CHAPTER 7:

(A)Intercompany Profits in
Depreciable Assets

(B) Intercompany Bondholdings

(you’ll be examined on Theory
only) Garabedian

Some ppt © 2019 McGraw-Hill Education

 Intercompany Profits in
Depreciable Assets
 Parents and subsidiaries often redistribute depreciable assets
among themselves for a variety of reasons including
management, income tax, and corporate restructuring.
 Such transactions usually are recorded at the market value of
the assets transferred.
 The selling company will record a gain (or loss) on the sale,
and the buying company will record the assets at the price it
paid, often higher than the original cost of the assets to the
combined entity.

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 Intercompany Profits in
Depreciable Assets
 The gain or loss on intercompany asset sales is unrealized to the
group until
 the asset is subsequently sold to a buyer outside the group or
 used in producing a product or service that is sold.
The effect of the gain or loss is eliminated in the
consolidated financial statements - “as if” the transaction never
taken place.
 Depreciation adjustment
The intercompany sales of depreciable assets at a profit or
loss results in depreciation being recorded by the buying company
at an amount that is different than what the selling company
would have recorded on the historical cost basis if the transaction had
not occurred.
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 Intercompany Profits in
Depreciable Assets
 The incremental depreciation, which is the portion that is not
based on historical cost to the group, must be eliminated.
 This incremental depreciation in later periods may also be
thought of as the realization of the intercompany gain or loss
through the process of consumption of the value of the asset.

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 Intercompany Profits in
Depreciable Assets
 Income tax
Deferred income tax (on the balance sheet) is computed on
the outstanding balance of the unrealized gain or loss at the
balance sheet date.
 Upstream gains and losses
Allocate portion of the unrealized upstream gain/loss of
depreciation and tax to income statement non-controlling
interest.
To compute balance sheet non-controlling interest, adjust
shareholders’ equity of subsidiary for unrealized upstream
gain/loss net of depreciation and tax.
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 Example of Depreciable
Asset Transfer
Example:
 Parent purchased equipment from an unrelated party for a cost
of $1,000.
 The equipment has a 10 year life and is depreciated on the
straight-line basis.
 Parent immediately sells the equipment to Subsidiary for
$1,500.
 Parent pays income tax for $200 (40%) on the $500 gain that
is unrealized for consolidated financial statement purposes.

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 Example of Depreciable
Asset Transfer
 The parent records the following entry on its books
Date Description Debit Credit
1-Jan Cash 1,500
Income tax expense 200
Income Tax Payable 200
Equipment 1,000
Gain 500
To record gain on equipment sale

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 Example of Depreciable
Asset Transfer
 To eliminate the unrealized gain on the parent’s books,
restore equipment to its original cost, and defer the $200 tax paid,
the following elimination entry is required on the consolidated
worksheet:
Gain $500
Deferred income tax 200
Equipment $500
Income tax expense 200

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 Example of Depreciable
Asset Transfer
 The subsidiary records the following entry on its books

Date Description Debit Credit

SUBSIDIARY GENERAL JOURNAL
1-Jan Equipment 1,500
Cash 1,500
To record equipment Purchase

31-Dec Depreciation Expense 150

Accumulated Depreciation 150
To depreciate equipment $1,500/10 years

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 Example of Depreciable
Asset Transfer
If the parent had not sold the equipment,
Depreciation = $1,000/10 years = $100
Since the subsidiary is depreciating at a cost of $1,500, Dep’n =$150
1. Reduce the depreciation expense in consolidated FS to what it would have
been if the transfer had not occurred (or to “realize” the gain over time as the
asset is consumed),

Accumulated Depreciation (or NBV of asset) $50

Depreciation Expense $50

2. Match the decrease in depreciation expense to related income taxes at the

parent’s 40% tax rate

Income Tax Expense $20

Deferred Income Tax $20
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 Example of Depreciable
Asset Transfer
In each of the following years, until either the equipment is fully depreciated or the
subsidiary sells it, two consolidation elimination entries are required on the
consolidation worksheet.

