Solution manual advanced accounting 11th edition joe ben hoyle chap006

CHAPTER 6 VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT, CONSOLIDATED CASH FLOWS, AND OTHER ISSUESChapter OutlineI.. However, when the parent uses the equity method, the parent’s Investm

CHAPTER 6 VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT, CONSOLIDATED CASH FLOWS, AND OTHER ISSUESChapter 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, sometimes 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 with a primary beneficiary is addressed by FASB ASC subtopic 810-10 Variable Interest Entities The following characteristics indicate a controlling financial interest in a variable interest entity.

1 The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

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

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 If a reporting entity has a controlling financial interest in a variable interest entity, it should include the assets, liabilities, and results of the activities of the variable interest entity its consolidated financial statements.

Proposed Accounting Standards Update on Variable Interest Entities

In November 2011, the FASB issued a proposed change for evaluating whether an entity must consolidate a VIE The proposed accounting standard update, entitled Principal versus Agent Analysis, would introduce a separate qualitative analysis to determine whether a reporting entity with the authority to make economic decisions for a VIE uses its power in a principal or agent capacity If the decision making party is a principal (rather than an agent of another party) then it is the controlling party Alternatively, if the party that exercises decision-making power acts in the capacity of an agent, under the proposed guidance that party would not consolidate the VIE As this latest FASB proposal

demonstrates, the manner in which control is assessed continues to evolve over time.

II Intra-entity debt transactions

A No special difficulty is created when one member of a business combination loans money

to another The resulting receivable/payable accounts as well as the interest 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 reported by the buyer will not equal the interest expense of the debtor.

C In the year of acquisition, the consolidation process eliminates intra-entity accounts (the liability, the receivable, interest income, and interest expense) 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 intra-entity debt.

D Even after the year of retirement, all intra-entity accounts must be eliminated again in each subsequent consolidation However, when the parent uses the equity method, the parent’s Investment in Subsidiary account is adjusted in consolidation rather than a gain

or loss account If the parent employs a non-equity method, then the parent’s Retained Earnings are adjusted for the prior years’ income net effects of the effective gain/loss on retirement.

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 adjustment 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 part of noncontrolling interest

B The fair value of any subsidiary preferred shares not acquired by the parent is added to the 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 Intra-entity 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 Dividends paid by the subsidiary to these outside owners are 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.

Answer to Discussion Question: Who Lost this $300,000?

This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case illustrates that there is no clear-cut solution This lack of an absolute answer makes financial accounting both intriguing and frustrating

The assignment decision is only necessary in the presence of a noncontrolling interest Regardless of the ownership level all intra-entity balances are eliminated on the worksheet with a gain or loss recognized Not until the consolidated net income is allocated across the controlling interest and the noncontrolling interest does the assignment decision have an impact.

We assume that financial and operating decisions are 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, an argument can be made against any assignment to either separate party.

Students should choose and justify one method Discussion often centers on the following:

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

so that its share of consolidated net income 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 agreed 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 agreed 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 power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

 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 in the subsidiary's records This difference creates accounting problems in handling the intra-entity transaction From a consolidated perspective, the debt is retired; a gain or loss is reported with no further interest being recorded In reality,

each company continues to maintain these bonds on their individual financial records Also,

because discounts and/or premiums are likely to be present, 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 intra-entity 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 (or the Investment account if the equity method is used) 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 (or the Investment account if the equity method is used) 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 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 (or the Investment account if the equity method is used) gradually decreases over the life of the bond.

9 No set rule exists for assigning the income effects from intra-entity debt transactions although several different theories exist and 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 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 cash flow statement is developed from consolidated balance sheet and income statement figures 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 because an actual cash outflow occurs.

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

basic EPS The parent’s basic earnings per share is computed by dividing the parent’s share

of 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 parent company’s diluted earnings per share.

15 Several reasons could exist for a subsidiary to issue new shares of stock to outside parties First, 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 the subsidiary’s assigned consolidation value, the overall valuation for Metcalf's stock has been increased Consequently, the Washburn's investment is increased to reflect this change To measure the effect, the value of Washburn's investment is calculated both before and after the new issue Because the increment is the result of a stock transaction, an increase is made to additional paid-in capital 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) carries into the consolidated figures Also, the noncontrolling interest percentage of the subsidiary increases.

