Solution manual advanced accounting 9e by hoyle ch06

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CHAPTER 6
INTERCOMPANY DEBT, CONSOLIDATED STATEMENT OF
CASH FLOWS AND OTHER ISSUES

Chapter 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, often 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 a primary beneficiary is referred to by FASB Interpretation
46R "Consolidation of Variable Interest Entities," (FIN 46R) as a variable interest entity.
The following characteristics indicate a controlling financial interest in a variable interest
entity.
1. The direct or indirect ability to make decisions about the entity's activities
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. FIN 46R reasons that if a "business enterprise has a controlling financial interest in a
variable interest entity, assets, liabilities, and results of the activities of the variable interest
entity should be included with those of the business enterprise." Therefore, primary
beneficiaries must include their variable interest entities in their consolidated financial
statements consistent with the provisions of SFAS 141R.

II. Intercompany debt transactions
A. No real consolidation problem is created when one member of a business combination
loans money to another. The resulting receivable/payable accounts as well as the interest
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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 being reported by the buyer will not correspond with the interest expense of

the debtor.
C. In the year of acquisition, all intercompany accounts (the liability, the receivable, interest
income, and interest expense) are eliminated within the consolidation process 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 intercompany debt.
D. Even after the year of retirement, all intercompany accounts must be eliminated again in
each subsequent consolidation; however, the beginning retained earnings of the parent
company is adjusted rather than a gain or loss account.
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 amount of the change made 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 component of the
noncontrolling interest.
B. In an acquisition, the fair value of any subsidiary preferred shares not acquired by the
parent is added to any 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. Intercompany 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 although any dividends paid to these outside owners is reported as a financing
activity.
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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.

Learning Objectives
Having completed Chapter 6, students should have fulfilled each of the following learning
objectives:
1. Describe a variable interest entity and primary beneficiary. Also should know when a variable
interest entity is subject to consolidation.
2. Eliminate all intercompany debt accounts and recognize any associated gain or loss created
whenever one company acquires an affiliate's debt instrument from an outside party.
3. Recognize that intercompany debt transactions require a constantly changing consolidation
entry to be prepared for each subsequent period until the debt is formally retired.
4. Compute the appropriate amounts and make the worksheet entry needed in each subsequent
consolidation when one company has purchased the debt of an affiliate directly from an
outside parry.
5. Discuss the various theories as to the appropriate allocation of any income effect created by
intercompany debt transactions and identify the assignment employed in this textbook (and
the rationale for its use).
6. Understand that subsidiary preferred stocks not owned by the parent are initially valued in
consolidated financial reports as noncontrolling interest at acquisition-date fair value.
7. Prepare a consolidated statement of cash flows.
8. Compute basic and diluted earnings per share for a business combination in which the
subsidiary has dilutive convertible securities.
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9. Identify subsidiary stock transactions that can impact the underlying book value figure
recorded within the parent's Investment account.
10. Calculate the effect that a subsidiary stock transaction has on the parent's investment balance
and make the required journal entry to record that impact.

Answer to Discussion Question
Who Lost the $300,000?
This case is designed to give life to a theoretical accounting issue discussed within the chapter: If
a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the
subsidiary? The case attempts to illustrate that no clear-cut solution to this question can be found.
This lack of an absolute answer makes financial accounting both intriguing and frustrating.
Interesting class discussion can be generated from this issue.
Students should note that the decision as to assignment only becomes necessary because of the
presence of the noncontrolling interest. Regardless of the level of ownership all intercompany
balances are simply eliminated on the worksheet with the gain or loss being recognized. Not until
the time that the noncontrolling interest computations are made does the identity of the specific
party become important.
All financial and operating decisions are assumed to be 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, a strong argument can be made against
any assignment to either separate party.
Students should be required to pick one method and justify its use. Discussion usually centers
on the following issues:






Parent company officials made the actual choice that created the loss. Therefore, assigning
the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong
party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case)
so that its financial records 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 was forced 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 was forced to pay more
than face value, that remaining portion is assigned to the buyer.

