Intercompany Transactions:

Bonds and Leases

FISCHER | TAYLOR | CHENG

 Learning Objectives

1. Explain the alternatives a parent company has if it wishes to acquire

outstanding subsidiary bonds from outside owners.
2. Follow the procedures used to retire intercompany bonds on a
consolidated worksheet.
3. Explain why a parent company would lease assets to the subsidiary.
4. Show how to eliminate intercompany operating lease transactions from
the consolidated statements.
5. Eliminate intercompany capital leases on the consolidated worksheet.
6. Demonstrate an understanding of the process used to defer intercompany
profits on sales-type leases.
7. (Appendix) Explain the complications caused by unguaranteed residual
values with intercompany leases.

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 Intercompany Bonds

The parent can effectively retire subsidiary bonds by

Lending money to the subsidiary for actual retirement
Buying the bonds from existing owners

Parent purchase of subsidiary bonds

The bonds cease to exist from a consolidated viewpoint
Bonds are retired on the consolidated worksheet by elimination

Difference between the amortized cost and the price paid creates a
gain or loss on retirement

In subsequent periods the bonds continue to be eliminated

Retained earnings is adjusted for the remaining retirement gain or loss
that has not already been amortized

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 Bond Originally Issued Off-Face: Facts

Sub (80%) issues to third parties $100,000, 5-year, 8% (annual

interest) bond on 1/1/2011 for $96,110
Straight line discount amortization = $778 per year
Int. Exp. = ($100,000 8%) + $778 = $8,778 per year
Parent purchases the bonds from third party for $103,600 on
12/31/2013
Straight line discount amortization = $1,800 per year
Int. Rev. = ($100,000 8%) - $1,800 = $6,200 per year
Consolidated statements: $5,156 loss on the date of purchase
Debt carrying value $98,444
Price paid to retire (103,600)
$ 5,156

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 Bond Example:
Journal Entries (Years 13)
Sub Journal Entries Parent Journal Entries
1/1/2011
Cash 96,110
Discount 3,890
Bond Pay. 100,000
12/31/2011 - 2013
Int. Exp. 8,778
Discount 778
Cash 8,000 12/31/2013
Invest S Bonds 103,600
Cash 103,600
Discount Balance 12/31/2013 = $1,556
Bond Carrying Value = $98,444
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 Bond Example:
Carrying Values Dec 31, 2014
Sub's Debt Parent's Asset
1/1/2011 $ 96,110
12/31/2011 96,888
12/31/2012 97,666
12/31/2013 98,444 $ 103,600 Loss on retire: $5,156
12/31/2014 99,222 101,800
12/31/2015 100,000 100,000

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 Bond Example:
Journal Entries (Years 4-5)
Sub Journal Entries Parent Journal Entries
12/31/2014 & 2015 12/31/2014 & 2015
Int. Exp. 8,778 Cash 8,000
Discount 778 Bond Invest. 1,800
Cash 8,000 Int. Rev. 6,200

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 Bond Example:
Eliminations (12/31/2014)
12/31/2014 Trial Balances Eliminations
Co. P Co. S Dr Cr
Investment in bonds 101,800 B 103,600
Bonds payable (100,000) B 100,000
Discount on bond pay. 778 B 778
Loss on retirement
Interest expense 8,778 B 8,778
Interest revenue 6,200 B 6,200
RE - Co. S X,XXX B 4,640
RE - Co. P X,XXX B 516

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 Bond Example:
Sub IDS (12/31/2014)
Subsidiary
Int generated inc $ 9,860
Int adjustment 2,578
Adjusted inc $ 12,438
NCI % 10%
NCI $ 1,244

Interest adjustment:
Subs interest exp $6,200 DR
Parents interest rev 8,778 CR
2,578 CR

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 Partial Effective Retirement of Bonds

Portion of bonds acquired by parent

Effective retirement of only that portion
Eliminate the portion of interest that relates to the
bonds acquired by the parent
Portion of bonds held by outsiders
A continuing debt on the consolidated balance sheet
Related interest expense is an expense to the
consolidated entity

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 Effective Interest Bonds

Amortization schedule shows interest for Parent

and Subsidiary
See Worksheet 5-4 and supporting amortization
tables in text
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 through difference in interest
= Gain or loss at start of year (RE adjustment or G/L)

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 Effective Interest Bond Example: Facts

Sub issues to third party a $100,000, 8-year, 10%

bond on 1/1/2011 for $102,400
100,000FV; 10,000pmt; 102,400PV; 8n = 9.5574%

Parent purchases the bonds from outsiders for

$99,200 on 1/1/2015 (4 years remain)
100,000FV; 10,000pmt; 99,200PV; 4n = 10.254%

Consolidated statements: $99,200 was paid to

retire bonds with a book value of $101,417.
$2,217 gain

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 Effective Interest Bond Example:
Amortization Tables
Sub Sub Sub Par Par Par
Date Cash Int. Amort. Bal. Int. Amort. Bal.
1/1/11 10,000 102,400
12/31/11 10,000 9,787 213 102,187
12/31/12 10,000 9,766 234 101,953
Parent
12/31/13 10,000 9,744 256 101,697
acquires on
12/31/14 10,000 9,720 280 101,417 1/1/2015 99,200
12/31/15 10,000 9,693 307 101,110 10,172 172 99,372
12/31/16 10,000 9,663 337 100,773 10,190 190 99,562
12/31/17 10,000 9,631 369 100,404 10,209 209 99,771
12/31/18 10,000 9,596 404 100,000 10,230 230 100,000

