Solution manual advanced financial accounting, 8th edition by baker chap008

CHAPTER 8 INTERCOMPANY INDEBTEDNESS ANSWERS TO QUESTIONSQ8-1 A gain or loss on bond retirement is reported by the consolidated entity whenever a one of the companies purchases its own bo

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 thanbook value, or (b) a company within the consolidated entity purchases the bonds of anaffiliate 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 consolidatedentity Although the debtor still considers the bonds as outstanding, and the investor viewsthe bonds as an investment, they are constructively retired for consolidation purposes Ifbonds are actually retired, the debtor purchases its own bonds from a nonaffiliate and theyare 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 andinterest expense are misstated in the income statement accounts There is also a premium ordiscount account to be eliminated when the bonds are not issued at par value Unlessinterest is paid at year-end, there is likely to be some amount of interest receivable andinterest 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 discountrecorded on the books of the debtor also will be improperly included In addition, theconstructive gain or loss on bond retirement will be omitted if no eliminating entries arerecorded 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 consolidatedentity in two dimensions If a company were to repurchase bonds from an affiliate, anyretirement gain or loss reported by the debtor is not a gain or loss to the economic entity andmust be eliminated in preparing consolidated statements Moreover, although a purchase ofdebt of any of the other companies in the consolidated entity will not be recognized as aretirement by the debtor, when emphasis is placed on the economic entity the purchase mustserve 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 gainfrom the viewpoint of the consolidated entity Thus, it must be eliminated in the consolidationprocess On the other hand, in a bond repurchase the buyer simply records an investment inbonds 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 theconsolidation process an entry must be made to show the gain on bond retirement that hasoccurred from the viewpoint of the economic entity

8-1

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 shouldhave no net effect on reported income The eliminating entries do not change consolidatednet income in this case, but they will result in a more appropriate statement of the relevantincome 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 interestexpense reported by the debtor When the two income statement accounts are eliminated inthe consolidation process, the effect will be to increase consolidated net income Becausethe full amount of the loss was recognized for consolidated purposes in the year in which thebonds were purchased by the affiliate, the effect of the elimination process in each of theperiods 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 ofunrecognized gain or loss at the end of the period To determine the amount of the gain orloss 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 thedebtor during the period is added to the difference between carrying values at the end of theperiod

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 bythe amount of the loss Because the loss is attributed to the subsidiary, income assigned tothe controlling and noncontrolling interests will decrease in proportion to their share ofcommon 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 thefull 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 thesubsidiary 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 parentcompany bonds from a nonaffiliate, interest income and interest expense will not be thesame unless the bonds are purchased from the nonaffiliate at an amount equal to the liabilityreported by the parent

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 subsidiaryeach period will be greater than the interest expense recorded by the parent Consolidatednet income for the current period will decrease by the difference between interest income andinterest expense as these amounts are eliminated in preparing the consolidated statements.Income to the noncontrolling interest will be unaffected since the constructive gain isassigned 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 thesubsidiary in each of the following periods Consolidated net income will increase wheninterest income and expense are eliminated Income assigned to the noncontrolling interestwill be based on the reported net income of the subsidiary plus the difference betweeninterest income and interest expense each period following the retirement As a result, theamount 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 ofthe bonds on its books, none is recognized from a consolidated viewpoint The differencebetween the sale price received by the parent and par value is a premium or discount Eachperiod there will be a need to establish the correct amount for the premium or discountaccount and to adjust interest expense recorded by the subsidiary to bring the reportedamounts 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 theconsolidated entity the bonds were retired at the point they were purchased by the parentand a gain or loss should have been recognized at that point

8-3

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 andBradley establishes a bond liability and discount account on its books No entry is made byCentury When Century purchases the bonds, Century records an investment and Floodremoves the balance in the investment account and records a gain on the sale Bradleymakes no entry When Bradley retires the issue, Bradley removes its liability andunamortized discount and records a loss on bond retirement Century removes the bondinvestment 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 timeCentury purchases the bonds from Flood The exact amount of the loss cannot beascertained without knowing the maturity date of the bonds, the date of initial sale, and thedate of purchase by Century

c The initial sale of bonds by Bradley is treated as a normal transaction with no need for anadjustment to income assigned to the noncontrolling shareholders Income assigned tononcontrolling shareholders will be reduced by a proportionate share of the loss reported inthe consolidated income statement in the period in which Century purchases the bonds fromFlood In the years before the bonds are retired by Bradley, income assigned to thenoncontrolling interest (assuming no differential) will be greater than a pro rata portion of thereported 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 retirementbefore assigning income to the noncontrolling interest No adjustment is made in the yearsfollowing the repurchase by Bradley

