 Hello and welcome to the session in which we would look at Intra entity or Intra company debt investment in the prior sessions just to keep track of what we are doing. We looked at Intra entity sales of inventory, land and depreciable asset. If you remember in those situation, one of the affiliates recognizes again prior to the time of the consolidation entity is entitled to recognize. So simply put when we have a sub and a parent. And what happened when they exchange land inventory, whatever they exchange again was recognized between the two entities, but the game cannot be recorded recognize on the consolidated because it was not sold on an outside party. In this session, we're going to be focusing on Intra company purchase of bonds when one company buys the bond of another company. Remember, when we do consolidation, the central theme, the central goal is to consolidate all entities as one single economic entity. So if we have notes payable, the process is straightforward because if we have a notes payable for one company, charging interest to another party, we have notes receivable so they cancel each other out. So that's easy. The complication starts with the purchaser of an affiliate debt instrument from an outside party. And this is where the debt investments gets a little bit more complicated. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Let's assume a subsidiary, a sub issued a bond, basically simply put sold a bond to outside parties. So we have a bonds outstanding. Now we have the parent company. Now the parent company purchased this bond from the third party. Now here's what happened. The sub issued the bond at a certain price, whatever that price is, and the parent company purchased it at another price. And the bond is listed on the sub company as of the book value. And you're going to see because of these complications, we're going to have to resolve this issue and consolidate everything. So from a consolidated point of view, the single entity has required its own debt. Keep in mind, each company, the sub, as well as the parent, will keep their own, the bonds at their own books, the bonds and the investments. So the sub will have a bonds payable and they'll keep track of that separately. The parent will have an investment in bond and they will keep track of that separately. Again, the price that the parent pay might be totally different how the bond is listed on the sub. So there's no risk, there might be no reciprocity and there will be no reciprocity. This is the example that we're going to be working. If there is reciprocity, then it's easy. It's like notes payable versus notes receivable, but that's not going to be the case here. So keep in mind that the parent record the investment and receive periodic interest income. The sub will show the bond as outstanding debt and would record periodic interest expense based on the initial selling price. However, the bond is technically retired. When we do the consolidation between the two entities, the bond is retired and the transfers of cash is basically inter entity transfer of cash. So that's easy. We're going to see the cash is easy to take care of. So what we have to do, we have to adjust balances to eliminate the bonds as retired. Now of the purchase price equal to the book value. So if we bought the bond for exactly the book value that's on the sub's book, we have no issues. All accounts are reciprocal. So we have the same amount of investment, the same amount of the bonds payable, the same amount of interest income, the same amount of interest expense and obviously the cash amount will be the same. But what happened if the purchase price is different than the carrying value? Then we have a gain and a loss and we have a premium and discount to resolve. So it gets a little bit more complicated. And this is what we need to work in this example is to show you what would happen when either the sub or the parents buy the bond of either the sub or the parent of the other entity in the open market at a different price than the book value. So the steps is to eliminate the investment and that accounts, eliminate interest revenue, interest expense, any interest payable, interest receivable and those they are not going to match because the price of the bond and what the bond is earning as an investment versus the book value will be different. We have to eliminate any discounts or premium. We have to recognize any gain or loss at the entity level and we have to make sure the entry balance and we're going to see how we're going to do this. The best way to illustrate this is to actually look at a complete example. Let's assume Maggie sold or issued a 9% $900,000 in bonds in the open market a few years ago. Simply put, Maggie is the issuer. The bond issuer means they sold the bond to an investor to be specific, a lender, a lender bought those bonds. The bond were issued at a discount yielding 9%. Of course, it's going to be issued at a discount because the yield is 12. The yield is a greater than the coupon. If you know anything about bonds, the bond was issued at a discount. Now, before I proceed further, maybe I should tell you this. If you are not familiar with how bonds are issued, the basics of bonds, this topic is mostly covered in advanced accounting. I would suggest you go to Farhad Lectures and look at my intermediate accounting course about bonds because