C ELIMINATING ENTRIES FOR INTERCOMPANY BONDS MECHANICS 1 Purchase directly from

C eliminating entries for intercompany bonds

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C. ELIMINATING ENTRIES FOR INTERCOMPANY BONDS – MECHANICS 1. Purchase directly from issuer a. When one affiliate purchases bonds of another affiliate directly from the issuing company, consolidation mechanics are easy because the book value of the investment equals the book value of the liability. b. The investment in bonds is simply eliminated against the bonds payable and interest expense is eliminated against interest income. 2. Purchase from outsiders a. If the intercompany bond purchase is made from outsiders, consolidation mechanics are more difficult. b. Because the purchase price usually differs from the book value of the liability, a constructive gain or loss must be recognized. D. ELIMINATING ENTRIES FOR INTERCOMPANY BONDS – OVERVIEW OF OBJECTIVES 1. A constructive gain or loss (if any) is reported in full in the year bonds are acquired by an affiliate in the determination of consolidated net income. 2. Interest expense is the amortized interest paid to outside parties during the fiscal period. 3. The book value of the debt is the amount held by outside parties on the balance sheet date. 2
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E. CONSTRUCTIVE GAIN OR LOSS ON INTERCOMPANY BOND HOLDINGS 1. Computing the Constructive Gain or Loss a. On the date that bonds of an affiliate are purchased, a constructive gain or loss is computed and this total gain or loss is allocated between the issuing and purchasing companies. b. There is no constructive gain or loss to the issuing company if the bonds are issued at par value, nor is there a constructive gain or loss to the purchasing company if the bonds are purchased at par value. c. If the issue price and the purchase price of the bonds were not equal to par value, there are four possible combinations that can result when a constructive gain or loss to the consolidated entity is allocated between two affiliated companies. 2. Allocation of Constructive Gain or Loss Four methods for allocating the constructive gain or loss between the parent and subsidiary are supported in practice and in the accounting literature. a. The constructive gain or loss is allocated entirely to the issuing company. b. The constructive gain or loss is allocated entirely to the purchasing company. c. The constructive gain or loss is allocated entirely to the parent company. d. The constructive gain or loss is allocated between the purchasing and issuing companies. i. Probably the soundest method conceptually ii. Consistent with the allocation of gains or losses between controlling and noncontrolling interest on other types of intercompany transactions. II. ILLUSTRATION OF INTERCOMPANY BOND HOLDINGS On the date the bonds are purchased, a constructive gain or loss is computed and allocated between the purchasing and issuing companies. The portion allocated to the 3
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purchasing company is the difference between the cost of the bonds and their par value.
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