C8-2 Borrowing by Variable Interest Entities

MEMO

To: President

Hydro Corporation

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 year operating lease Hydro currently reports the annual lease payment as an operatingexpense and in the notes to its financial statements must report a contingent liability for itsguarantee of the debt of the joint venture I have been asked to review the current financialreporting standards and determine whether Hydro’s current reporting is appropriate

10-The circumstances surrounding the creation of the joint venture and the lease arrangementwith Hydro appear to point to the need for Hydro to consolidate the joint venture with its ownoperations Although Rich Corner Bank holds 100 percent of the equity of the joint venture, ithas contributed less than 1 percent of the total assets of the joint venture ($200,000 of equityversus $30,000,000 of total borrowings) Under normal circumstances, less than a 10percent 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 andhas 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 jointventure and establish Hydro Corporation as the primary beneficiary of the entity The FASBrequires 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’sassets and the debt as part of its long-term liabilities The claim on the net assets of the jointventure held by Rich Corner Bank will be reported as part of noncontrolling interest Hydro’sconsolidated 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 theinterest payment made on the borrowing of the joint venture

Primary citation:

FASB INT 46

8-5

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 MicroCompany and Eagle Corporation The purpose of the consolidated statements is to presentthe 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 thepurchasing affiliate and the liability reported by the debtor must be eliminated and a gain orloss 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 followingeliminating 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 areduction of $8,400 ($24,000 x 35) in income assigned to noncontrolling shareholders Thiserror should be corrected by restating the financial statements of the consolidated entity for20X4

While omission of the eliminating entry resulted in incorrect financial statements for theconsolidated entity, it should have no impact on the financial statements of the individualsubsidiaries 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 premiumpaid 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:

C8-3 (continued)

C8-4 Interest Income and Expense

a Snerd apparently paid more than par value for the bonds and is amortizing the premiumagainst interest income over the life of the bonds Thus, the cash received is greater than theamount 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 carryingamount of the bonds on the subsidiary’s books because a constructive gain on bondretirement is included in the 20X3 consolidated income statement Since Snerd paid parvalue 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 thesubsidiary will be less than the annual interest payment made to the parent

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

8-7

C8-5 Intercompany Debt

Answers to this case can be found in the SEC Form 10-K filed by Hershey Foods and itsannual 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 aredenominated in a currency that rapidly changes in value against the dollar Hershey Foodsand many other companies in the same situation hedge their intercompanyreceivables/payables through foreign currency forward contracts and swaps

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

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:

Investment in Lamar Corporation Bonds 155,400

Eliminate intercorporate bond holdings

Eliminate intercompany receivable/payable

8-9

E8-2 Computation of Transfer Price

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

c Eliminating entries, December 31, 20X4:

E8-4 Evaluation of Intercorporate Bond Holdings

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

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

c In 20X6, consolidated net income was decreased as a result of the loss on constructiveretirement of bonds Each period following the purchase, the amount of interest expenserecorded 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 theamounts 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]

6 c Operating income of Kruse Corporation $40,000

Net income of Gary's Ice Cream Parlors 20,000

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

3 b Net income of Solar Corporation $30,000

Unrecognized portion of gain

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

$40,500Proportion of stock held by

noncontrolling interest x 20

Income to noncontrolling interest $ 8,100

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:

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:

Loss on Constructive Bond Retirement 2,730

Investment in Farley Corporation Bonds 297,120

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 3,150Book value of liability at January 1, 20X8 $294,150

E8-10 Loss on Constructive Retirement

Eliminating entries, December 31, 20X8:

Investment in Apple Corporation Bonds 106,000

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:

8-15

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

$8,000 - [($8,000 / 10 years) x 3.5 years] 5,200

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

Adjustment for excess of interest income

over interest expense:

Interest expense 10,600 (1,000)Increase in consolidated net income $ 12,000

d Eliminating entries, December 31, 20X6:

Investment in Bundle Company Bonds 192,800

Eliminate intercorporate bond holdings:

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:

Interest expense 21,200 (2,000)

Proportion of ownership held x .30 Income assigned to noncontrolling interest 14,400 $

8-17

E8-13 Elimination of Intercorporate Bond Holdings

a Eliminating entries, December 31, 20X8:

Constructive Loss on Bond Retirement 1,400

Investment in Stang Corporation Bonds 104,200

Eliminate intercompany receivable/payable

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

Adjustment for excess of interest expense

over interest income:

