Chapter 5 Intercompany Debt C 5 Intercompany debt

Chapter 5 Intercompany Debt C 5

Intercompany debt u Intercompany loans are eliminated with interest u Bonds held by affiliate are retired u Capital lease debt is eliminated; asset becomes an owned asset C 5 2

Simple intercompany loan Parent loans sub $100, 000 at 8% on July 1; annual interest Parent Journal Entries 7/1 Note Rec 100, 000 Cash 100, 000 12/31 Int Rec 4, 000 Int Rev 4, 000 C 5 Sub Journal Entries 7/1 Cash 100, 000 Note Pay 100, 000 12/31 Int Exp 4, 000 Int Pay 4, 000 3

Simple intercompany loan (continued) Worksheet Eliminations LN 1 Note Payable 100, 000 Int Payable 4, 000 Note Rec 100, 000 Int Rec 4, 000 LN 2 Interest Revenue 4, 000 Interest Expense 4, 000 No impact on income distribution schedule C 5 4

Intercompany bonds u A subsidiary may have debt that is more expensive than if it were issued by the parent. u One member of the affiliated group (usually the Subsidiary) has bonds outstanding that are held by outsiders - The other member (usually the parent) purchases the bonds from the outsiders. u We treat it as WS retirement with an ordinary gain or loss (no longer extraordinary). u The result is the same if the parent loans money to the subsidiary and the subsidiary retires the bonds. C 5 5

Bond example: Facts Sub (80%) issues to third parties $100, 000, 8 year, 10% (annual interest) bond on 1/1/1 for $102, 400 4 premium amortization (straight line) = $300 per year 4 Int Exp = $9, 700 per year Parent purchases the bonds from third party for $99, 200 on 1/1/5 (4 remaining years) 4 discount amortization (straight-line) = $200 per year 4 Int Rev = $10, 200 per year Consolidated statements: $99, 200 was paid to retire bonds with a book value of $101, 200. There is $2, 000 gain on the date of purchase. C 5 6

Bond example: Journal entries years 1 -4 Sub Journal Entries Year 1 Cash 102, 400 Bond Pay 100, 000 Premium 2, 400 Parent Journal Entries No entries Years 1, 2, 3, & 4 Int Exp 9, 700 Premium 300 Int Pay 10, 000 Premium Balance 1/1/5 = $1, 200 C 5 7

Bond example: Carrying values Parent buys 1/1/5 C 5 8

Bond example: Journal entries years 5 -8 Sub Journal Entries Year 5 10, 000 Parent Journal Entries Year 5 Bond invest 99, 200 Cash 99, 200 Int Rec 10, 000 Bond Invest 200 Int Rev 10, 200 Years 6, 7, & 8 Int Exp 9, 700 Premium 300 Int Pay 10, 000 Years 6, 7, & 8 Int Rec 10, 000 Bond Invest 200 Int Rev 10, 200 Int Exp Premium Int Pay C 5 9, 700 300 9

Bond example: Eliminations 12/31/5 C 5 10

Bond example: Eliminations 12/31/5 (continued) Proof of gain on 12/31/5: Book value of debt 100, 900 Investment balance 99, 400 1, 500 Interest revenue 10, 200 Interest expense 9, 700 500 Gain on 1/1/5 2, 000 C 5 11

Bond example: Sub IDS 12/31/5 Sub IDS Interest adj. (B 1) C 5 500 Int generated inc Gain on retire Adjusted net inc NCI % NCI share 34, 000 2, 000 35, 500 20% 7, 100 12

Bond example: Eliminations 12/31/6 C 5 13

Bond example: Eliminations 12/31/6 (continued) Proof of gain on 12/31/6: Book value of debt Investment balance Interest revenue Interest expense Gain on 1/1/6 C 5 100, 600 99, 600 10, 200 9, 700 1, 000 500 1, 500 14

Bond example: Sub IDS 12/31/6 Sub IDS Interest adj. (B 1) C 5 500 Int generated inc Adjusted net inc NCI % NCI 24, 000 23, 500 20% 4, 700 15