I'm going to assume you have a basic understanding a lot of how bonds work. In 20x1, at the beginning of 20x1, Adam Company, a subsidiary of Maggie, purchased only 20% of the bonds and Adam paid, Adam Company 201 yielding 7%. So for bond, for Adam, the investment is earning 7%. When Maggie sold the bond, the bond discount yielding is 12%. So notice the interest expense that Maggie record will be different than the interest revenue that Adam is going to record. At that time, the carrying value of the bond on Maggie's book was 760,000. So we're going to prepare the consolidation entries for 20x1. So for the first year, and we're going to skip two years and prepare the consolidation entries for 20x3. Now, preparing the consolidation entries for 20x1 as a CPA candidate, you should be very comfortable with that. For 20x3, it's good that you would know it, but it's not required for the CPA exam. I don't think they would ask you questions like this, but I'm going to cover both. First, let's see the amount of gain or loss. The purchase price is 201. Adam paid 201. So how do we determine whether we have a gain or a loss on this transaction for the whole entity? It's how much the affiliate paid. Well, Adam paid 201. The bond book value, 760 times, we're only retiring 20% of it times 20%, 152. We paid 201. The book value is 152. We'll give us a loss of 49,000. Now, if I want to make this example a little bit more complicated, I can give you the face value of the bond and I can give you the un-amortized discount. And you'll have to find the book value, which is, we assume here that 900 minus the un-amortized discount gave us the 760. Okay? To make it even more complicated, I will tell you, they use the straight line, find the book value of the bond. But here, the book value is giving because, again, we're trying to make a point to show you the consolidation entries, not basic bonds. So this is the loss on the bond. What we paid versus the book value, we have a loss. Now, why do you say we have a loss? Because we assume, although Adam bought the bond, we assume as if Maggie bought the bond because they're affiliates. They are related. So now, let's take a look at December 31, 2021, and let's look at some computation. The cash amount will be exchanging hands between the parent and the affiliate is 16,200. How? The bond has a face value of 900,000. Adam purchased 20%. The bond pays 9% interest. So every year, the parent company will have to pay, in total, they'll have to pay 81,000 in cash, but we don't care about the 81,000. All we care is 20% of the 81,000, 16,200. So every year, the parent will have to, Maggie will have to write a check to Adam for 16,200, because that's how much the bond is earning. Now, how much would Adam record as interest revenue? Well, that's different. Interest revenue is computed or interest income on this bond is computed, basically taking the book that you paid for the bond, which is technically your book value, the investment book value times the yield, the market rate, the bond. We said this investment is yielding 7%. So the first thing I want you to notice is, and hopefully you know this, Adam is recording $14,070 in revenue and interest revenue and only receiving 16,200 in cash. Obviously, Adam paid a premium for this bond, paid a premium for this bond. Now, how much would Maggie record interest every period or every year for the sponsors? We're assuming it's yearly. Well, we're going to take the book value of the bond, only for the 20% book value, multiplied by the what? By the market rate. How much the bond is yielding? The bond was yielding when it was issued at 12%. Therefore, this is the interest expense. So notice, Adam's interest income for the same bond is $14,070. Maggie's interest expense is $18,240. And Maggie's interest expense, notice, she is going to pay only 16,200, but the expense is $18,240. Why? Because the bond was issued at a discount. So now that discount, that extra interest expense that we lost upfront reflected in the periodic interest payment. So now we know the interest income, the interest expense, and the cash exchange, the cash that we exchange. The best way to keep going is to look at an amortization table for both the bond payable and the bond investment. So the investment will be on Adam's books, and this is Maggie. So Adam will start the carrying value of the bond of 201. The cash, as I showed you how we compute the cash, the cash amount is the same. Interest revenue is taken, the 201 multiplied by the 7%. So Adam would record $14,070 of revenue. The difference between the cash and the revenue is the amount of the amortization that Adam will have to reduce the bond by, because I told you the bond was purchased at a premium. Therefore, the bond will go down in value by the amortization amount. And the journal entry would look something like this. Adam will debit cash $16,200, will credit the investment in bond. We don't credit the premium. We credit the investment to reduce the investment. Then we credit interest revenue for $14,070. So this is the entry that we make. Then for year X2, the cash is the same. The interest revenue is $13,921. We reduce the investment by $22,79. For year III, the cash is the same. Interest revenue $13,761. And notice the carrying value of the bond is going down. It has to go down back to the face value. Now let's take a look at how Maggie