 Hello and welcome to the session. This is Professor Farhad and the session we're going to be looking at elimination of intercompany bond holding. This topic is covered in advanced accounting and it's definitely covered on the CPA exam. As always, I would like to remind my viewers which is you to connect with me on LinkedIn. If you don't have a LinkedIn account, I strongly suggest you create one and connect with me on LinkedIn. YouTube is where you would need to subscribe. I have over 1500 accounting, tax and auditing lectures on YouTube. Please subscribe, like my lectures, share them, put them in playlists, let the world know about them. If you are benefiting from my YouTube then other people might benefit as well, please share the wealth. This is my Instagram account, please follow me on Instagram as I'm trying to grow my following. This is my Facebook and definitely you want to give visit my website where I have special discounts on CPA courses. What is the big idea and do you need any prerequisite? Well, maybe. If you're not familiar with bonds, I strongly suggest you go to my intermediate accounting and review your bonds. You want to make sure you are comfortable with your bonds, but assuming you are comfortable with your bond, we need to know how it works. Basically, one company issue bonds. What does it mean issue a bond? It means they borrowed money. Let's assume one company borrowed money and they received cash $110,000. They debit cash, credit bonds payable for the face value of $100,000. Then they have a premium on bond for $10,000. This is the issue in company. We issued a bond and we received $110,000. Now, this bond now is on the market. One of our subsidiaries, one of our affiliate, purchased that bond from the open market. Okay. When they purchase the bond, they're going to debit investment, whatever they bought it for, investment, let's assume they purchase it for $105,000 and they are going to credit cash for $105,000. Now, this company is our subsidiary. This is the parent company and this is the subsidiary. Now, technically, if the subsidiary bought back the bond, it is as if we have bought the bond. It is as if the parent company bought the bond because do those two entities, the parent and the sub, they'll be consolidated. So that's the overall idea. That's the overall idea. Now, remember the parent company will have interest expense because they have to pay interest on the bond. The sub company will have revenue. So the parent company will have to pay interest expense on the bond and their interest expense is going to the sub as a revenue. Well, again, we have expense and we have revenue. They have to cancel each other out. We have an investment and we have a liability. They have to cancel, they have to cancel each other out. So this is the basic idea or the big idea about this chapter. Let's dive into the details. So an affiliate company may purchase bonds issued by another affiliate. So we have one company buying the bond of their affiliate. Guess what? Inter company bond investments, which is a receivable, which would have a receivable and bond payable has to be canceled against each other. So the issuing company, they have a loan, but the loan is held by the affiliate. So we have a liability. They have an asset. They have to cancel each other out. One company pay interest expense. The issuing company pays interest expense. The company that bought the bond will receive interest revenue. They're both inter company. I am kind of paying myself. So all these must be eliminated. So bond not held by external parties are viewed as being constructively retired. Although the issuing company did not buy them, but since our affiliate bought them, well, guess what? It's as weak as we bought them. They are constructively retired. So this is viewed as an early retirement of that. Now, again, this is a good idea to go back to my intermediate accounting chapter 14. If you don't know how to retire that, I strongly suggest you go there. Now, I'm going to cover how to retire that here, but it's a little bit different as if you have only one company. Okay? So let's go back to basics and illustrate an example about bonds. Just illustrate an example just to make sure you are familiar. Now, if what I'm going to be going over here is confusing you, guess what? You need to go back to my intermediate accounting. So a three-year bond with a par value of 100,000 was issued on January 2, 2010 for 85,000. So it was issued at a discount. The bond pays 7% interest each December, assuming straight line amortization. So this is the amortization table. This is the carrying value at the issuance, 85,000. The bond pays interest of 7%, 7,000, 7,000, 7,000. That's the cash. We have discount of total 15,000. It's going to be amortized a straight line 5,000 each year. And notice the bond carrying value go back to maturity when it mature, which is 100,000. It goes back to the par value. So this is basically a basic, a real basic amortization table for a bond. This is what the issuance company would enter. The issuance company will debit cash 85,000. They will debit discount on bonds 15, and they will credit bonds payable 100,000. So this is the issuance company, the company that issued the bond. Then they have to pay interest every six months for a 7,000 dollar. Then they have to amortize the discount, which amortizing the discount will increase interest expense. So notice amortizing the discount. When the discount goes down, our interest expense goes up. So we're amortizing the discount. So those are the entries that the issuance company would make for having that bond. They'll have to pay cash, and they'll have to amortize the discount. Now, we have the investor. The investor is the company that bought the bond. The company that bought the bond made an investment. Therefore, they have the increased or asset by 85,000, and they would reduce their cash