Chapter 7
INTERCOMPANY PROFIT TRANSACTIONS — BONDS
Answers to Questions
1 Intercompany borrowing gives rise to notes or advances receivable from and payable to affiliates, as well
as reciprocal interest receivable and payable accounts and interest income and expense accounts.
2 Direct lending and borrowing transactions do not give rise to unrealized gains and losses. Any income
reported by the lender is precisely reciprocal to an expense reported by the borrower, and the transactions
are complete on the date consummated. Similarly, direct lending and borrowing transactions do not give
rise to unrecognized gains and losses since intercompany amounts received and paid are both realized
and recognized from the viewpoint of the separate legal entities.
3 Actual retirement occur in any of these three following options:
a) The issuer (parent or subsidiary) use its available resources to purchase and retire its own bonds.
b) The issuer (parent or subsidiary) borrow money from unaffiliated entities at the market rate of
interest and use the proceeds to retire its own bonds. (This option constitutes refunding)
c) The issuer can borrow money from an affiliate and use the proceeds to retire its own bonds.
4 The book value of the liability is $1,004,700, computed as $1,000,000 plus $10,000 minus $5,300. If an
affiliate purchases half of the bonds at 98, it will record a bond investment of $490,000. From the
viewpoint of the consolidated entity, the purchase of the bonds results in a constructive retirement of
$500,000 par of bonds payable. The constructive gain on the bonds is $12,350 [($1,004,700 ´ 50%) –
$490,000].
5 A constructive gain on bonds is a gain for consolidated statement purposes that is not recorded on the
books of the separate affiliates. The affiliates continue to carry the bonds as a liability (issuer) and
investment (purchaser) on their separate books. Alternatively, an unrealized gain on the sale of land is
recorded on the books of the selling affiliate, but it is not recognized as a gain for consolidated statement
purposes because the land is still held within the consolidated entity. Thus, a constructive gain on bonds
is realized and recognized from the viewpoint of the consolidated entity but it is not recognized on the
books of the affiliates. An unrealized gain on the sale of land is recognized on the books of the selling
affiliate but is not realized or recognized from the viewpoint of the consolidated entity.
6 Constructive gains on intercompany bonds are realized and recognized through the interest income and
expense reported on the separate books of the affiliates. The difference between the interest income
reported by the investor and the interest expense reported by the issuer on the intercompany bonds is the
amount of constructive gain recognized in each period. Constructive gains and losses are recognized in
the consolidated financial statements before they are recognized on the books of the affiliates.
7 If a subsidiary purchases parent bonds at a price in excess of book value, a constructive loss results. The
loss is attributed to the parent since it is the parent bonds that are constructively retired. This approach of
associating constructive gains and losses on intercompany bonds with the issuer is consistent with the
procedures used in earlier chapters of associating gains and losses on intercompany sales transactions
with the selling affiliates.
Copyright © 2015 Pearson Education Limited
,7-2 Intercompany Profit Transactions — Bonds
8a Assume bonds were purchased at the beginning of the current year
10% bonds payable 52,000
Interest income 5,250
Interest payable 2,500
Investment in S bonds 49,000
Interest expense 4,500
Interest receivable 2,500
Constructive gain on bonds 3,750
To eliminate reciprocal bond investment and liability amounts,
reciprocal interest income and expense amounts, reciprocal
interest receivable and payable amounts, and enter the
constructive gain on bonds. The constructive gain is computed as
the $52,500 book value of bonds that were retired for $48,750.
8b Assume bonds were purchased one year earlier
10% bonds payable 52,000
Interest income 5,250
Interest payable 2,500
Investment in S bonds 49,000
Interest expense 4,500
Interest receivable 2,500
Investment in S stock (90%) 3,375
Noncontrolling interest 375
To eliminate reciprocal bond investment and liability amounts,
reciprocal interest income and expense amounts, reciprocal
interest receivable and payable amounts, and adjust controlling
and noncontrolling interest holdings for constructive gain less
piecemeal recognition. The constructive gain is computed as:
$53,000 book value - $48,500 cost = $4,500 of which $750 was
recognized on the books of the affiliate in the prior year.
9 The amount of piecemeal recognition of a constructive gain or loss is always the difference between the
intercompany interest expense and income account that are eliminated. If the straight-line amortization is
used, the amount of piecemeal recognition of each year can be calculated with the constructive gain or
loss divided by the remaining life of the bond when the retirement occurred. However, this approach
cannot be applied if effective interest method is used.
10 Elimination of interest expense will eventually increase the controlling share of consolidated income and
the opposite, elimination of interest income will eventually decrease the controlling share of consolidated
income. Logically, interest expense is the debit account of the controlling share, so eliminating it will
eventually increase the income or credit account and vice versa for the interest income.
11a A constructive gain will result when interest income exceeds interest expense on the bonds that are
constructively retired.
11b The constructive gain is associated with the parent since the issuer reports interest expense.
11c The $200 difference between interest income and expense represents a piecemeal recognition of the
constructive gain on the books of the separate companies.
Copyright © 2015 Pearson Education Limited
, Chapter 7 7-3
SOLUTIONS TO EXERCISES
Solution E7-1
1 c 3 d
2 a 4 a
Solution E7-2
1 a
Book value of Pan bond’s acquired by
Sow ($900,000 + $48,000) ´ 2/3 $632,000
Cost to Sow 602,000
Constructive gain $ 30,000
2 d
Nominal interest on Pan’s remaining
outstanding bonds $300,000 ´ 8% $ 24,000
Less: Amortization of premium ($48,000 ´ 1/3)/ 4 years 4,000
Interest expense on consolidated income statement $ 20,000
Copyright © 2015 Pearson Education Limited
INTERCOMPANY PROFIT TRANSACTIONS — BONDS
Answers to Questions
1 Intercompany borrowing gives rise to notes or advances receivable from and payable to affiliates, as well
as reciprocal interest receivable and payable accounts and interest income and expense accounts.