would amortize this bonds payable. The carrying value is $152. This is again Maggie or the parent company. The cash is $16,200, which is, I showed you how to compute the cash. The interest expense is taking the book carrying value at the beginning of the period. And this bond is yielding 12%, $18,240. The difference between them is the amount of discount that Maggie is going to amortize. And since this is a discount, what's going to happen? The discount is added to the $152 to the previous value to come up with a new carrying value. And what's the journal entry? Maggie will debit interest expense $18,240, which is this amount here. The cash is $16,200. The discount on the bond is $2,040. Now for year X2, the cash is always the same. $16,240. The interest expense is taking the carrying value times 12%. The difference between them is the amount that Maggie would amortize. And the bond carrying value will go up. And you got it for the third year. $16,00 for cash. Interest expense $18,759. The difference is amortization. And the bond carrying value will keep on rising. Now it's going to keep on rising until it gets to $176. And this will keep on going down until it goes down to $176 as well. Now, if you notice, I'm sure you can clearly see that the cash amount, debit cash, credit cash, that's easy. Basically those two would cancel each other. Would cancel each other. That's not a problem. Now, the revenue, interest revenue and interest income, they're not the same. That's clearly showing. Also, the investment, the carrying value of the investment on Adam's books is different than the carrying amount of the investment at Maggie's book. They have two different carrying value. At the end of the year, we have to prepare the consolidation. Now let's prepare the journal entries, the consolidated journal entries at the end of year X1. And let's assume we don't know much. In other words, we don't know the details of how to do this except general rules. If we know the general rules, what do we know? We need to know to eliminate this bond. So this bonds should not stay on Maggie's books, 20% of the bonds. So let's start with that. We're going to debit $154,040. Also, the investment here cannot be there because this is an intercompany. We have to remove that investment in Maggie's bonds, $198,870. We have to invest to remove those two. Remember, this interest income here is really intercompany interest income. And the expense is intercompany expense. So we're going to remove the income, debit the income, credit the expense. And the good thing is the cash, the $16,200 and the $16,200, they cancel each other out. Now if we add the debits and if we add the credits, they don't balance. Well, guess what? Year one, we're going to have either a gain or a loss. And if you remember on the prior slide, we computed the loss on this investment and the loss is $49,000. The loss on the retirement. And this is basically what we're doing. So what we're saying is this, this loss, this is company-wide. In other words, we said this loss is company-wide. It's reported on what? On the consolidated financial statement. It's not reported on Adam's company. It's not reported on Maggie's company neither. The loss is company-wide. Now, this is straightforward, simple, not simple, but I would say simple, straightforward, simple consolidation when it comes to year one. Now remember, I'm going to go from year one and I'm going to go ahead and work the journal entry for year three when we have to consolidate the books in year three. Remember, every time we have to consolidate the books, we have to assume we are standing back at the beginning when we started this process. Because remember, the consolidation is a worksheet. This doesn't go, these entries don't go on either the parent or the sub. The parent and the sub, they make those entries. So every time we have to consolidate, we have to assume we're back to the original position. So let's go ahead and look at year three. In year three, let's first see what the sub and the parent will record. Adam will debit cash $16,200 for the $16,200 credit interest income $13,761 and the amortization amount that we're going to be reducing the investment by $24,39. Maggie, the same thing. It should be pretty straightforward. The cash is $16,200. The interest expense is $18,759 and the difference is the amount that Maggie is going to amortize for this period. Let's start this process again when it comes to year three. Again, starting with simple what we know. First, let's eliminate the bonds payable. The bonds payable will have to be eliminated from Maggie's books when we consolidate $158,884. We have to eliminate the interest income. So this is gone. This is gone. We have to remove the investment $194,52 and we have to remove the interest expense. This is gone. Again, the cash, they simply cancel each other out. The cash will cancel each other out. Now you might be saying, you might be asking, how about the discount? How about the discount and how about the investment in the bond? Those $25,59 and $24,39, they differ, but when we eliminated the carrying value, the carrying value included the $24,39 and the $158,884, the bond also included the amortization. We kept it simpler. Now you could also eliminate the discount separately, but I just have it in one account. So the $158,84 include the discounted amount that we need to