Answers to Questions

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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 direct or indirect ability to make decisions about the entity's activities
 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 as found on the subsidiary's records. This difference
creates accounting problems in handling the intercompany transaction. From a consolidated
perspective, the debt has been retired; a gain or loss should be reported with no further
interest being recorded. In reality, each company will continue to maintain these bonds on
their individual financial records. Also, because discounts and/or premiums are likely to be
present, both of 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 intercompany 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 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. 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
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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 gradually decreases over the life of the bond.
9. No set rule exists for assigning the income effects that result from intercompany debt
transactions although several different theories have been put forth over the years which
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 being made 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 statement of cash flows is developed from the information found in the
consolidated balance sheet and income statement. 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 of the business combination because an
actual cash outflow is created.
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
consolidated basic EPS. Consolidated basic earnings per share is computed by dividing
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 diluted
earnings per share for the business combination.
15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties.
Clearly, 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.

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16. Because the new stock was issued at a price above book value, the book value per share of
Metcalf's stock has been increased. Consequently, the book value of Washburn's investment
should be increased to reflect this change. To measure the effect, the underlying book value
of Washburn's investment is calculated both before and after the new issuance. Because the
increment is the result of a stock transaction, an increase is made to additional paid-in capital
although recording a gain or loss is currently allowed. 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) does carry into the consolidated figures. In addition, the percentage of the
subsidiary attributed to the noncontrolling interest will have increased.
17. A stock dividend does not alter the book value of the subsidiary company and, thus, creates

no effect on Washburn's investment account or on the consolidated figures. Hence, no entry
is recorded at all by the parent company in connection with the subsidiary's stock dividend.

Answers to Problems
1. D
2. C
3. A
4. D
5. A
6. D Cash Flow from Operations:
Net income .................................................................
Depreciation ..............................................................
Trademark amortization ............................................
Increase in accounts receivable ...............................
Increase in inventory.................................................
Increase in accounts payable ...................................
Cash Flow from Operations .....................................
7. C

Cash Flow from Financing Activities:
Dividends to parent’s interest ..................................
Dividends to noncontrolling interest (20%  $5,000)
Reduction in long-term notes payable.....................
Cash Flow from Financing Activities .......................

$45,000
10,000
15,000
(17,000)
(40,000)

12,000

(20,000)
$25,000

($12,000)
(1,000)
(25,000)
($38,000)

8. C
9. C
10. C Rodgers' Reported Balance ......................................
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Ferdinal's reported balance .....................................
Eliminate interest expense—intercompany ............
Eliminate interest income—intercompany .............
Recognize gain on retirement of debt ($212,000 – $199,000)
Consolidated net income ...................................

80,000
21,000
(22,000)
13,000
$292,000

11. B Eliminate interest expense—intercompany ............
Eliminate interest income—intercompany .............
Recognize loss on retirement of debt ($206,000 – $189,000)
Reduction in retained earnings, 1/1/10 ..............

$21,000
(18,000)
(17,000)
$(14,000)

12. B Ace reported income ................................................
Remove intercompany dividends (cost method) ....
Byrd reported income ..............................................
Gain on extinguishment of debt ($48,300 – $46,600)
Eliminate interest expense on "retired" debt
($48,300 x 10%) ....................................................
Eliminate interest income on "retired" debt
($46,600 x 12%) ....................................................
Consolidated net income ..............................

$400,000
(7,000) $393,000
100,000
1,700

4,830
(5,592)
$493,938

13. D 30% of Byrd's reported income of $100,000; the intercompany debt
transaction is attributed solely to the parent company.
14. A For 2010, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2009 interest
expense, and the elimination of the 2009 interest income.
Gain on Retirement of Bond
Original book value .............................................................
2006–2008 amortization ($600,000 ÷ 20 yrs. x 3 yrs.) ........
Book value, January 1, 2009 ...............................................
Percentage of bonds retired ...............................................
Book value of retired bonds ...............................................
Cash received ($4,000,000 x 96.6%) ...................................
Gain on retirement of bonds ..............................................
Interest Expense on Intercompany Debt—2009
Cash interest expense (9% x $4,000,000) ...........................
Premium amortization ($30,000 per year total x 40%
retired portion of bonds) ...............................................
Interest expense on intercompany debt ............................
Interest Income on Intercompany Debt—2009
Cash interest income (9% x $4,000,000) ............................
Discount amortization ($136,000 ÷ 17 yrs.) ........................
Interest income on intercompany debt ..............................
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$10,600,000