2 Direct lending and borrowing transactions do not give rise to unrealized gains and losses. Any income
reported by the lender is precisely reciprocal to an expense reported by the borrower, and the transactions
are complete on the date consummated. Similarly, direct lending and borrowing transactions do not give
rise to unrecognized gains and losses since intercompany amounts received and paid are both realized
and recognized from the viewpoint of the separate legal entities.
3 Actual retirement occur in any of these three following options:
a) The issuer (parent or subsidiary) use its available resources to purchase and retire its own bonds.
b) The issuer (parent or subsidiary) borrow money from unaffiliated entities at the market rate of
interest and use the proceeds to retire its own bonds. (This option constitutes refunding)
c) The issuer can borrow money from an affiliate and use the proceeds to retire its own bonds.
4 The book value of the liability is $1,004,700, computed as $1,000,000 plus $10,000 minus $5,300. If an
affiliate purchases half of the bonds at 98, it will record a bond investment of $490,000. From the
viewpoint of the consolidated entity, the purchase of the bonds results in a constructive retirement of
$500,000 par of bonds payable. The constructive gain on the bonds is $12,350 [($1,004,700 ´ 50%) –
$490,000].
5 A constructive gain on bonds is a gain for consolidated statement purposes that is not recorded on the
books of the separate affiliates. The affiliates continue to carry the bonds as a liability (issuer) and
investment (purchaser) on their separate books. Alternatively, an unrealized gain on the sale of land is
recorded on the books of the selling affiliate, but it is not recognized as a gain for consolidated statement
purposes because the land is still held within the consolidated entity. Thus, a constructive gain on bonds
is realized and recognized from the viewpoint of the consolidated entity but it is not recognized on the
books of the affiliates. An unrealized gain on the sale of land is recognized on the books of the selling
affiliate but is not realized or recognized from the viewpoint of the consolidated entity.
6 Constructive gains on intercompany bonds are realized and recognized through the interest income and
expense reported on the separate books of the affiliates. The difference between the interest income
reported by the investor and the interest expense reported by the issuer on the intercompany bonds is the
amount of constructive gain recognized in each period. Constructive gains and losses are recognized in
the consolidated financial statements before they are recognized on the books of the affiliates.
7 If a subsidiary purchases parent bonds at a price in excess of book value, a constructive loss results. The
loss is attributed to the parent since it is the parent bonds that are constructively retired. This approach of
associating constructive gains and losses on intercompany bonds with the issuer is consistent with the
procedures used in earlier chapters of associating gains and losses on intercompany sales transactions
with the selling affiliates.
Copyright © 2015 Pearson Education Limited
,7-2 Intercompany Profit Transactions — Bonds
8a Assume bonds were purchased at the beginning of the current year
10% bonds payable 52,000
Interest income 5,250
Interest payable 2,500
Investment in S bonds 49,000
Interest expense 4,500
Interest receivable 2,500
Constructive gain on bonds 3,750
To eliminate reciprocal bond investment and liability amounts,
reciprocal interest income and expense amounts, reciprocal
interest receivable and payable amounts, and enter the
constructive gain on bonds. The constructive gain is computed as
the $52,500 book value of bonds that were retired for $48,750.
8b Assume bonds were purchased one year earlier
10% bonds payable 52,000
Interest income 5,250
Interest payable 2,500
Investment in S bonds 49,000
Interest expense 4,500
Interest receivable 2,500
Investment in S stock (90%) 3,375
Noncontrolling interest 375
To eliminate reciprocal bond investment and liability amounts,
reciprocal interest income and expense amounts, reciprocal
interest receivable and payable amounts, and adjust controlling
and noncontrolling interest holdings for constructive gain less
piecemeal recognition. The constructive gain is computed as:
$53,000 book value - $48,500 cost = $4,500 of which $750 was
recognized on the books of the affiliate in the prior year.
9 The amount of piecemeal recognition of a constructive gain or loss is always the difference between the
intercompany interest expense and income account that are eliminated. If the straight-line amortization is
used, the amount of piecemeal recognition of each year can be calculated with the constructive gain or
loss divided by the remaining life of the bond when the retirement occurred. However, this approach
cannot be applied if effective interest method is used.
10 Elimination of interest expense will eventually increase the controlling share of consolidated income and
the opposite, elimination of interest income will eventually decrease the controlling share of consolidated
income. Logically, interest expense is the debit account of the controlling share, so eliminating it will
eventually increase the income or credit account and vice versa for the interest income.
11a A constructive gain will result when interest income exceeds interest expense on the bonds that are
constructively retired.
11b The constructive gain is associated with the parent since the issuer reports interest expense.
11c The $200 difference between interest income and expense represents a piecemeal recognition of the
constructive gain on the books of the separate companies.
Copyright © 2015 Pearson Education Limited
, Chapter 7 7-3
SOLUTIONS TO EXERCISES
Solution E7-1
1 c 3 d
2 a 4 a
Solution E7-2
1 a
Book value of Pan bond’s acquired by
Sow ($900,000 + $48,000) ´ 2/3 $632,000
Cost to Sow 602,000
Constructive gain $ 30,000
2 d
Nominal interest on Pan’s remaining
outstanding bonds $300,000 ´ 8% $ 24,000
Less: Amortization of premium ($48,000 ´ 1/3)/ 4 years 4,000
Interest expense on consolidated income statement $ 20,000
Copyright © 2015 Pearson Education Limited