eliminate, which is $25,59 and the investment include the $29,39. I should have mentioned this, but that's okay in case you're wondering. Now what we need to do is we need to book, this is year three. Well, guess what? We need to book a debit because if you add the debits and the credits, let's add them up. If we add up the debit $158,884 plus $13,761, that's equal to $172,645. If we add the credits, $194,152 plus $18,759, that is $229,11. So there's a difference $172,645. There's a difference between those two. The difference between the debits and the credits is $40,266. So we are missing a debit for $40,266. The question is, what do we debit? We can no longer debit a loss because the loss was recorded in year one. This is when the transaction took place in year one and the loss was close to retained income, eventually overall for the company overall. So one way to look at it is we can say, well, we're going to close the loss to the what? We're going to let Adam carry the loss. One way to do it is to let Adam carry the loss. Simply put, we can debit the retained earnings for Adam, for Adam beginning retained earnings. That's one way to look at it. That's if we are using the partial or the partial equity method or the initial value. But we're not using those. Most tax book we focus on the equity method. So rather than debiting the beginning retained earnings of Adam company, what we're going to do, we're going to debit the investment in Maggie's company. So the debit will be the investment to Maggie's company because we're saying who should get the loss? Well, we're going to bury the loss in the investment in Maggie's company in this. This investment account will be closed in the elimination. That's fine. It will be closed in the elimination. But what does that mean? Why did we debited the investment in Maggie's company? Well, let's think of it this way. What we're accounting for is for the loss. The loss that we incurred. Now, the loss initially was 49,000. Why did the loss went from 49,000 to a loss of 40,000 to 66? Well, let's compute the difference. 49,000. Let's compute the difference here. If we take 49,000 and we subtract now somehow the loss, which is somehow we're calling it investment in Maggie. But we're going to see why we did this to 462. Let's compute the difference. The initial loss was 49,000 minus 40,266. And that's a reduction of 8,734. So what does this number represent? Why did the loss went from 49,000 to 40,266? Well, let's look into this a little bit further. If we look at the interest revenue that Adam recorded over the past two years. Well, he recorded 14,070 and 13,921 for the past two years. Now for this year, for this amount, we're already accounted for it in this journal entry. So let's compute the interest revenue. If we add, so this is the revenue that Adam recorded 14,070 plus 13,921. So in total 14,070 plus 13,921. That's 27,991. And let's look at what Maggie recorded on her books in interest expense over those years, over the same period. So if we take now this is, let's put the expense here, the expense. We're going to take 18,240 plus 18,485. Let's compute this 18,240 plus 18,485. And that's equal to 36,725. So if we take the difference between the 36,275 and the 27,000. And I can't really see this 991. 991. Let's find the difference. 36,725 minus 27,991. Let's see. Minus 27,991. That's equal to 8,734. Okay. What did we see this number? We see this number, 8,734. Is the reduction in the loss? Is this a reduction in the loss? Not really. Over the past two years, we recorded more expenses in the past two years. We recorded more expenses than revenues as a consolidation. So part of the loss was already factored in. What's left is the 40,260. Now we can no longer debit a loss. So we say, we would say this loss, it's going to be part of the investment in Maggie's company. And this investment account, obviously it will be closed. So this is why. So think of this as a plug, but I want you to understand why it's a plug and how did we come up with that number? Because you need to basically close this entry. I told you one way to do it is to close it to Adam's beginning retained earnings. Because Adam really is the sub that incurred the loss. Because Adam paid, Adam company paid for the bond and paid more. So Adam really should record the loss, which is it will be part of the retained earnings. But since we're using the equity method, we would assume that the investment in Maggie's company represent that retained earnings. And I hope this makes sense. What should you do now? Again, this topic is you don't have to go this far on the CPA exam. You don't have to consolidate a third year, but it doesn't hurt to learn it. Now, if you are an advanced accounting students, well, that's you have to, I make you know this for my class. What should you do now? Go to far hat lectures, whether you are an advanced accounting student, go to my advanced accounting course or a CPA candidate to look at additional resources, multiple choice exercises that's going to help you understand this topic further. This is advanced accounting, advanced accounting by its nature, by its name. It's more more advanced than intermediate and introductory. So if you are listening to me, it means you are an advanced accounting students. And your next step is the CPA exam. It's worth it. Good luck. Study hard. And of course, stay safe.