 The first entry records the cumulative effect of adjustments made in prior
years as follows:
Accumulated Depreciation$xxx
Deferred income tax xxx
Retained earnings xxx
Equipment $500

 The second entry adjusts for the excess depreciation for that particular year as
follows:
Accumulated Depreciation (or NBV) $50
Income tax expense 20
Depreciation expense 50
Deferred income tax 20 11
 Problem 7-2
Equipment gain

Before Tax 40% tax After tax

Year 2 sale – Sally selling 15,000 6,000 9,000

Dep Years 2 and 3 (3,000  2) 6,000 2,400 3,600

Bal Dec 31, Year 3 (opening R/E) 9,000 3,600 5,400

Depreciation Year 4 (I/S) 3,000 1,200 1,800

Balance Dec 31, Year 4 (B/S) 6,000 2,400 3,600

$5,400 will be deducted from Subsidiary opening R/E Year 4

$3,600 will be deducted from Subsidiary opening R/E Year 4
$2,400 will be the DIT on Consolidated B/S Year 4
$6,000 should be deducted from NBV of Equipment on Consolidated B/S Year 4
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 (a) Calculation of consolidated profit attributable to Peggy’s
shareholders for Year 4

Profit of Peggy 185,000

Profit of Sally 53,000
Add: Equipment gain realized 1,800
Adjusted profit 54,800
Consolidated profit 239,800
Attributable to:
Shareholders of Peggy 226,100
NCI (25% x 54,800) 13,700
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 Peggy Company
Consolidated Income Statement
Year 4
Revenues (580,000 + 270,000) ` $850,000

Miscellaneous expense (110,000 + 85,000) 195,000

Depreciation expense (162,000 + 97,000 - (a) 3,000) 256,000

Income tax expense (123,000 + 35,000 + (a) 1,200) 159,200

Total expenses 610,200

Consolidated profit 239,800

Attributable to:

Shareholders of Peggy 226,100

NCI (25% x 54,800) 13,700

239,800 15
INTER-COMPANY BOND HOLDINGS Cont.

 Why are inter-company bond holdings created?

 Usually one company buys the (already issued) bonds of
an associated company on the open market.
 It is unlikely that one company would directly issue bonds
to an associated company – there are easier ways for
one company to loan funds to another!
 Similar techniques would be used for inter-corporate
investments in notes payable of related companies.

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 Intercompany Bondholdings
 When we discuss intercompany profits, we are generally
concerned with eliminating profits recorded by individual
companies, but unrealized by the group.

 When purchased on the open market, intercompany

bondholdings present the opposite situation:
 Profits associated with these bonds are unrealized at the
individual company level, but realized by the group as a
whole since they occurred with outside parties and arose as a
result of changes in prevailing market interest rates since the
bonds were originally issued.
 The intercompany bonds involves the recognition of these gains
and losses in the consolidated financial statements
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INTER-COMPANY BOND HOLDINGS
 We understand that inter-company balances
should be eliminated on consolidation. E.g. If P
owes $100 to S, the elimination entry is:

DR A/P (to S) 100

CR A/R (from P) 100

Now, replace A/P with Bonds Payable, and A/R

with Investment in Bonds!

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INTER-COMPANY BOND HOLDINGS Cont.

 If a member of the consolidated group issues

BONDS, which are purchased by another
member of the group, this produces the following
accounts to be eliminated:

Issuer: Purchaser:

Bonds Payable (L) Investment in Bonds (A)

Interest Expense Interest Revenue

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INTER-COMPANY BOND HOLDINGS Cont.

If the bonds were issued at par, the eliminations

are straightforward:

 Bonds payable = Investment in Bonds,

and
 Interest expense = Interest revenue

One side of each adjustment affects the issuer, the

other side the investor in the bonds.
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INTER-COMPANY BOND HOLDINGS Cont.

 However, if the bonds were not issued at par (or

if the purchaser bought them on the market),
then

Issuer Purchaser

Bonds payable (L) ≠ Investment in bonds (A)

Interest expense ≠ Interest revenue

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INTER-COMPANY BOND HOLDINGS Cont.

 The elimination of the inter-company bond

holdings treats the liability AS IF IT were
purchased and retired by the consolidated
group.

 This may CREATE a gain/loss on consolidation

 (where no gain or loss has been recorded by

either the parent or subsidiary).

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 INTER-COMPANY BOND HOLDINGS Cont.

The gain/loss on effective ‘retirement’ of the inter-

company bonds =
Carrying amount of bond liability- Cost of investment in bonds

WHO DOES THIS GAIN BELONG TO?

 Parent OR Subsidiary

 Issuer of bond OR Purchaser of bond

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The four approaches are as follows:
(a) The purchasing affiliate acted as an agent for the
issuing affiliate; therefore gains or losses are
allocated to the issuer.
(b) Gains or losses are allocated to the purchasing
affiliate because it made the open market purchase
of the bonds.
(c) Gains or losses are allocated to the parent
company because it controls the actions of the
affiliates.
(d) Gains or losses are allocated to both the
purchasing and the issuing affiliates.
Approach (d) is conceptually superior because each affiliate will
actually record the gain (loss) so allocated when it amortizes the
premiums or discounts that caused the consolidated gains (losses) in
the first place. As a result, the eliminations in consolidated statements
mirror the entries made by both the purchaser and the issuer.
INTER-COMPANY BOND HOLDINGS Cont.

