection ($400,000 x 9%) $36,000 Amortization of discount for 2009 (above) 2,000 Intercompany interest income $38,000

25 (continued)

b In 2010, because straight-line amortization is used, the interest accounts remain unchanged at $38,000 and $34,000 However, the premium

associated with the bond payable as well as the discount on the

investment are affected by the $2,000 per year amortization In addition, the gain now has to be included as a component of beginning retained earnings Concurrently, the two interest balances recorded by the

individual companies in 2009 are removed from retained earnings

because they resulted after the intercompany retirement Gain of $32,000 plus $34,000 expense removal less $38,000 income elimination gives

$28,000 increase in retained earnings

c As with part b, new premium and discount balances must be determined and then removed The adjustment made to retained earnings takes into account that another year of interest expense ($34,000) and income

($38,000) have been closed into this equity account by the separate

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26 (12 Minutes) (Determine consolidated income statement accounts after

acquisition of intercompany bonds.)

 Interest Expense To Be Eliminated = $84,000 x 11% = $9,240

 Interest Income To Be Eliminated = $108,000 x 8% = $8,640

 Loss To Be Recognized = $108,000 – $84,000 = $24,000

CONSOLIDATED TOTALS

 Revenues and Interest Income = $1,051,360 (add the two book values and

eliminate interest income on intercompany bond)

 Operating and Interest Expense = $751,760 (add the two book values and

eliminate interest expense on intercompany bond)

 Other Gains and Losses = $152,000 (add the two book values)

 Loss on Retirement of Debt = $24,000 (computed above)

 Net Income = $427,600 (consolidated revenues, interest income, and

gains less consolidated operating and interest expense and losses)

27 (30 Minutes) (Consolidation entry for two years to report effects of

intercompany bond acquisition Effective rate method applied.)

a Loss on Repurchase of Bond

Cost of acquisition $121,655 Book value ($668,778 x 1/8) 83,597 Loss on repurchase $38,058

Interest Balances for 2009

Interest income:

$121,655 x 6% $7,299

Interest expense:

$83,597 (book value [above]) x 10% $8,360

Investment Balance, December 31, 2009

Original cost, 1/1/09 $121,655 Amortization of premium:

Cash interest ($100,000 x 8%) $8,000 Effective interest income (above) 7,299 701 Investment, 12/31/09 $120,954

27 (continued)

Bonds Payable Balance, December 31, 2009

Book value, 1/1/09 (above) $83,597 Amortization of discount:

Cash interest ($100,000 x 8%) $8,000 Effective interest expense (above) 8,360 360 Bonds payable, 12/31/09 $83,957

Entry B—12/31/09

Bonds Payable 83,957 Interest Income 7,299 Loss on Retirement of Debt 38,058 Investment in Bonds 120,954 Interest Expense 8,360 (To eliminate intercompany debt holdings and recognize loss on retirement.)

b Interest Balances for 2010

Interest income: $120,954 (investment

balance for the year) x 6% $7,257

Interest expense: $83,957 (liability balance

for the year) x 10% $8,396

Investment Balance, December 31, 2010

Book value, January 1, 2010 (part a) $120,954 Amortization of premium:

Cash interest ($100,000 x 8%) $8,000

Effective interest income (above) 7,257 743 Investment balance, December 31, 2010 $120,211

Bonds Payable Balance, December 31, 2010

Book value, January 1, 2010 (part a) $83,957 Amortization of discount:

Cash interest ($100,000 x 8%) $8,000

Effective interest expense (above) 8,396 396 Bonds payable balance,

December 31, 2010 $84,353

Interest Balances for 2011

Interest income: $120,211 (investment $7,213 balance for the year [above]) x 6%

Interest expense: $84,353 (liability balance

for the year [above]) x 10% $8,435

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27 (continued)

Investment Balance, December 31, 2011

Book value, January 1, 2011 (above) $120,211 Amortization of premium:

Cash interest ($100,000 x 8%) $8,000

Effective interest income (above) 7,213 787 Investment balance, December 31, 2011 $119,424

Bonds Payable Balance, December 31, 2011

Book value, January 1, 2011 (above) $84,353 Amortization of discount:

Cash interest ($100,000 x 8%) $8,000

Effective interest expense (above) 8,435 435 Bonds payable balance,

December 31, 2011 $84,788

Adjustment Needed to Retained Earnings, January 1, 2011

Loss on retirement of debt (part a) $38,058 Balances currently in retained earnings:

Interest income: 2009 ($7,299)

2010 (7,257) ($14,556) Interest expense: 2009 $8,360

28 (35 Minutes) (Consolidation procedures and balances related to intercompany bonds Both straight-line and effective interest rate methods are used.)

a Acquisition price of bonds $283,550 Book value of bonds payable (see Schedule 1)