(90,000)
$10,510,000
40%
$4,204,000
3,864,000
$340,000
$360,000
(12,000)
$348,000
$360,000
8,000
$368,000

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Adjustment to 1/1/10 Retained Earnings
Recognition of 2009 gain on extinguishment of debt (above) ....
Elimination of 2009 intercompany interest expense (above) ......
Elimination of 2009 intercompany interest income (above) ........
Increase in retained earnings, 1/1/10 .........................$320,000

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$340,000
348,000

(368,000)

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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 ...........................
400,000
Acquisition-date fair value ............................................................ 6,480,000
Acquisition-date book value ......................................................... (6,000,000)
Goodwill ......................................................................................... $480,000
16. C Consideration transferred for preferred stock ............................ $106,000
Consideration transferred for common stock .............................
916,400
Noncontrolling interest fair value for common ...........................
580,000
Acquisition-date fair value ............................................................ $1,602,400
Acquisition-date book value ......................................................... (1,500,000)
Excess fair value ............................................................................ $102,400
to building ....................................................................................
50,000
to goodwill ....................................................................................
$52,400
17. A Parent’s reported sales ............................................
Subsidiary's reported sales .....................................

Less: intercompany transfers ..................................
Sales to outsiders ...............................................
Eliminate increase in receivables (less cash collected)
Cash generated by sales ....................................

$300,000
200,000
(40,000)
$460,000
(30,000)
$430,000

18. B Book value of subsidiary prior to issuing new shares
(12,000 x $40) .......................................................
Parent's ownership ..................................................
Book value acquired ................................................

$480,000
100%
$480,000

Book value of subsidiary after issuing new shares (above
value plus 3,000 shares at $50 each) .................
Parent's ownership (12,000 ÷ 15,000 shares) .........
Book value acquired ................................................

$630,000
80%
$504,000

Investment in Nestlum increases by $24,000 ($504,000 less $480,000)
19. A Because the parent acquired 80 percent of the new shares, its proportion of
ownership has remained the same. Because the purchase price 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 book value of subsidiary ($795,000 + $150,000) ..........
Current parent ownership (32,000 shs. ÷ 50,000 shs.) ................
Book value acquired .................................................................
Book value acquired currently recorded in parent's investment account ($795,000 x 80%) ...............................................
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$945,000
64%
$604,800
636,000

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Required adjustment—decrease .......................................

$(31,200)

21. D Adjusted book value of subsidiary ($795,000 – $192,000) ..........
Current parent ownership (32,000 shs. ÷ 32,000 shs.) ................
Book value equivalency of parent's ownership .....................

Book value equivalency currently recorded in parent's investment account ($795,000 x 80%) ...............................................
Required adjustment—decrease ........................................

$603,000
100%
$603,000
636,000
$(33,000)

22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)
Consolidation of a variable interest entity is required if a parent has a
variable interest that will


Absorb a majority of the entity's expected losses if they occur



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.

(40 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. According to FIN 46R, an entity qualifies as a VIE and is subject to
consolidation if either of the following conditions exist.


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 direct or indirect ability to make decisions about an entity's
activities through voting rights or similar rights.
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)

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23. continued
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 is required if a parent has a variable interest that will


Absorb a majority of the entity's expected losses if they occur



Receive a majority of the entity's expected residual returns if they occur

Also, a direct or indirect ability to make decisions that significantly affect the
results of the activities of a variable interest entity is a strong indication that
an enterprise has one or both of the characteristics that would require
consolidation of the variable interest entity.

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.



During construction 11.1% of project cost potential termination loss.

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

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).

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24. (10 minutes) (Consolidation of variable interest entity.)
a. Implied valuation and excess allocation for Softplus.
Noncontrolling interest fair value
Consideration transferred by Pantech
Total business fair value
Fair value of VIE net assets
Excess net asset value fair value

$ 60,000
20,000
80,000
100,000
$20,000

The $20,000 excess net asset fair value is recognized by PanTech as a
bargain purchase. All SoftPlus’ assets and liabilities are recognized at their
individual fair values.
Cash
Marketing software
Computer equipment
Long-term debt

Noncontrolling interest
Pantech equity interest
Gain on bargain purchase

$20,000
160,000
40,000
(120,000)
(60,000)
(20,000)
(20,000)
-0-

b. Implied valuation and excess valuation for Softplus.
Noncontrolling interest fair value
Consideration transferred by Pantech
Total business fair value
Fair value of VIE net identifiable assets
Goodwill

60,000
20,000
80,000
60,000
$20,000

When the business 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 a goodwill.