Effective interest bonds u. Need an amortization schedule to see it u. See worksheet 5 -4 and supporting amortization tables in text u. The “easy out” entry - eliminate bonds payable, discount or premium on bonds, interest expense and interest revenue Gain or loss at year end + Gain or loss amortized = Gain or loss at start of year (RE adj or G/L) C 5 16

Effective interest bond example: Facts Sub issues to third party a $100, 000, 8 year, 10% bond on 1/1/1 for $102, 400 4100, 000 FV; 10, 000 pmt; 102, 400 PV; 8 n = 9. 5574% Parent purchases the bonds from outsiders for $99, 200 on 1/1/5 (4 remaining years) 4100, 000 FV; 10, 000 pmt; 99, 200 PV; 4 n = 10. 254% Consolidated statements: $99, 200 was paid to retire bonds with a book value of $101, 200. There is a $2, 000 gain C 5 17

Effective interest bond example: Amortization tables C 5 18

Effective interest bond example: Eliminations 12/31/6 C 5 19

Effective interest bond example: Eliminations 12/31/6 (continued) Proof of gain on 12/31/6: Book value of debt Investment balance Interest revenue Interest expense Gain on 1/1/6 C 5 100, 773 99, 561 10, 189 9, 663 1, 212 526 1, 738 20

Effective interest bond example: Sub IDS 12/31/6 Sub IDS Interest adj. (B 1) C 5 526 Int generated inc 24, 000 Adjusted net inc 23, 474 NCI % 20% NCI 4, 695 21

Intercompany Leases u. Operating lease – just eliminate rental expense and revenue – no adjustment to consolidated net income u. Financing type (capital) lease – asset is on lessor’s books at cost – similar to intercompany loan – trick is that Lessee has Capt Lease Obligation (at PV) while Lessor has Min LP Rec (at gross) less Unearned Interest (brings gross amount down to PV) – no adjustment to consolidated net income C 5 22

Intercompany leases (continued) u. Sales type lease – recorded same as financing type lease – there is a profit for the lessor, it is deferred in the same manner as the gain on a fixed asset sale. u. Residual values – chapter assumes there is a bargain purchase option or guaranteed residual which means the residual value is included in the minimum lease payments – appendix considers unquaranteed residual: interest expense and revenue are not equal. In this case, there is an impact on consolidated net income. C 5 23

Financing-type lease example: Data u. Sub is 80% owned by Parent u. Cost of equipment leased is $21, 682 u. Implicit rate is 12% for both parties u. Origination date is 1/1/1 u. Terms: – start-of-period payments = $6, 000 – 4 years – bargain purchase option = $2, 000 C 5 24

Financing-type lease example: Amortization schedule C 5 25

Financing-type lease example: Journal entries year 1 Sub/Lessee Journal Entries 1/1/1 Leased Asset 21, 682 Lease Oblig 15, 682 Cash 6, 000 12/31/1 Int Exp Int Pay 1, 882 Parent/Lessor Journal Entries 1/1/1 Min LP Rec 26, 000 Unearn Int 4, 318 Cash 21, 682 Cash 6, 000 Min LP Rec 6, 000 12/31/1 Unearned Int 1, 882 Int Rev 1, 882 Unearned interest = $2, 436 C 5 26

Financing-type lease example: Eliminations 12/31/1 C 5 27

Financing-type lease example: Journal entries year 2 Sub/Lessee Journal Entries 1/1/2 Int Pay 1, 882 Lease Oblig 4, 118 Cash 6, 000 Parent/Lessor Journal Entries 1/1/1 Cash 6, 000 Min LP Rec 6, 000 12/31/1 Int Exp Int Pay 12/31/1 Unearned Int Rev 1, 388 Unearned interest = $1, 048 C 5 28

Financing-type lease example: Eliminations 12/31/2 C 5 29

Sales Type Leases First - eliminate the lease Then - the asset is overstated Procedure (like any other fixed asset profit): 4 reduce asset to cost 4 reduce accumulated depreciation and correct RE for prior years depreciation 4 reduce current year depreciation C 5 30