($443,497 x 50%) (221,749) Loss on retirement $61,801

SCHEDULE 1—Book Value of Bonds Payable

Effective

Date Value (12% Rate) Interest Amortization Book Value

Effective interest income ($283,550 x 8%) 22,684

Amortization 2,316 Investment in Bloom bonds, 12/31/10 $281,234

Although not required, the consolidation entry as of 12/31/10 is as follows The reduction in retained earnings represents the loss only; no intercompany

interest was recognized in the previous year because the purchase was made

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28 continued

c Loss on Retirement of Bond

Because Bloom uses the straight-line method of amortization, the loss on retirement must be computed again

Original issue price—1/1/07 $435,763 Discount amortization (2007–2009) ([$64,237 ÷ 11] x 3 years) 17,519 Book value 12/31/09 $453,282

Intercompany portion of bonds payable (50%) $226,641 Purchase price 283,550 Loss on retirement $56,909

Investment in Bloom Bonds

Purchase price—12/31/09 $283,550 Premium amortization (2010) ($33,550 ÷ 8) (4,194) Book value 12/31/10 $279,356

Interest Income

Cash interest ($250,000 x 10%) $25,000 Premium amortization (above) (4,194) Intercompany interest income—2010 $20,806

Bonds Payable

Original issue price 1/1/07 $435,763 Discount amortization (2007–2010) [($64,237 ÷ 11) x 4 years] 23,359 Book value 12/31/10 $459,122 Opus ownership 50% Intercompany portion—12/31/10 $229,561

Interest Expense

Cash interest ($250,000 x 10%) $25,000 Discount amortization ([$64,237 ÷ 11] x 1/2) 2,920 Intercompany interest expense—2010 $27,920 The reduction in retained earnings represents the loss only; no intercompany interest was recognized in the previous year because the purchase was made

29 (8 Minutes) (Determine goodwill for a purchase in which subsidiary has both common stock and preferred stock)

Consideration transferred for common stock $1,600,000

Consideration transferred for preferred stock 630,000

Noncontrolling interest in common stock 400,000

Noncontrolling interest in preferred stock 270,000

Hepner’s acquisition-date fair value $2,900,000

30 (30 Minutes) (Consolidation entries for a purchase where subsidiary has

outstanding cumulative preferred stock.)

a The preferred shares are entitled to the specified cumulative dividend Thus, the noncontrolling interest's share of the subsidiary's income equals $160,000 or 8 percent of the preferred stock's par value

b Acquisition-Date Fair Value Allocation and Amortization

Consideration transferred $14,040,000 Noncontrolling interest fair value (preferred shares) 2,000,000 Acquisition-date fair value of Smith 16,040,000 Book value (16,000,000) Franchises $40,000 Period of amortization 40 years Annual amortization $1,000

Investment in Smith Account, December 31, 2009

Consideration transferred, January 1, 2009 $14,040,000 Equity accrual (income remaining for common stock

after preferred stock dividend) 290,000 Dividends collected ($360,000 total less $160,000

paid to preferred shareholders) (200,000) Amortization for 2009 (above) (1,000) Investment in Smith account, December 31, 2009 $14,129,000

c Consolidation Entries

Entry S and A combined

Preferred Stock (Smith) 2,000,000

Common Stock (Smith) 4,000,000

Retained Earnings, 1/1/09 (Smith) 10,000,000

Franchises 40,000

Investment in Smith 14,040,000 Noncontrolling Interest in Smith, Inc 2,000,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009

(To eliminate subsidiary stockholders’ equity, record excess fair values, and record outside ownership of subsidiary's preferred stock at fair value)

30 c (continued)

Entry I Equity Income of Subsidiary 285,000

Investment in Smith 285,000 (To eliminate equity accrual made in connection with common stock

[$290,000] along with excess amortization recorded by parent.)

Entry D Investment in Smith 200,000

Dividends Paid 200,000 (To remove intercompany dividend payments made on common stock [see computation above].)

Entry E Amortization Expense 1,000

Franchises 1,000 (To recognize amortization of franchises for current year [see computation above].)

31 (30 Minutes) (Prepare consolidation entries for a purchase where subsidiary has outstanding preferred stock)

Consideration transferred for common stock $ 7,368,000

Consideration transferred for preferred stock 3,100,000

Noncontrolling interest in common stock 4,912,000

Acquisition-date fair value for Young $15,380,000

to building (5-year life) $200,000

to equipment (10-year life) (100,000) 100,000

CONSOLIDATION ENTRIES

Entries S and A combined

Preferred Stock (Young) 1,000,000

Common Stock (Young) 4,000,000

Retained Earnings (Young) 10,000,000

Brand name 280,000

Building 200,000

Equipment 100,000 Investment in Young's Preferred Stock (100%) 3,100,000 Investment in Young's Common Stock (60%) 7,368,000 Noncontrolling interest 4,912,000

(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred stock at acquisition-date fair value)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009

31 (continued)

Entry I1

Dividend Income 80,000

Dividends Paid 80,000 (To offset intercompany preferred stock dividend payments recognized as income by parent—$1,000,000 par value x 8% dividend rate.)