Cash
Marketing software
Computer equipment
Goodwill (excess business fair value)
Long-term debt
Noncontrolling interest
Pantech equity interest

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

$20,000
120,000
40,000
20,000
(120,000)
(60,000)
(20,000)
-0-

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25.

(25 Minutes) (Consolidation entry for three consecutive years to report
effects of intercompany bond acquisition. Straight-line method used.)

a. Book Value of Bonds Payable, January 1, 2009
Book value, January 1, 2007 ..................................................
Amortization—2007–2008 ($5,000 per year
[$50,000 premium ÷ 10 years] for two years) ..................
Book value of bonds payable, January 1, 2009 ....................
Book value of 40% of bonds payable
(intercompany portion), January 1, 2009 ........................
Gain on Retirement of Bonds, January 1, 2009
Purchase price ($400,000 x 96%) ..........................................
Book value of liability (computed above) .............................
Gain on retirement of bonds .................................................

$1,050,000
10,000
$1,040,000
$416,000
$384,000
416,000
$32,000

Book Value of Bonds Payable, December 31, 2009
Book value, January 1, 2009 (computed above) .................. $1,040,000
Amortization for 2009..............................................................
5,000
Book value of bonds payable, December 31, 2009 ............... $1,035,000
Book value of 40% of bonds payable (intercompany portion),
December 31, 2009.............................................................
$414,000
Book Value of Investment, December 31, 2009
Book value of investment, January 1, 2009 (purchase price)

Amortization for 2009 ($16,000 discount ÷ 8-yr. rem. life) ...
Book value of investment, December 31, 2009 ....................
Intercompany Interest Balances for 2009
Interest expense:
Cash payment ($400,000 x 9%) ........................................
Amortization of premium for 2009 ($5,000 per year
multiplied by 40% intercompany portion) ..................
Intercompany interest expense .......................................
Interest income:
Cash collection ($400,000 x 9%) ......................................
Amortization of discount for 2009 (above) ......................
Intercompany interest income .........................................

$384,000
2,000
$386,000

$36,000
2,000
$34,000
$36,000
2,000
$38,000

CONSOLIDATION ENTRY B (2009)
Bonds Payable .......................................................... 400,000
Premium on Bonds Payable ..................................... 14,000
Interest Income ......................................................... 38,000
Investment in Bonds ............................................
386,000

Interest Expense ...................................................
34,000
Extraordinary Gain on Retirement of Bonds ......
32,000
(To eliminate accounts stemming from intercompany bonds [balances
computed above] and to recognize gain on the retirement of this debt.)
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25. (continued)
b. In 2010, 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 included as a component of beginning retained
earnings. Concurrently, the two interest balances recorded by the
individual companies in 2009 are removed from retained earnings
because they resulted after the intercompany retirement. Gain of $32,000
plus $34,000 expense removal less $38,000 income elimination gives
$28,000 increase in retained earnings.
CONSOLIDATION ENTRY *B (2010)
Bonds Payable ...................................................
400,000
Premium on Bonds Payable ($2,000 amortization)

12,000
Interest Income ..................................................
38,000
Investment in Bonds ($2,000 amortization) .
388,000
Interest Expense ............................................
34,000
Retained Earnings, 1/1/10 (Darges) ..............
28,000
(To remove intercompany bond accounts that remain on the individual
records of both companies. Both debt and investment balances have
been adjusted for 2009–10 amortization. Entry to retained earnings 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 retained earnings takes into
account that another year of interest expense ($34,000) and income
($38,000) have been closed into this equity account by the separate
companies.
CONSOLIDATION ENTRY *B (2011)
Bonds Payable ....................................................
Premium on Bonds Payable ...............................
Interest Income ...................................................
Investment in Bonds .....................................
Interest Expense ............................................
Retained Earnings, 1/1/11 (Darges) ..............