17 A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates

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

is recorded 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 Post-issue subsidiary valuation ($800,000 + $250,000) $1,050,000

Arcola’s new ownership percentage (40,000 ÷ 50,000) 80%

10 D Jordan’s income from own operations $200,000

Fey's income 80,000 Eliminate intra-entity interest income (21,000) Eliminate intra-entity interest expense 22,000 Recognize retirement gain on debt ($212,000 – $199,000) 13,000 Consolidated net income $294,000

11 B Mattoon’s share of consolidated net income $465,000

12 B Ace net income $400,000

Less intra-entity dividends (initial value method) (7,000) $393,000 Byrd reported income 100,000

Eliminate interest expense on "retired" debt

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

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

13 D 30% of Byrd's net income of $100,000; the intra-entity debt transaction is

attributed solely to the parent company.

14.A For 2013, the adjustment to beginning retained earnings should recognize

the gain on the retirement of the debt, the elimination of the 2012 interest expense, and the elimination of the 2012 interest income.

Gain on Retirement of Bond:

Original book value $10,600,000 2009–2011 amortization ($600,000 ÷ 20 yrs × 3 yrs.) (90,000) Book value, January 1, 2012 $10,510,000 Percentage of bonds retired 40% Book value of retired bonds $4,204,000 Cash received ($4,000,000 × 96.6%) 3,864,000 Gain on retirement of bonds $ 340,000

Interest Expense on Intra-entity Debt—2012

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

retired portion of bonds) (12,000) Interest expense on intra-entity debt $348,000

Interest Income on Intra-entity Debt—2012

Cash interest income (9% × $4,000,000) $360,000 Discount amortization (.034 × $4,000,0000 ÷ 17 years) 8,000 Interest income on intra-entity debt $368,000

Adjustment to 1/1/13 Retained Earnings

Recognition of 2012 gain on extinguishment of debt (above) $340,000 Elimination of 2012 intra-entity interest expense (above) 348,000 Elimination of 2012 intra-entity interest income (above) (368,000) Increase in retained earnings, 1/1/13 $320,000

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 440,000 Acquisition-date fair value 6,520,000 Acquisition-date identified net asset fair value (6,000,000) Goodwill $ 520,000

16 D Consideration transferred for preferred stock $106,000

Consideration transferred for common stock 870,000 Noncontrolling interest fair value for common 580,000 Acquisition-date fair value $1,556,000 Acquisition-date book value (1,460,000) Excess fair over book value $ 96,000

to building 50,000

to goodwill $ 46,000

17 A Parent’s reported sales $300,000

Subsidiary's reported sales 200,000 Less: intra-entity 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 Subsidiary’s unamortized fair value of prior to new share issue

(12,000 × $49) $588,000 Parent's ownership 100% Unamortized subsidiary fair value $588,000 Subsidiary unamortized fair value after issuing new

shares (above value plus 3,000 shares at $50 each) $738,000 Parent's ownership 12,000 ÷ 15,000 shares) 80% Unamortized subsidiary fair value after stock issue $590,400 Investment in Veritable increases by $2,400 ($590,400 less $588,000).

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

ownership remains the same Because the amount the parent pays 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 acquisition-date sub fair value at 1/1/13

Consideration transferred $592,000 Noncontrolling interest acquisition-date fair value 148,000 Increase in Stamford book value 80,000 Stock issue proceeds 150,000 Subsidiary valuation basis 1/1/13 970,000 New parent ownership (32,000 shs ÷ 50,000 shs.) 64% Parent’s post-stock issue ownership balance $620,800 Parent's investment account ($592,000 + [80% × 80,000]) 656,000 Required adjustment —decrease $(35,200)

21 D Adjusted acquisition-date fair value ($820,000 – $192,000) $628,000

New parent ownership (32,000 shs ÷ 32,000 shs.) 100% Fair value equivalency of parent's ownership $628,000 Parent's investment account ($592,000 + [80% × 80,000]) 656,000 Required adjustment—decrease $(28,000)

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

Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm

 The power, through voting rights or similar rights, to direct the activities

of an entity that most significantly impact the entity’s economic

performance.

 The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to 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 (30 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 An entity qualifies as a VIE and is subject to consolidation if either of the

23 (continued)

 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 power, through voting rights or similar rights, to direct the

activities of an entity that most significantly impact the entity’s economic performance.

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)

3 The right to receive the expected residual returns of the entity (e.g., the investors' return may be capped by the entity's governing

documents or other arrangements with variable interest holders) Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm

 The power, through voting rights or similar rights, to direct the activities

of an entity that most significantly impact the entity’s economic

performance.

 The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to receive a majority of the entity's expected residual returns if they occur

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 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

23 (continued)

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.