Entry I2

Dividend Income 192,000

Dividends Paid 192,000 (To eliminate intercompany dividend payments [60% of $320,000] on

common stock Because the $320,000 in dividends remaining after Entry I1 equals exactly 8 percent of the common stock par value, the participation factor does not affect the distribution.)

Entry E

Amortization Expense 44,000

Equipment 10,000

Building 40,000 Brand name 14,000 (To record 2009 amortization of specific accounts

recognized within acquisition price of preferred stock.)

32 (15 Minutes) (The effect that various events have on a consolidated statement of cash flows.)

 Sale of building The $44,000 in cash received from the sale is listed as a

cash inflow within the company's investing activities If the company is using the direct approach in presenting cash flows from operations, the

$12,000 gain is merely omitted However, if the indirect approach is in use, the gain (a positive) must be eliminated from net income by a subtraction

 Intercompany inventory transfers Because these transactions do not occur

with any parties outside of the business combination, they are not reflected

in the consolidated statement of cash flows

 Dividend paid by the subsidiary The $27,000 payment to the parent is

eliminated in consolidated statements and is not a cash outflow from the consolidated entity The remaining $3,000 payment to the noncontrolling interest is reported as a cash outflow from a financing activity

 Amortization of intangible asset This $16,000 noncash expense appears in

the consolidated income statement If the combined companies are using the direct approach to present cash flows from operations, this expense is

omitted If the indirect approach is used, the expense must be removed from consolidated net income by an addition

 Decrease in accounts payable Cash payments have been used to reduce

this liability balance during the period If the direct approach is used to

present cash flows from operations, the change is added to cost of goods sold as one step in deriving the cash paid during the period for inventory (an outflow) If the indirect approach is applied, the decrease is subtracted from net income in arriving at the net cash generated from operations during the period

33 (20 Minutes) (Determine cash flows from operations for a consolidated entity.)

NOTE–CORRECTION TO PROBLEM: The noncontrolling interest’s share of the

subsidiary’s income is $9,800 (not $12,000 as listed on page 285 of text)

DIRECT APPROACH

Cash revenues (add book values, eliminate intercompany transfers,

and add decrease in accounts receivable) $648,000 Cash inventory purchases (add book values, eliminate

intercompany transfers, eliminate unrealized gains, add increase in

inventory, and add decrease in accounts payable) (370,000) Depreciation and amortization (omit as noncash expenses) -0- Other expenses (add book values) (40,000) Gain on sale of equipment (omit because this is an investing activity) -0- Equity in earnings of Wallace (not an operating cash flow) -0-

Cash generated from operations $238,000

Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below:

Revenues (add book values and subtract intercompany transfers) $640,000 Cost of goods sold (add book values, less intercompany

transfers and beginning unrealized gain, plus ending

unrealized gain) (353,000) Depreciation and amortization (add book values plus

amortization from excess fair value allocations) (61,000)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009

Other expenses (add book value) (40,000) Gain on sale of equipment 30,000 Consolidated net income $216,000

34 (30 Minutes) (Compute basic and diluted earnings per share for a business combination.)

(Note: This question may require students to review earnings per share

fundamentals analyzed in intermediate accounting.)

The following computations assume that Parent acquired its interest in Sub's bonds directly from Sub Therefore, no gain or loss was created and interest income will exactly offset interest expense

BASIC EARNINGS PER SHARE—BUSINESS COMBINATION

CONSOLIDATED NET INCOME

- Parent's reported income $150,000

- Sub's reported income 130,000

- Amortization expense (10,000)

Consolidated net income $270,000

Parent shares outstanding 60,000

Basic earnings per share ($270,000 ÷ 60,000) $4.50

FULLY DILUTED EARNINGS PER SHARE—SUBSIDIARY

saved net of taxes) $154,000

Sub's shares assuming conversion of Sub's bonds

(30,000 + 12,000) 42,000

Diluted earnings per share

(154,000 ÷ 42,000) $3.67 (rounded) Because diluted earnings per share is below basic earnings per share, the convertible bonds have a dilutive impact on the computation and should be included

PARENT'S SHARE OF SUBSIDIARY'S DILUTED EARNINGS

Total shares used in computation above 42,000

Parent's ownership (30,000 plus 20% of 12,000) 32,400

Parent's portion of shares (32,400 ÷ 42,000) 77% (rounded) Sub's earnings used in diluted computation

(above) $154,000

Parent's portion of shares 77%

Earnings attributed to business combination $118,580