400,000
10,000
38,000

390,000
34,000
24,000

(To remove intercompany bond accounts that remain on the individual
records of both companies. Both debt and investment balances have
been adjusted for 2009– 2011 amortization. Entry to retained earnings
brings the totals reported by the individual companies to the balance of
the original gain.)
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26.

(12 Minutes) (Determine consolidated income statement accounts after
acquisition of intercompany bonds.)


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



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



Loss To Be Recognized = $108,000 – $84,000 = $24,000

CONSOLIDATED TOTALS

27.



Revenues and Interest Income = $1,051,360 (add the two book values and
eliminate interest income on intercompany bond)



Operating and Interest Expense = $751,760 (add the two book values and
eliminate interest expense on intercompany bond)



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)

(30 Minutes) (Consolidation entry for two years to report effects of
intercompany bond acquisition. Effective rate method applied.)
a. Loss on Repurchase of Bond
Cost of acquisition ........................................
Book value ($668,778 x 1/8) ...........................
Loss on repurchase .......................................

$121,655
83,597
$38,058

Interest Balances for 2009
Interest income:
$121,655 x 6% ...........................................

$7,299

Interest expense:
$83,597 (book value [above]) x 10% ........

$8,360

Investment Balance, December 31, 2009
Original cost, 1/1/09 ........................................
Amortization of premium:
Cash interest ($100,000 x 8%) ..................
Effective interest income (above) ............
Investment, 12/31/09 ............................

McGraw-Hill/Irwin
6-16

$121,655
$8,000
7,299

701
$120,954

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27. (continued)
Bonds Payable Balance, December 31, 2009
Book value, 1/1/09 (above) ............................
Amortization of discount:
Cash interest ($100,000 x 8%) ..................
Effective interest expense (above) ..........
Bonds payable, 12/31/09 ......................

$83,597
$8,000
8,360

360
$83,957

Entry B—12/31/09
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 intercompany debt holdings and recognize loss on
retirement.)
b. Interest Balances for 2010
Interest income: $120,954 (investment
balance for the year) x 6% .......................................

$7,257

Interest expense: $83,957 (liability balance
for the year) x 10% ....................................................

$8,396

Investment Balance, December 31, 2010
Book value, January 1, 2010 (part a) .......................
Amortization of premium:
Cash interest ($100,000 x 8%) ............................
Effective interest income (above) ......................

Investment balance, December 31, 2010 .......
Bonds Payable Balance, December 31, 2010
Book value, January 1, 2010 (part a) .......................
Amortization of discount:
Cash interest ($100,000 x 8%) ............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2010 .........................................
Interest Balances for 2011
Interest income: $120,211 (investment ....................
balance for the year [above]) x 6%
Interest expense: $84,353 (liability balance
for the year [above]) x 10% .................................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

$120,954
$8,000
7,257

743
$120,211
$83,957

$8,000
8,396

396
$84,353

$7,213

$8,435

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27. (continued)
Investment Balance, December 31, 2011
Book value, January 1, 2011 (above) ......................
Amortization of premium:
Cash interest ($100,000 x 8%) ............................
Effective interest income (above) ......................
Investment balance, December 31, 2011 .......
Bonds Payable Balance, December 31, 2011
Book value, January 1, 2011 (above) ......................
Amortization of discount:
Cash interest ($100,000 x 8%) ............................
Effective interest expense (above) .....................
Bonds payable balance,
December 31, 2011 ...................................

$120,211
$8,000
7,213

787

$119,424
$84,353

$8,000
8,435

435
$84,788

Adjustment Needed to Retained Earnings, January 1, 2011
Loss on retirement of debt (part a) .........................
Balances currently in retained earnings:
Interest income:
2009
($7,299)
2010
(7,257)
($14,556)
Interest expense:
2009
$8,360
2010
8,396
16,756
Reduction needed to beginning retained
earnings to arrive at consolidated total ..........................

$38,058

2,200

$35,858

Entry *B—12/31/11
Bonds Payable ..........................................................
Interest Income .........................................................
Retained earnings, 1/1/11 (Parent) ..........................
Investment in Bonds ...........................................
Interest Expense .................................................

84,788
7,213
35,858
119,424
8,435

(To eliminate intercompany bond holdings and adjust beginning retained
earnings balance of the parent to amount representing loss on retire ment.
Amounts computed above.)