WHY DOES THIS MATTER?

Any gain or loss on ‘retirement’ of the bonds (the
elimination entry) allocated to the subsidiary,
will affect the NCI.

 Thus, we will allocate part of the gain to each

party
 The assumption is that each party ‘retires’ the
bond (liability or investment) at face value.

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INTER-COMPANY BOND HOLDINGS Cont.

 P Co. pays $10,100 to purchase all of the

outstanding bonds payable of S Co.
 Face value of the bonds is $10,000.
 S Co. has a bond discount of $300  Carrying
value of the bonds payable = $9,700.

Problem:
We want to eliminate a $10,100 ‘Investment in Bonds’
against a net $9,700 ‘Bonds Payable’.

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INTER-COMPANY BOND HOLDINGS Cont.

 On consolidation we will report (create) a total

loss of $400.
 This represents the fact that the purchaser has
paid $10,100 to effectively eliminate a liability
with a value of only $9,700.
ASSET $10,100 LIABILITY $9,700
ELIMINATION ENTRY:
DR Liability 9,700
CR Asset 10,100
DR Loss 400

Bus 420 D1 & E1 Chapter 7

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 INTER-COMPANY BOND HOLDINGS Cont.

Gain/Loss Gain/Loss
Allocated to Allocated to Issuer
Purchaser (P Co) (S Co)
Par value of $ 10,000 $ 10,000
bonds
Investment in 10,100
bonds
Carrying value of 9,700
bond liability
Gain/(Loss) $ (100) $ (300)

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INTER-COMPANY BOND HOLDINGS Cont.

 S Co (the bond issuer) is allocated $300 of the

overall loss of $400,
 This is considered an UPSTREAM loss, and

affects the NCI.

 The gains/losses allocated to the issuer and

purchaser must disappear once the bond
matures (and the asset and liability disappear
from the individual company f/s).

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INTER-COMPANY BOND HOLDINGS Cont.

 To eliminate the gains/losses recognized on

consolidation (by each of the purchaser and
issuer), over the life of the bond:

 These gains/losses are amortized

 The amortization adjustments are reflected
through the interest revenue and interest
expense accounts in the consolidated income
statement.

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INTER-COMPANY BOND HOLDINGS Cont.

On the consolidated balance sheet:

 ‘Investment in bonds’ is eliminated against

‘Bonds payable’, including any ‘premium or

discount on bonds payable’.

 There may also be an effect on future income

taxes, as the ‘creation of a gain/loss’ and
subsequent amortization of gains/losses on
‘retirement’ of the bonds, is tax effected.

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 Intercompany Bondholdings –
Complex Example
 Example: Parent owns 100% of subsidiary. On January 1,
subsidiary pay $9,800 on the open market to purchase $10,000 of
bonds that were originally issued by Parent for $10,000 (i.e. no
issuing premium/discount). Bonds pay interest at 10% annually
and mature in 4 years.
 Gain on retirement of bonds = $10,000 - $9,800 = $200
 Income tax on gain (assume 40% rate) = $200 x 40% = $80
 Annual intercompany interest = $10,000 x 10% = $100 (Parent books
reflects expense, Subsidiary books reflect income)
 Each year, Subsidiary amortizes discount $200 / 4 = $50 to
income (entry is Dr bond investment, Cr interest income)

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 Intercompany Bondholdings -
Example
 The following adjustments are required on the consolidation
worksheet to:
 (i) eliminate the intercompany bonds and record the gain on
retirement;
 (ii) match the gain recognized to related income tax expense; and
 (iii) eliminate the intercompany interest net of income tax.
 Consolidation adjusting entries – January 1:
(i) Bonds payable (Parent) $10,000
Investment in bonds(Sub) $9,800
Gain on bond retirement 200

(ii) Income tax expense $80

Deferred income tax $80

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 Intercompany Bondholdings -
Example
 Consolidation adjusting entries – December 31:
 Parent has recorded $1,000 interest expense and subsidiary has
recorded $1,000 interest income + $50 discount amortization.
 Net pre-tax income = $1,050 - $1,000 = $50 x 40% tax rate =
$20 income tax paid.
 Subsidiary’s books reflect bond investment as $9,800 paid +
$50 amortization = $9,850 of which $ 9,800 was eliminated on
January 1, see consolidation adjusting entry:
Interest Income $1,050
Deferred income tax 20
Interest expense $1,000
Income tax expense 20
Investment in bonds 50

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 Less Than 100% Purchase of
Affiliate’s Bonds
 If a subsidiary purchased only 40% of the parents bonds then the
gain on bond retirement is recognized only on the portion of the
bonds being retired from a consolidated perspective.

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