The previous chapter explored the consolidation procedures required by the intra-entity transfer of inventory, land, and depreciable assets. In consolidating these transactions, all re- sulting gains were deferred until earned through either the use of the asset or its resale to outside parties. Deferral was necessary because these gains, although legitimately recog- nized by the individual companies, were unearned from the perspective of the consolidated entity. The separate financial information of each company was adjusted on the worksheet to be consistent with the view that the related companies actually composed a single eco- nomic concern.
This same objective applies in consolidating all other intra-entity transactions: The finan- cial statements must represent the business combination as one enterprise rather than as a group of independent organizations. Consequently, in designing consolidation procedures for intra-entity transactions, the effects recorded by the individual companies first must be iso- lated. After the impact of each action is analyzed, worksheet entries recast these events from the vantage point of the business combination. Although this process involves a number of nu- ances and complexities, the desire for reporting financial information solely from the per- spective of the consolidated entity remains constant.
We introduced the intra-entity sales of inventory, land, and depreciable assets to- gether (in Chapter 5) because these transfers result in similar consolidation procedures.
In each case, one of the affiliated companies recognizes a gain prior to the time the consolidated entity actually earned it. The worksheet entries required by these transac- tions simply realign the separate financial information to agree with the viewpoint of the business combination. The gain is removed and the inflated asset value is reduced to his- torical cost.
The next section of this chapter examines the intra-entity acquisition of bonds and notes.
Although accounting for the related companies as a single economic entity continues to be the central goal, the consolidation procedures applied to intra-entity debt transactions are in dia- metric contrast to the process utilized in Chapter 5 for asset transfers.
Before delving into this topic, note that directloans used to transfer funds between affili- ated companies create no unique consolidation problems. Regardless of whether bonds or notes generate such amounts, the resulting receivable/payable balances are necessarily identi- cal. Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation. A worksheet entry simply offsets the two corre- sponding balances. Furthermore, the interest revenue/expense accounts associated with direct loans also agree and are removed in the same fashion.
LO2
Understand the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party.
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Acquisition of Affiliate’s Debt from an Outside Party
The difficulties encountered in consolidating intra-entity liabilities relate to a specific type of transaction: the purchase from an outside third party of an affiliate’s debt instrument.A par- ent company, for example, could acquire a bond previously issued by a subsidiary on the open market. Despite the intra-entity nature of this transaction, the debt remains an outstanding obligation of the original issuer but is recorded as an investment by the acquiring company.
Thereafter, even though related parties are involved, interest payments pass periodically be- tween the two organizations.
Although the individual companies continue to report both the debt and the investment, from a consolidation viewpoint this liability is retired as of the acquisition date. From that time for- ward, the debt is no longer owed to a party outside the business combination. Subsequent inter- est payments are simply intra-entity cash transfers. To create consolidated statements, worksheet entries must be developed to adjust the various balances to report the debt’s effective retirement.
Acquiring an affiliate’s bond or note from an unrelated party poses no significant consoli- dation problems if the purchase price equals the corresponding book value of the liability.
Reciprocal balances within the individual records would always be identical in value and eas- ily offset in each subsequent consolidation.
Realistically, though, such reciprocity is rare when a debt is purchased from a third party.
A variety of economic factors typically produce a difference between the price paid for the investment and the carrying amount of the obligation. The debt is originally sold under mar- ket conditions at a particular time. Any premium or discount associated with this issuance is then amortized over the life of the bond, creating a continuous adjustment to book value. The acquisition of this instrument at a later date is made at a price influenced by current economic conditions, prevailing interest rates, and myriad other financial and market factors.
Therefore, the cost paid to purchase the debt could be either more or less than the book value of the liability currently found within the issuing company’s financial records. To the business combination, this difference is a gain or loss because the acquisition effectively re- tires the bond; the debt is no longer owed to an outside party.For external reporting purposes, this gain or loss must be recognized immediately by the consolidated entity.
Accounting for Intra-Entity Debt Transactions––Individual Financial Records
The accounting problems encountered in consolidating intra-entity debt transactions are fourfold:
1. Both the investment and debt accounts must be eliminated now and for each future consol- idation despite containing differing balances.
2. Subsequent interest revenue/expense (as well as any interest receivable/payable accounts) must be removed although these balances also fail to agree in amount.