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28. (35 Minutes) (Consolidation procedures and balances related to intercompany

bonds. Both straight-line and effective interest rate methods are used.)
a. Acquisition price of bonds ..............................................................
Book value of bonds payable (see Schedule 1)
($443,497 x 50%) ..........................................................................
Loss on retirement ...........................................................................

$283,550
(221,749)
$61,801

SCHEDULE 1—Book Value of Bonds Payable

Date
2007
2008
2009

Book
Value
$435,763
$438,055
$440,622

Effective
Interest
(12% Rate)
$52,292
$52,567
$52,875

Cash
Interest
$50,000
$50,000
$50,000

Amortization
$2,292
$2,567
$2,875

b. Investment in Bloom Bonds
Purchase price—12/31/09 .........................................
Cash interest ($250,000 x 10%) ................................
Effective interest income ($283,550 x 8%) ..............
Amortization ........................................................
Investment in Bloom bonds, 12/31/10 .....................

$25,000
22,684

Bonds Payable
Book value—12/31/09 (computed above) ...............
Cash interest ($500,000 x 10%) ................................
Effective interest expense ($443,497 x 12%) ...........
Amortization ........................................................
Bonds payable, 12/31/10 ..........................................

$50,000
53,220

Year-End
Book Value
$438,055
$440,622
$443,497

$283,550

2,316
$281,234

$443,497

3,220
$446,717

Although not required, the consolidation entry as of 12/31/10 is as follows. The
reduction in retained earnings represents the loss only; no intercompany
interest was recognized in the previous year because the purchase was made
on December 31.
Entry *B (2010)
Bonds Payable ($446,717 x 50%) .............................
Interest Income .........................................................
Retained Earnings, 1/1/10 ........................................
Interest Expense ($53,220 x 50%) ......................
Investment in Bloom Bonds ...............................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

223,359
22,684
61,801
26,610
281,234

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28. continued
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—1/1/07 ........................................................
Discount amortization (2007–2009) ([$64,237 ÷ 11] x 3 years) ...
Book value 12/31/09 ....................................................................

$435,763
17,519
$453,282

Intercompany portion of bonds payable (50%) .........................
Purchase price .............................................................................
Loss on retirement ......................................................................

$226,641

283,550
$56,909

Investment in Bloom Bonds
Purchase price—12/31/09 ...........................................................
Premium amortization (2010) ($33,550 ÷ 8) ................................
Book value 12/31/10 ...............................................................

$283,550
(4,194)
$279,356

Interest Income
Cash interest ($250,000 x 10%) ...................................................
Premium amortization (above) ...................................................
Intercompany interest income—2010 ...................................

$25,000
(4,194)
$20,806

Bonds Payable
Original issue price 1/1/07 ...........................................................
Discount amortization (2007–2010) [($64,237 ÷ 11) x 4 years] ..
Book value 12/31/10 ...............................................................
Opus ownership .....................................................................
Intercompany portion—12/31/10 ......................................

$435,763
23,359

$459,122
50%
$229,561

Interest Expense
Cash interest ($250,000 x 10%) ...................................................
Discount amortization ([$64,237 ÷ 11] x 1/2) ..............................
Intercompany interest expense—2010 .................................

$25,000
2,920
$27,920

The reduction in retained earnings represents the loss only; no intercompany
interest was recognized in the previous year because the purchase was made
on December 31.
Entry *B (2010)
Bonds Payable ..........................................................
Interest Income .........................................................
Retained Earnings, 1/1/10 .......................................
Interest Expense ................................................
Investment in Bloom Bonds ...............................

McGraw-Hill/Irwin
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229,561
20,806
56,909
27,920

279,356

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29. (8 Minutes) (Determine goodwill for a purchase in which subsidiary has both
common stock and preferred stock)
Consideration transferred for common stock
Consideration transferred for preferred stock
Noncontrolling interest in common stock
Noncontrolling interest in preferred stock
Hepner’s acquisition-date fair value
Book value of Hepner
Goodwill

$1,600,000
630,000
400,000
270,000
$2,900,000
2,500,000
$400,000

30. (30 Minutes) (Consolidation entries for a purchase where subsidiary has
outstanding cumulative preferred stock.)
a. The preferred shares are entitled to the specified cumulative dividend. Thus, the
noncontrolling interest's share of the subsidiary's income equals $160,000 or 8

percent of the preferred stock's par value.
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, 2009
Consideration transferred, January 1, 2009 .............................. $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 2009 (above) ........................................................
(1,000)
Investment in Smith account, December 31, 2009 ..................... $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, 1/1/09 (Smith) ........................... 10,000,000
Franchises ................................................................