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 Effective Interest Bond Example:
Eliminations (12/31/2016)
Trial Balances Eliminations
Co. P Co. S Dr Cr
Investment in bonds 99,562 B1 99,562
Interest receivable 10,000 B2 10,000
Bonds payable (100,000) B1 100,000
Premium on bond pay. (773) B1 773
Interest payable (10,000) B2 10,000
Interest revenue 10,190 B1 10,190
Interest expense 9,663 B1 9,663
RE - Co. P X,XXX B1 1,390
RE - Co. S X,XXX B1 348

In subsequent years, recognize gain as of beginning

of the year for consolidated balance sheet

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 Effective Interest Bond Example:
Eliminations (12/31/2016) continued
Proof of gain on 12/31/2016:
Book value of debt 100,773
Investment balance 99,562 1,211
Interest revenue 10,190
Interest expense 9,663 527
Gain on 1/1/2016 1,738

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 Effective Interest Bond Example:
Sub IDS (12/31/2016)
Subsidiary
Interest adj (B1) $ 526 Int generated inc $ 24,000

Adjusted inc $ 23,474

NCI % 20%
NCI $ 4,695

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 Intercompany Lease
Operating
Eliminate rental expense and revenue
No adjustment to consolidated net income

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 Intercompany Lease
Capital / Direct-Financing
Present value of minimum lease payments is equal to
asset cost
No gain or loss arises from lease; similar to
intercompany loan
No adjustment to consolidated net income
Lessee
Lease Obligation carried at present value
Interest expense
Lessor
Minimum Lease Pmt Receivable (gross) less Unearned Interest
Interest revenue

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 Financing-Type Lease Example: Data

Sub is 80% owned by Parent

Cost of equipment leased is $21,682
Origination date is 1/1/2011
Terms:
4 years
Implicit rate is 12% for both parties Present value of
minimum lease
Start-of-period payments = $6,000 payments: $21,682
Bargain purchase option = $2,000

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 Financing-Type Lease Example:
Amortization Schedule

Date Pmt. Int. Prin. Bal.

1/1/2011 6,000 6,000 15,682
1/1/2012 6,000 1,882 4,118 11,564
1/1/2013 6,000 1,388 4,612 6,952
1/1/2014 6,000 834 5,166 1,786
12/31/2014 2,000 214 1,786 0

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 Financing-Type Lease Example:
Journal Entries (Year 1)
Sub/Lessee Parent/Lessor
Journal Entries Journal Entries
1/1/2011 1/1/2011
Leased Asset 21,682 Min. LP Rec. 26,000
Lease Oblig. 15,682 Unearned Int. 4,318
Cash 6,000 Cash 21,682
Cash 6,000
Min. LP Rec. 6,000
12/31/2011 12/31/2011
Int. Exp. 1,882 Unearned Int. 1,882
Int. Pay. 1,882 Int. Rev. 1,882

Unearned interest balance = $2,436

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 Financing-Type Lease Example:
Eliminations (12/31/2011)
Trial Balances Eliminations
Co. P Co. S Dr Cr
Min. lease payment rec. 20,000 CL2 20,000
Unearned interest (2,436) CL2 2,436
Interest income (1,882) CL1 1,882
Obligation - Capt. lease (15,682) CL2 15,682
Accrued interest pay. (1,882) CL2 1,882
Interest expense 1,882 CL1 1,882

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 Financing-Type Lease Example:
Journal Entries (Year 2)
Sub/Lessee Parent/Lessor
Journal Entries Journal Entries
1/1/2012 1/1/2012
Int. Pay. 1,882 Cash 6,000
Lease Oblig. 4,118 Min. LP Rec. 6,000
Cash 6,000

12/31/2012 12/31/2012
Int. Exp. 1,388 Unearned Int. 1,388
Int. Pay. 1,388 Int. Rev. 1,388

Unearned interest balance= $1,048

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 Financing-Type Lease Example:
Eliminations (12/31/2012)
Trial Balances Eliminations
Co. P Co. S Dr Cr
Min. lease pmt. rec. 14,000 CL2 14,000
Unearned interest (1,048) CL2 1,048
Interest income (1,388) CL1 1,388
Obligation - Capt. lease (11,564) CL2 11,564
Accrued interest pay. (1,388) CL2 1,388
Interest expense 1,388 CL1 1,388

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 Intercompany Lease
Capital / Sales-Type
Lessor records sale profit (loss) at inception
Difference between fair value and cost
Sales Profit on Lease
Deferred at time of sale
Amortize over
Asset useful life if lease contains a bargain purchase or
renewal option, or if title transfers at lease end
Otherwise use lease term
Exactly same procedure as deferral of gain (loss) on
sale of fixed asset

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 Intercompany Transactions
Prior to Business Combination

When an acquisition occurs, prior sales between

the two entities are not eliminated on the
consolidated worksheet
Profits made prior to the acquisition are allowed
to stand
Debt and lease instruments between the parties
change their nature on the acquisition date
Amounts that were due between separate entities
now become intercompany debt or leases that must
be eliminated

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 Intercompany Leases
Residual values

Chapter assumes there is a bargain purchase

option or guaranteed residual
The residual value is included in the minimum lease
payments
Appendix considers unguaranteed residual
An UGRV causes the present value of the lease for
the lessor to exceed that of the lessee
The interest applicable to the UGRV is allowed to
remain in the consolidated statements since it will
come from the outside world

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