because they paid 85,000. Now, every six months, they would receive, actually, sorry, I didn't mean to say every six months, every year, I guess the bond pays interest every year. Every year, the issuance company pays them 7,000 in cash. So they will debit cash and they will credit interest revenue. Now, also, they bought the bond at a premium. Now, when it comes to premium, notice there is no premium here because when you buy the bond is if you're an investor, you don't amortize the premium. What you do, every time you receive a payment, you will increase your investment by the premium amount, which is increase your investment. So you don't record the premium, you just simply increase your investment by that amount. So you increase your investments and you earn an additional 5,000. So notice the investor received cash and have revenue. The issuance company paid cash and have an expense. The issuance company have an expense and a discount. The investor company, they increase their asset and they increase their revenue. Basically, the opposite of each other. Once again, if these entries are confusing you, stop. Don't proceed any further. Go understand how bonds work, then come back and keep on going. But this is a very brief review. Now, the acquisition of an affiliate outstanding bond from an outsider is considered a constructive retirement by the consolidated entity. So if one of our affiliates bought the bond, it doesn't have to buy the bond directly from us. If they bought it from the market from someone else, well, it's within the consolidated entity, then it's constructively retired. The constructive gain or loss is recognized in the consolidated income statement prior to the recognition of gain or loss on the individual book. So simply put, we have to recognize the gain on the loss prior to the recognition of the gain on the loss and the loss on the individual company. So this is a little bit unusual in consolidation. So simply put, before each company record the gain or the loss, the gain or the loss will have to be recorded first in the consolidated entity. So in the period the bond are purchased, work papers are in entries are made to accelerate the recognition of gain or loss. So notice when we buy it, we we prepare work working paper entries to recognize the gain or the loss. And after the bond is purchased, work paper entries are needed to eliminate the gain or the loss recorded in the period of the books on the of the individual company that eventually will put that gain or loss on the individual company books. Now, we're talking about the gain or the loss. How do you allocate the gain or the loss? There are four methods to allocate the gain or the loss. So what are those four methods? One is allocated entirely to the issue one company. So the company that issued the bond should record the gain or the loss. Why? Because the purchasing affiliate as a member of the consolidated group is operating under a common management control. What we assume is it's as if the issue one company bought the bond. They were simply acting as an agent on behalf of the issue one company. So the whole gain or loss is with the issue one company. Or we could put everything with the purchasing company. Well, the company that initiated that transaction should absorb the gain or the loss. Or we can have everything to the parent company all the gain or the loss. So management of the parent company controlled the financing this financing decision of the consolidated affiliate. So now the parent company will have it where whoever the parent company is. It could be the parent company could be the issue one company too. Or the fourth method allocate the purchasing and the issue one company. So allocate I'm sorry allocate the gains and the loss between the purchasing company and the issue one company. So what happened is we're going to take the gain or the loss and allocate it between the two. This method recognize that a discount or premium will often be associated with both the issuance and the purchase on the open markets. What we're saying is since there's a premium and a discount, let the let each company worry about their premium and or discount. And again or loss will be recognized over the remaining life of the bond as each company amortize the related discount or premium either to interest expense if it's a discount to interest expense and the premium to interest revenue. Okay. If the bond are held to maturity, the full amount of the gain or the loss will be recognized by the two entities. So eventually once it mature, what's gained for one party is a loss for another party if we wait till the end. We're going to be using this method to illustrate the concept because basically the other methods especially the issuance company and the parent company, even the entirely by the purchasing company, it's we cover this in one way or another in intermediate and intermediate accounting. Okay. Now how do we compute the gain or the loss? Now let me show you how we compute the gain or the loss when we are dealing with the parent company only. So simply put when we are dealing with the parent company only. So this is not what we're going to be doing here. What we do is we look at how much cash paid. So how much cash we paid? And we compare this to the book value of the bond. If we pay more than the book value, we have a loss. If we cash paid, cash paid is less than the book value. If we paid, we have a gain. Now if we paid exactly the book value, we have no gain and no loss. This is basically this formula will apply for one, two and three. Now for forward, it's going to be a little bit different. Okay. On the date of the bond of an affiliate or purchase, a constructive gain or loss is issued. Now how do we remember we're going to have to allocate it between the two? The portion allocated to the issuance company. Now the issuance company is the company that