PanTech recognizes the $20,000 excess net asset fair value as a bargain purchase and records all of SoftPlus’ assets and liabilities at their individual fair values.

-0-b Implied valuation and excess allocation for Softplus.

Fair value of VIE net identifiable assets 60,000

When the 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 as goodwill

-0-25 (40 minutes) (Acquisition-date consolidated worksheet for a parent and a

variable interest entity)

Noncontrolling interest fair value 1,260,000

Acquisition-date fair value $2,100,000

Excess fair over book value $2,000,000

Research and development asset 1,800,000

26 (25 Minutes) (Consolidation entry for three consecutive years to report effects

of intra-entity bond acquisition Straight-line method used Parent uses equity method)

a Book Value of Bonds Payable, January 1, 2012

Book value, January 1, 2010 $1,050,000 Amortization—2010–2011 ($5,000 per year

[$50,000 premium ÷ 10 years] for two years) 10,000 Book value of bonds payable, January 1, 2012 $1,040,000 Book value of 40% of bonds payable

(intra-entity portion), January 1, 2012 $416,000

Gain on Retirement of Bonds, January 1, 2012

Purchase price ($400,000 × 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, 2012

Book value, January 1, 2012 (computed above) $1,040,000 Amortization for 2012 5,000 Book value of bonds payable, December 31, 2012 $1,035,000 Book value of 40% of bonds payable (intra-entity portion),

December 31, 2012 $414,000

Book Value of Investment, December 31, 2012

Book value of investment, January 1, 2012 (purchase price) $384,000 Amortization for 2012 ($16,000 discount ÷ 8-yr rem life) 2,000 Book value of investment, December 31, 2012 $386,000

Intra-entity Interest Balances for 2012

Interest expense:

Cash payment ($400,000 × 9%) $36,000 Amortization of premium for 2012 ($5,000 per year

× 40% intra-entity portion) 2,000 Intra-entity interest expense $34,000 Interest income:

Cash collection ($400,000 × 9%) $36,000 Amortization of discount for 2012 (above) 2,000 Intra-entity interest income $38,000

b In 2013, 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 removed from the Investment in Hamilton account Concurrently, the two interest balances recorded by the individual

companies in 2012 are removed from the Investment in Hamilton because they occurred after the intra-entity retirement Gain of $32,000 plus

$34,000 expense removal less $38,000 income elimination yields a

$28,000 credit to the investment account.

records of both companies Both debt and bond investment balances have been adjusted for 2012–13 amortization Entry to Investment in Hamilton brings the totals reported by the individual companies [interest income and expense] to the balance of the original gain.)

c As with part b, new premium and discount balances must be determined and then removed The adjustment made to the Investment in Hamilton takes into account that another year of interest expense ($34,000) and income ($38,000) have been incorporated into the investment account through application of the equity method.

(To remove intra-entity bond accounts that remain on the individual

records of both companies Both debt and bond investment balances have been adjusted for 2012–2014 amortization Credit to Investment in Hamilton brings the totals reported by the individual companies to the balance of the original gain.)

27 (12 Minutes) (Determine consolidated income statement accounts after

acquisition of intra-entity bonds.)

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

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

 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)

28 (30 Minutes) (Consolidation entry for two years to report effects of

intra-entity bond acquisition Effective rate method applied.)

a Loss on Repurchase of Bond

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

Interest Balances for 2012

Interest income:

$121,655 × 6% $7,299 Interest expense:

Investment Balance, December 31, 2012

Original cost, 1/1/12 $121,655 Amortization of premium:

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

Bonds Payable Balance, December 31, 2012

Book value, 1/1/12 (above) $83,597 Amortization of discount:

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

Entry B—12/31/12

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 intra-entity debt holdings and recognize loss on retirement.)

b Interest Balances for 2013

Interest income: $120,954 (investment

balance for the year) × 6% $7,257

Interest expense: $83,957 (liability balance

for the year) × 10% $8,396

28 (continued)

Investment Balance, December 31, 2013

Book value, January 1, 2013 (part a) $120,954 Amortization of premium:

Cash interest ($100,000 × 8%) $8,000

Effective interest income (above) 7,257 743

Bonds Payable Balance, December 31, 2013

Book value, January 1, 2013 (part a) $83,957 Amortization of discount:

Cash interest ($100,000 × 8%) $8,000

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

December 31, 2013 $84,353

Interest Balances for 2014

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

Interest expense: $84,353 (liability balance

for the year [above]) × 10% $8,435

Investment Balance, December 31, 2014

Book value, January 1, 2014 (above) $120,211 Amortization of premium:

Cash interest ($100,000 × 8%) $8,000

Effective interest income (above) 7,213 787

Bonds Payable Balance, December 31, 2014

Book value, January 1, 2014 (above) $84,353 Amortization of discount:

Adjustment Needed to Investment in Bierman for Bond Retirement Loss:

Loss on retirement of debt (part a) $38,058 Amounts recognized in previous years:

2013 8,396 16,756 2,200

Adjustment needed to Investment in Bierman

to arrive at consolidated total $35,858 Entry *B—12/31/14

Bonds Payable 84,788

Interest Income 7,213

Investment in Bierman 35,858

Investment in Bonds 119,424 Interest Expense 8,435

(To eliminate intra-entity bond holdings and adjust the Investment in

Bierman for the unrecognized loss on retirement Amounts computed

Effective

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

Amortization 2,316 Investment in Bloom bonds, 12/31/13 $281,234

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—1/1/10 $435,763 Discount amortization (2010–2012) ([$64,237 ÷ 11] × 3 years) 17,519 Book value 12/31/12 $453,282 Intra-entity portion of bonds payable (50%) $226,641 Purchase price 283,550 Loss on retirement $ 56,909

Investment in Bloom Bonds

Purchase price—12/31/12 $283,550 Premium amortization (2013) ($33,550 ÷ 8) (4,194) Book value 12/31/13 $279,356

Interest Income

Cash interest ($250,000 × 10%) $25,000 Premium amortization (above) (4,194) Intra-entity interest income—2013 $20,806

Bonds Payable

Original issue price 1/1/10 $435,763 Discount amortization (2010–2013) [($64,237 ÷ 11) × 4 years] 23,359 Book value 12/31/13 $459,122 Opus ownership 50% Intra-entity portion—12/31/13 $229,561

Interest Expense

Cash interest ($250,000 × 10%) $25,000 Discount amortization ([$64,237 ÷ 11] × 1/2) 2,920 Intra-entity interest expense—2013 $27,920 The reduction in retained earnings represents the loss only; no intra-entity interest was recognized in the previous year because the purchase was made

30 (8 Minutes) (Determine goodwill for an acquisition 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

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, 2013

Consideration transferred, January 1, 2013 $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 2013 (above) (1,000 ) Investment in Smith account, December 31, 2013 $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, 1/1/13 (Smith) 10,000,000

Franchises 40,000

Investment in Smith 14,040,000 Noncontrolling Interest in Smith, Inc 2,000,000 (To eliminate subsidiary stockholders’ equity, record excess fair values, and record outside ownership of subsidiary's preferred stock at fair value)

31 c (continued)

Entry I Equity Income of Subsidiary 289,000

Investment in Smith 289,000 (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 intra-entity 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].)

32 (30 Minutes) (Prepare consolidation entries for an acquisition where subsidiary has outstanding preferred stock)

Consideration transferred for common stock $ 7,368,000

Consideration transferred for preferred stock 3,100,000

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

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)

32 (continued)

Entry I1

Dividend Income 80,000

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

Entry I2

Dividend Income 192,000

Dividends Paid 192,000 (To eliminate intra-entity 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 2013 amortization of specific accounts

recognized within acquisition price of preferred stock.)

33 (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 method in presenting cash flows from operating activities, the $12,000 gain is not presented However, if the indirect method is used, the gain (a positive) must be eliminated from net income by a subtraction.

 Intra-entity 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 method to present cash flows from operating activities, this expense not presented If the indirect method is used, the expense must be removed

by adding it back to consolidated net income.

 Decrease in accounts payable Cash payments have reduced this liability

balance during the period If the direct method is used to present cash flows from operating activities, 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 method is applied, the decrease is subtracted from net income in arriving at the net cash generated from operating activities during the period 34.(20 Minutes) (Determine cash flows from operations for a consolidated entity.) DIRECT METHOD

Cash revenues (add book values, eliminate intra-entity transfers,

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

intra-entity 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 Knight (intra-entity so not included) -0-

Net cash flow from operating activities $238,000 INDIRECT METHOD

Consolidated net income (computed below) $216,000 Adjustments:

Depreciation and amortization 61,000 Gain on sale of equipment (30,000) Increase in inventory (11,000) Decrease in accounts receivable 8,000 Decrease in accounts payable (6,000) Net cash flow from operating activities $238,000