3. Changes in all of the preceding accounts occur constantly because of the amortization process.
4. The business combination must recognize the gain or loss on retirement of the debt, even though this balance does not appear within the financial records of either company.
To illustrate, assume that Alpha Company possesses an 80 percent interest in the outstand- ing voting stock of Omega Company. On January 1, 2009, Omega issued $1 million in 10-year bonds paying cash interest of 9 percent annually. Because of market conditions prevailing on that date, Omega sold the debt for $938,555 to yield an effective interest rate of 10 percent per year. Shortly thereafter, the prime interest rate began to fall, and by January 1, 2011, Omega made the decision to retire this debt prematurely and refinance it at the currently lower rates.
To carry out this plan, Alpha purchased all of these bonds in the open market on January 1, 2011, for $1,057,466. This price was based on an effective yield of 8 percent, which is as- sumed to be in line with the interest rates at the time.
Many reasons could exist for having Alpha, rather than Omega, reacquire this debt. For ex- ample, company cash levels at that date could necessitate Alpha’s role as the purchasing agent.
Also, contractual limitations can prohibit Omega from repurchasing its own bonds.
250 Chapter 6
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 251
In accounting for this business combination, an early extinguishment of the debt has oc- curred. Thus, the difference between the $1,057,466 payment and the January 1, 2011, book value of the liability must be recognized in the consolidated statements as a gain or loss. The exact account balance reported for the debt on that date depends on the amortization process.
Although the issue was recorded initially at the $938,555 exchange price, after two years the carrying value increased to $946,651, calculated as follows:7
Bonds Payable—Book Value—January 1, 2011
Book Effective Interest Cash Year-End
Year Value (10 percent rate) Interest Amortization Book Value
2009 $938,555 $93,855 $90,000 $3,855 $942,410
2010 942,410 94,241 90,000 4,241 946,651
Because Alpha paid $110,815 in excess of the recorded liability ($1,057,466 ⫺$946,651), the consolidated entity must recognize a loss of this amount. After the loss has been acknowl- edged, the bond is considered to be retired and no further reporting is necessary by the busi- ness combinationafter January 1, 2011.
Despite the simplicity of this approach, neither company accounts for the event in this man- ner. Omega retains the $1 million debt balance within its separate financial records and amor- tizes the remaining discount each year. Annual cash interest payments of $90,000 (9 percent) continue to be made. At the same time, Alpha records the investment at the historical cost of
$1,057,466, an amount that also requires periodic amortization. Furthermore, as the owner of these bonds, Alpha receives the $90,000 interest payments made by Omega.
To organize the accountant’s approach to this consolidation, a complete analysis of the sub- sequent financial recording made by each company should be produced. Omega records only two journal entries during 2011 assuming that interest is paid each December 31:
7The effective rate method of amortization is demonstrated here because this approach is theoretically preferable. However, the straight-line method can be applied if the resulting balances are not materially different than the figures computed using the effective rate method.
Omega Company’s Financial Records
12/31/11 Interest Expense. . . 90,000
Cash. . . 90,000 To record payment of annual cash interest on $1 million,
9 percent bonds payable.
12/31/11 Interest Expense. . . 4,665
Bonds Payable (or Discount on Bonds Payable) . . . 4,665 To adjust interest expense to effective rate based on original
yield rate of 10 percent ($946,651 book value for
2011 ⫻10% ⫽$94,665). Book value increases to $951,316.
Alpha Company’s Financial Records
1/1/11 Investment in Omega Company Bonds . . . 1,057,466
Cash . . . 1,057,466 To record acquisition of $1,000,000 in Omega Company
bonds paying 9 percent cash interest, acquired to yield an effective rate of 8 percent.
Concurrently, Alpha journalizes entries to record its ownership of this investment:
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12/31/11 Cash . . . 90,000
Interest Income . . . 90,000 To record receipt of cash interest from Omega Company
bonds ($1,000,000 ⫻9%).
12/31/11 Interest Income . . . 5,403
Investment in Omega Company Bonds . . . 5,403 To reduce $90,000 interest income to effective rate
based on original yield rate of 8 percent ($1,057,466 book value for 2011 ⫻8% ⫽$84,597). Book value decreases to $1,052,063.