Interest income (11,300) 200

Proportion of ownership held x .35 Income assigned to noncontrolling interest 6,580 $

c Eliminating entries, December 31, 20X9:

SOLUTIONS TO PROBLEMS

P8-14 Consolidation Workpaper with Sale of Bonds to Subsidiary

a Entries recorded by Porter on its investment in Temple:

Investment in Temple Corporation Stock 6,000 Record dividends from Temple:

$10,000 x 60Investment in Temple Corporation Stock 18,000

Record equity-method income:

P8-14 (continued)

d Eliminating entries, December 31, 20X2:

Investment in Temple Corporation Stock 90,000

Eliminate beginning investment balance:

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

P8-14 (continued)

Consolidation WorkpaperDecember 31, 20X2Porter Temple Eliminations Consol- Item Co Corp Debit Credit idated

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

carry forward 277,200 70,000 86,000 16,000 277,200 Cash and Accounts

8-21

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 90Investment in Tarp Company Stock 22,500

Record equity-method income:

$25,000 x 90

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

Record interest payment:

P8-15 (continued)

d Eliminating entries, December 31, 20X4:

Eliminate income from subsidiary

E(2) Income to Noncontrolling Interest 2,500

Assign income to noncontrolling interest:

$2,500 = $25,000 x 10

Investment in Tarp Company Stock 117,000

Eliminate beginning investment balance:

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

8-23

P8-15 (continued)

Consolidation WorkpaperDecember 31, 20X4Mega Tarp Eliminations Consol- Item Corp Co Debit Credit idated

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

P8-16 Direct Sale of Bonds to Parent

a Journal entries recorded by Fern Corporation:

Investment in Vincent Company Stock 7,000 Record dividends for Vincent:

$7,000 = $10,000 x 70Interest Receivable (Current Receivables) 2,000Investment in Vincent Company Bonds 250

Accrue interest income at year-end

Investment in Vincent Company Stock 21,000

Record equity-method income:

$21,000 = $30,000 x 70

Investment in Vincent Company Stock 2,800 Record amortization of differential:

P8-16 (continued)

December 31, 20X3

Interest Payable (Current Liabilities) 4,000 Accrue interest expense at year-end

c Elimination entries, December 31, 20X3:

Eliminate intercorporate bond holdings:

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

E(6) Interest Payable (Current Liabilities) 2,000

Interest Receivable (Current Receivables) 2,000 Eliminate intercompany receivable/payable

Land, Buildings and Equipment (net) 8,000 Eliminate profit on intercompany sale of land

P8-16 (continued)

Consolidation WorkpaperDecember 31, 20X3Fern Vincent Eliminations Consol- Item Corp Company Debit Credit idated

carry forward 281,600 120,000 140,100 14,500 276,000 Cash and Current

Land, Buildings and

Equipment (net) 320,000 180,000 (4) 44,000 (7) 8,000 536,000 Discount on Bonds

8-27

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:

Investment in Gross bonds, December 31, 20X7 $198,200 Amortization of discount following purchase

[($200,000 - $198,200) / 3 years] x 2.5 years (1,500)

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:

P8-18 Prior Retirement of Bonds

a Amount paid by Amazing Corporation for bonds:

Amortization of premium during 20X6

Investment in Broadway Company Bonds 102,800

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 Operating income reported by Amazing $120,000 $150,000

Adjustment for excess of interest expense

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

Income to noncontrolling interest:

($80,000 + $900) x 15 (12,135)

8-29

P8-19 Incomplete Data

a Purchase price of bonds:

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

Amount amortized per year ($9,000 / 6 years) 1,500

b Carrying amount of liability on date of purchase:

Amount amortized per year ($6,000 / 6 years) 1,000

Carrying amount of liability, January 1, 20X4 $107,000

c Income to noncontrolling interest in 20X5:

Adjustment for excess of interest expense over interest income recorded in 20X5 500

$ 30,500Proportion of stock held by noncontrolling interest x 30Income assigned to noncontrolling interest $ 9,150Excess of interest expense over interest income

Interest expense:

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

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

P8-20 Balance Sheet Eliminations

a Eliminating entries, December 31, 20X4:

E(1) Common Stock — Stang Brewing Company 100,000

Investment in Stang Brewing Stock 216,000

Eliminate balance in investment account

interest (10,500 x 20) $ 2,100 E(5) Interest Payable (Accounts Payable) 4,000

Interest Receivable (Cash and

8-31