actually issued the bond within the affiliate. We're going to look at the difference between the book value, which is the carrying value, which is what they have under books and the power value. Okay. So this is what we're going to be doing. We're going to be looking for the issuance company to determine if we have a gain or a loss. We're going to look at the book value, then compare this to the power value. For the purchasing company, it's the difference between the power value and what they paid and their cost. Their cost is what they paid. Okay. There'll be no constructive gain or loss if the bond are issued or purchase at par. So simply put, if the bond was issued at par, issued at par, it means issued at its face value or purchase at its face value, there's no gain and no loss if that's the case. Now let's take a look at different scenarios on how to compute the gain or the loss. Okay. If the issu price and the purchase price were not equal to the power value, so we're assuming they're not equal to the power value, and often they're not equal, there are four possible combinations that can result. So let's take a look at those four possible combination. For the issuance company, remember for the issuance company, we're going to compare the book value to the power value, the book value to the power value. Now let's take a look at the first scenario. We have 110,000 of a book value, but the power value is 100,000. What does that mean really? What does that mean? Well, it means we received, if the book value is 110 and the power value is 100,000, it means we are dealing with a, hopefully you know this, we are dealing with a premium bond. What does that mean? It means if we're dealing with a premium bond, it means we received more money, more money than the power value. What does that mean? It means if you received more money than the power value, all that we have to pay at the end is the power value. Therefore, under this scenario, we have a constructive gain. We have a constructive gain, constructive gain. Now for the purchasing company, we look at the purchase price, how much they paid versus the power value. And here what they paid is, if you think about it, they paid 85,000 dollar. They paid 85,000 dollar, right? They paid 85,000 dollar for something, okay, for something that's worth 100,000 because once that bond is retired, they all get back 100,000. Guess what? They have a gain. They have a gain. They have a gain, okay. Now let's take a look at scenario two. Scenario two, the bond book value is 90,000. Well, 90,000 means the bond if the power is 100, means this bond is a discount. But when the bond retired, the company will have to pay 100,000. Well, guess what? The company here has a loss, constructive loss of 10,000. Now the purchasing company, they paid 115,000. They paid 115,000. They paid that much for something that's going to be worth to them once it retired, once it matures, if the capital maturity is 100,000. Well, guess what? They have a loss. They have a loss of 150,000, okay. Let's take a look at example three and example four. In example three, the book value is 110. What does it mean the book value 110? It means this bond was initially issued at a premium and the company, the issuer and company will have to pay only 100,000. Guess what? They have a gain. The purchasing company, they paid 115,000. But once the bond matured, they're going to get back only 100,000. They have a constructive loss. So notice the issuer and company will have a constructive gain. The purchasing company will have a constructive loss. Overall, for the whole consolidated group will have a 5,000 constructive loss. Can you work this example and see what happened here? Well, let's do it. Book value is 90,000. The bond was issued at a discount. When it matured, we have to pay 100,000. Well, guess what? We are at a loss. The purchasing company paid $85,000. For a bond, if they wait until it matured, they will get 100,000. Well, we have a gain there. Overall, we have a constructive gain of $5,000. So this is how we compute constructive gain and constructive loss. Look at it this way. For the issuer and company, if the bond was issued at a premium, they will have a gain. If the bond is issued at a premium, they will have a gain under the scenario. Why? Because what they have to pay, they always have to pay the face value. The face value is less than the face value is always less than a premium bond. Okay? Now, for the purchasing company, it depends if they paid more or less. But think of it this way. And if it's a discount bond, they will have a loss for the issuer and company because the bond already at a discount and they have to pay the full value at maturity. Therefore, they have to come up with a difference. They will have a loss. That's for the issuer and company. The best way to illustrate this is to actually get our feet wet and work in example. We have P company owns 90% of the outstanding stock of S company. So we have 90%, okay? During 2012, S company issued a half a million power value bond for 520. So notice S company subsidiary issued the bond at a premium. It's a 10-year live bond and paid 6% interest. In 2014, P company bought the entire bond issued at the open market for 450. So the parent company bought the bond of an affiliate. Both companies use the straight line method to amortize the premium or the discount. The income and dividend for both companies are as follow. So we have the income for P company, the dividend, the income for S company in the dividend. Oops. Okay? So the first thing they want us to do is to compute the total gain or loss on the constructive retirement of the debt. So we have to know the gain or loss, the total, the total. They're asking for the total, the total gain or loss. All right. So the total, this is, they're not asking for a specific company. They're asking for the total. Well, to compute the total, it's