40,000
Investment in Smith ........................................
Noncontrolling Interest in Smith, Inc ............
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2,000,000

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(To eliminate subsidiary stockholders’ equity, record excess fair values, and
record outside ownership of subsidiary's preferred stock at fair value)

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30. c. (continued)
Entry I

Equity Income of Subsidiary ..............................
285,000
Investment in Smith .......................................
285,000
(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 intercompany 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].)

31. (30 Minutes) (Prepare consolidation entries for a purchase where subsidiary
has outstanding preferred stock)
Consideration transferred for common stock
$ 7,368,000
Consideration transferred for preferred stock
3,100,000
Noncontrolling interest in common stock
4,912,000

Acquisition-date fair value for Young
$15,380,000
Young’s book value
15,000,000
Excess fair over book value
380,000
to building (5-year life)
$200,000
to equipment (10-year life)
(100,000)
100,000
to brand name (20-year life)
$280,000
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 ...........................................................
Investment in Young's Preferred Stock (100%) .
Investment in Young's Common Stock (60%) ...
Noncontrolling interest .......................................

100,000
3,100,000
7,368,000

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)
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31. (continued)
Entry I1
Dividend Income ......................................................
80,000
Dividends Paid ....................................................
80,000
(To offset intercompany preferred stock dividend payments recognized as
income by parent—$1,000,000 par value x 8% dividend rate.)
Entry I2
Dividend Income ......................................................
192,000
Dividends Paid ....................................................
192,000
(To eliminate intercompany 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 ...............................................................
Brand name .........................................................
(To record 2009 amortization of specific accounts
recognized within acquisition price of preferred stock.)

40,000
14,000

32. (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 approach in presenting cash flows from operations, the
$12,000 gain is merely omitted. However, if the indirect approach is in use,
the gain (a positive) must be eliminated from net income by a subtraction.



Intercompany 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 approach to present cash flows from operations, this expense is

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omitted. If the indirect approach is used, the expense must be removed from
consolidated net income by an addition.


Decrease in accounts payable. Cash payments have been used to reduce
this liability balance during the period. If the direct approach is used to
present cash flows from operations, 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 approach is applied, the decrease is subtracted from
net income in arriving at the net cash generated from operations during the
period.

33. (20 Minutes) (Determine cash flows from operations for a consolidated entity.)
NOTE–CORRECTION TO PROBLEM: The noncontrolling interest’s share of the
subsidiary’s income is $9,800 (not $12,000 as listed on page 285 of text).
DIRECT APPROACH
Cash revenues (add book values, eliminate intercompany transfers,
and add decrease in accounts receivable) ..................................
$648,000
Cash inventory purchases (add book values, eliminate
intercompany transfers, eliminate unrealized gains, add increase in
inventory, and add decrease in accounts payable) .....................
(370,000)
Depreciation and amortization (omit as noncash expenses) ...........
-0Other expenses (add book values) ....................................................
(40,000)
Gain on sale of equipment (omit because this is an investing activity)
-0Equity in earnings of Wallace (not an operating cash flow) ............
-0Cash generated from operations ............................................
$238,000
INDIRECT APPROACH
Consolidated net income (computed below) ....................................
Adjustments:
Depreciation and amortization ................................................
Gain on sale of equipment ......................................................
Increase in inventory ...............................................................
Decrease in accounts receivable ............................................
Decrease in accounts payable ................................................

Cash generated from operations .......................................

$216,000
61,000
(30,000)
(11,000)
8,000
(6,000)
$238,000

Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below:
Revenues (add book values and subtract intercompany transfers) $640,000
Cost of goods sold (add book values, less intercompany
transfers and beginning unrealized gain, plus ending
unrealized gain) ........................................................................
(353,000)
Depreciation and amortization (add book values plus
amortization from excess fair value allocations) ...................
(61,000)
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