Even a brief review of these entries indicates that the reciprocal accounts to be eliminated within the consolidation process do not agree in amount. You can see the dollar amounts appearing in each set of financial records in Exhibit 6.3. Despite the presence of these recorded balances, none of the four intra-entity accounts (the liability, investment, interest expense, and interest revenue) appears in the consolidated financial statements. The only figure that the business combination reports is the $110,815 loss created by the extinguishment of this debt.
Effects on Consolidation Process
As previous discussions indicated, consolidation procedures convert information generated by the individual accounting systems to the perspective of a single economic entity. A worksheet entry is therefore required on December 31, 2011, to eliminate the intra-entity balances shown in Exhibit 6.3 and to recognize the loss resulting from the repurchase. Mechanically, the dif- ferences in the liability and investment balances as well as the interest expense and interest in- come accounts stem from the $110,815 difference between the purchase price of the investment and the book value of the liability. Recognition of this loss, in effect, bridges the gap between the divergent figures.
Consolidation Entry B (December 31, 2011)
Bonds Payable . . . . 951,316 Interest Income . . . . 84,597 Loss on Retirement of Bond . . . . 110,815
Investment in Omega Company Bonds . . . . 1,052,063 Interest Expense . . . . 94,665 To remove intra-entity bonds and related interest accounts
and record loss on the early extinguishment of this debt.
(Labeled “B”in reference to bonds.) 252 Chapter 6
EXHIBIT 6.3
ALPHA COMPANY AND OMEGA COMPANY Effects of Intra-Entity Debt Transaction
2011
Omega Alpha Company Company Reported Debt Investment
2011 interest expense* . . . . $ 94,665 $ –0–
2011 interest income†; . . . . –0– (84,597) Bonds payable* . . . . (951,316) –0–
Investment in bonds, 12/31/11†; . . . . –0– 1,052,063 Loss on retirement . . . . –0– –0–
Note: Parentheses indicate credit balances.
*Company total is adjusted for 2011 amortization of $4,665 (see journal entry).
†Adjusted for 2011 amortization of $5,403 (see journal entry).
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 253
The preceding entry successfully transforms the separate financial reporting of Alpha and Omega to that appropriate for the business combination. The objective of the consolidation process has been met: The statements present the bonds as having been retired on January 1, 2011. The debt and the corresponding investment are eliminated along with both interest accounts. Only the loss now appears on the worksheet to be reported within the consolidated financial statements.
Assignment of Retirement Gain or Loss
Perhaps the most intriguing issue in accounting for intra-entity debt transactions to be ad- dressed concerns the assignment of any gains and losses created by the retirement. Should the
$110,815 loss just reported be attributed to Alpha or to Omega? From a practical perspective, this assignment is important only in calculating and reporting noncontrolling interest figures.
However, at least four different possible allocations can be identified, each of which demon- strates theoretical merit.
First, a strong argument can be made that the liability hypothetically extinguished is that of the issuing company and, thus, any resulting income relates solely to that party. This approach assumes that the retirement of any obligation affects only the debtor. Proponents of this posi- tion hold that the acquiring company is merely serving as a purchasing agent for the bonds’
original issuer. Accordingly, in the previous illustration, the benefits derived from paying off the liability should accrue to Omega because refinancing reduced its interest rate. It incurred the loss solely to obtain these lower rates. Therefore, under this assumption, the entire
$110,815 is assigned to Omega, the issuer of the debt. This assignment is usually considered to be consistent with the economic unit concept.
Second, other accountants argue that the loss should be assigned solely to the investor (Alpha). According to proponents of this approach, the acquisition of the bonds and the price negotiated by the buyer created the income effect.
A third hypothesis is that the resulting gain or loss should be split in some manner between the two companies. This approach is consistent with both the parent company concept and pro- portionate consolidation. Because both parties are involved with the debt, this proposition con- tends that assigning income to only one company is arbitrary and misleading. Normally, such a division is based on the original face value of the debt. Hence, $57,466 of the loss would be allocated to Alpha with the remaining $53,349 assigned to Omega:
Alpha Omega
Purchase price . . . $1,057,466 Book value . . . $ 946,651 Face value . . . 1,000,000 Face value . . . 1,000,000 Loss—Alpha . . . $ 57,466 Loss—Omega . . . $ 53,349 Allocating the loss in this manner is an enticing solution; the subsequent accounting process creates an identical division within the individual financial records. Because both Alpha’s premium and Omega’s discount must be amortized, the loss figures eventually affect the respective companies’ reported earnings. Over the life of the bond, Alpha records the
$57,466 as an interest income reduction, and Omega increases its own interest expense by
$53,349 because of the amortization of the discount.