how much we paid, how much we paid for the bond. So how much did we pay? We paid for the bond, paid 450. We paid 450. Now what we have to do, we have to figure out what's the book value of the bond. Okay? What's the book value of the bond? Now when the bond was originally issued, it was issued at 500 and 20,000. That was the book value. It means it has a discount of 20,000. That discount will have to be amortized over 10 years. So every year we're going to be amortizing $2,000. We're going to be amortizing, sorry, we're going to be amortizing $2,000. Now we issued the bond in 2012 and we retired in 2014. So we're going to go with two years of amortization. So we're going to amortize minus 4,000 of premium. So the book value when we issued the bond is 516,000. Now we have a bond with the book value of 516. We paid for it 450. Well, guess what? Overall, total is we have a gain. We're going to have a gain. We're going to have a gain of the difference between those two and the difference between 450 and 516. What we paid in the book value is 66,000 because the question's asking for the full amount, the total gain or total loss. Okay. Hopefully we get this. All right. Now, second question. Allocate the total gain and the total loss above to P and to S. Now remember, now this is a different formula. Now we have to allocate the 66,000 to each one for the steps for the issuing company. Smokey is the issuing company. What we do is we look at the book value and the book value was 516. We already computed the book value. Now we're going to compare the book value to the par value. The par value is 500,000. Guess what? I issued the bond above the par value. All I have to pay back is the par value. I have a gain of 16,000. That's the gain for the issuer and the issuer happens to be S company. Now for P company, P company is the purchasing company. Now the purchasing company, it happens to be also the P company. The purchase company, they paid, how much they paid? They paid 454,000. Well, we're going to take the difference between what they paid and the par value. They paid 50,000 less. So P company, or the parent company, which happens to be called Perl. Perl will have a gain of 50,000. So this is how we allocated the gain. Together, that's 66,000. And this is what we computed in the first question. How much was the total gain? 66,000. How much is allocated to each? Well, the issuer and company will take the book value versus the par value for the purchasing company. It's the par value versus the purchase price. The par value versus the purchase price. But we allocate the gain to the two different companies. Let's take a look at part C. Prepare the entries for Perl and Smokey company that they would record in 2014. So let's start with the P company, Perl. What did the parent company do? Well, the parent company made an investment. Although it's an investment under subsidiary, nevertheless, it's an investment. Therefore, we debit investment in bonds, which is an asset 450. This is how much they paid. And they will credit cash 450,000. Now, what would an investment in bonds gives you? The investment in bond will generate interest revenue. Therefore, the interest revenue is $30,000. Why $30,000? It's 6% and a half a million dollar bond. So if per year, the subsidiary will pay $30,000. Well, we're going to debit cash, credit, revenue, interest revenue $30,000. Now, bear in mind, bear in mind, I know I'm setting the ground for this, that this is from S company, this interest revenue from S company. It's a subsidiary. Well, guess what? We're receiving revenue, intercompany revenue. What do we have to do? Eventually, we have to kind of eliminate those revenues. And we're going to see how undirectly how it works. Now, what else do we have to do? Are we done yet? No. When we bought this bond, when P company bought this bond, they bought the bond at a $50,000 discount. Remember, they paid 450. Now, this $50,000 discount will be amortized over eight years because this is the remaining life of the bond. Therefore, every year, we have to amortize full revenue. So it's going to be increase our revenue 6250. So we're going to debit investment in bond, credit interest revenue 6250. Why? Because we bought the bond at a discount. Now, for the investor, which is P company, we don't amortize it. We don't have a premium. Notice, it's amortized for interest revenue. We don't have a premium for the investor. Because we are the investor. Yes, we are the investor here. Now, what would Smokey do? Well, remember also, before we proceed this interest revenue, this is intercompany revenue, because this revenue coming technically from S company. Because when the bond mature, they have to pay us back half a million. Therefore, we have an extra $50,000, but that $50,000 coming from our subsidiary. S company, they will have to debit interest expense $30,000, credit cash $30,000, because they have to pay us $30,000. Notice what happened here. This is interest expense paying the P company. So this interest expense and this interest revenue technically cancel each other out. This debit to cash and this credit to cash cancel each other out. Now, we did not cancel this entry. We're going to take care of this later, but I just want to show you that I want you to be in that realm of intercompany transaction. Now, what else? You remember, when S company issued this bond, they issued this bond at a premium. They issued the bond at $520, and they were amortizing $2,000. So every year, they have to debit premium on bond and credit interest expense of $10,000. Once again, remember, this interest expense now technically is intercompany, because this interest expense is part of an intercompany transaction. Because who holds the bond? The parent company. So this is the entries that they make. Now, obviously, we have to look at the elimination entries at the end. Now, I believe we did this. Yeah, we