A fourth perspective takes a more practical view of intra-entity debt transactions: The par- ent company ultimately orchestrates all repurchases. As the controlling party in a business combination, the ultimate responsibility for retiring any obligation lies with the parent. The gain or loss resulting from the decision should thus be assigned solely to the parent regardless of the specific identity of the debt issuer or the acquiring company. In the current example, Alpha maintains control over Omega. Therefore, according to this theory, the financial conse- quences of reacquiring these bonds rest with Alpha so that the entire $110,815 loss must be attributed to it.
Each of these arguments has conceptual merit, and if the FASB eventually sets an official standard, any one approach (or possibly a hybrid) could be required. Unless otherwise stated, however, all income effects in this textbook relating to intra-entity debt transactions are
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assigned solely to the parent company,as discussed in the final approach. Consequently, the results of extinguishing debt always are attributed to the party most likely to have been responsible for the action.
Intra-Entity Debt Transactions––Subsequent to Year of Acquisition
Even though the preceding Entry Bcorrectly eliminates Omega’s bonds in the year of retire- ment, the debt remains within the financial accounts of both companies until maturity. There- fore, in each succeeding time period, all balances must again be consolidated so that the liability is always reported as having been extinguished on January 1, 2011. Unfortunately, a simple repetition of Entry Bis not possible. Developing the appropriate worksheet entry is complicated by the amortization process that produces continual change in the various account balances. Thus, as a preliminary step in each subsequent consolidation, current book values, as reported by the two parties, must be identified.
To illustrate, the 2012 journal entries for Alpha and Omega follow. Exhibit 6.4 (on the following page) shows the resulting account balances as of the end of that year.
WHO LOST THIS $300,000?
Several years ago, Penston Company purchased 90 percent of the outstanding shares of Swansan Corporation. Penston made the acquisition because Swansan produced a vital component used in Penston’s manufacturing process. Penston wanted to ensure an ade- quate supply of this item at a reasonable price. The former owner, James Swansan, re- tained the remaining 10 percent of Swansan’s stock and agreed to continue managing this organization. He was given responsibility for the subsidiary’s daily manufacturing op- erations but not for any financial decisions.
Swansan’s takeover has proven to be a successful undertaking for Penston. The sub- sidiary has managed to supply all of the parent’s inventory needs and distribute a variety of items to outside customers.
At a recent meeting, Penston’s president and the company’s chief financial officer be- gan discussing Swansan’s debt position. The subsidiary had a debt-to-equity ratio that seemed unreasonably high considering the significant amount of cash flows being gener- ated by both companies. Payment of the interest expense, especially on the subsidiary’s outstanding bonds, was a major cost, one that the corporate officials hoped to reduce.
However, the bond indenture specified that Swansan could retire this debt prior to ma- turity only by paying 107 percent of face value.
This premium was considered prohibitive. Thus, to avoid contractual problems, Penston acquired a large portion of Swansan’s liability on the open market for 101 percent of face value. Penston’s purchase created an effective loss of $300,000 on the debt, the excess of the price over the book value of the debt, as reported on Swansan’s books.
Company accountants currently are computing the noncontrolling interest’s share of consolidated net income to be reported for the current year. They are unsure about the impact of this $300,000 loss. The subsidiary’s debt was retired, but officials of the parent company made the decision. Who lost this $300,000?
Discussion Question
Omega Company’s Financial Records—December 31, 2012
Interest Expense . . . . 90,000
Cash . . . . 90,000 To record payment of annual cash interest on $1 million,
9 percent bonds payable.
Interest Expense . . . . 5,132
Bonds Payable (or Discount on Bonds Payable) . . . . 5,132 To adjust interest expense to effective rate based on an original yield
rate of 10 percent ($951,316 book value for 2012 ⫻10% ⫽$95,132).
Book value increases to $956,448.
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