did prepare the journal entries for both. Use the information. Compute the controlling interest in the consolidated net income and the non-controlling interest. Okay, now we're going to compute the controlling interest and the non-controlling interest. We can do this here. So compute the controlling interest and the non-controlling interest, because we have all the data here. Well, P reported $100,000 of revenue. So we're going to start with P net income. P net income, they reported $100,000. Let's keep it here. $100,000. Now, of this $100,000, remember, because S company gave them dividend of $20,000, we have to back out the dividend less, because we only have to account for revenue less 90% of $20,000 dividend, which is 90% times $20,000. So we have to deduct from this amount $18,000. Okay, so what's the income from independent operation? It's $82,000. Then we're going to have to add the constructive gain, because that gain is to them constructive gain. And the constructive gain, if we remember the constructive gain for P company, how much was it? Let's go back. I forgot. The constructive gain for P company is $50,000. Therefore, we had to add up the constructive gain of $50,000. So the NS, we have $132,000, and that's pearl contribution to the consolidated statement. Okay. Now also, P, since it's the parent company, they're going to get the portion that S reported. Well, S net income, S net income reported $75,000. So they're going to also get S net income. So S net income is $75,000. Then S also had constructive gain, add constructive gain, add constructive gain of $16,000, because we allocated $50,000 to the parent. So this is going to be their contribution is $91,000. Okay. Now remember, of this $91,000, the parent company is going to absorb 90% because we're 90% owner. Therefore, that's going to be $81,900. Okay. So therefore, the controlling interest is $213,900. So this is the controlling interest, consolidated net income. Now, what is the non-controlling interest? Easy. If it's 10%, so it's $91,000, we said, S, if 90% goes to the parent company, 10% is for the minority or the non-controlling. So that's going to be $9,100. This is the non-controlling, and this is the controlling interest. So this is the consolidated income for the controlling, non-controlling interest. And that was the question. Let's take a look at the eliminating entries. Prepare the eliminating entries necessary to eliminate intercompany transaction. Now, what do we have to eliminate? Remember, we computed the bond, the bond gain, the constructive gain on the retirement of the bond. But we did not add the transaction to each company. We did not add the transaction to P. We did not add the transaction to S. Remember, for bonds, once we have a gain or a loss, we book it right there for the consolidated, then at the end of the year, we have to add the gain to each company separately. So remember, investment in bond will have to be increased for P company. So P company had part of the bond, $50,000. So this is the gain for P company. So remember, we computed $50,000 of gain. Now we have to book the gain on P company books. S company had a gain of $16,000. Well, what's going to happen? We're going to debit the premium on bonds payable for $16,000 and credit the gain. Same thing. What we are doing in these two entries, we are recording the gain on S books and on P books, because those gains, they will need to be recorded separately. $50,000 for P, $16,000 for S, we computed earlier. Now what else do we have to do? Remember, P company bought the bond from S company. This is an intra company transaction. Well, we have to eliminate the investment and we have to eliminate the bond, because the bond is no longer outstanding. If P company bought it, it's part of our company. So part of the consolidated. So we debit bonds payable and we credit investments. This way, bonds is gone and the investment is gone. Okay. Now what else do we have to do? If you remember what I told you earlier, that the interest revenue that we amortize and the interest expense that we amortize, that's those are inter company interest and revenue. So what do we have to do? We have to eliminate the interest revenue of $62,250. We debit interest revenue of $62,250. We credit investment and bond of $62,250. You might be saying, why did we do this? Well, let me show you. And I kind of planted the ground when I did this. I told you when we, when we eventually we're going to have to eliminate, let me highlight this in yellow, I told you eventually we have to eliminate this and this is what I just did. And as I also told you, we're going to have to eliminate this entry, which we're going to be doing next. So we eliminate this interest, inter revenue interest, and we have to eliminate the reduction in the expense. Therefore, we debit expense, we basically reverse the entry. We debit expense and credit premium on bond table. So those two entries basically reversal of what we did earlier when we recorded the transaction. Now, if you're having any difficulty with this topic, I'm going to tell you why. The reason why it's not because this topic is difficult, it is challenging. I'm not saying it's not challenging, but the reason could be because you don't have your prerequisite. What does that mean? It means if you're really having difficulty in this topic or in this chapter, go back to my intermediate accounting chapter 14. And I cover bonds in depth. Bonds is on the CPA exam heavily covered. So you need to understand how bonds work. This chapter, advanced accounting, assume you have mastered intermediate accounting. Therefore, if that's not the case, go back and take care of this. If you have any questions about this stop, this recording, email me. If you happen to visit my website for additional lectures, please consider donating, study hard for your CPA exam, and see you on the other side of success.