The explored the consolidation procedures required by the intercompany transfer of inventory, land, and depreciable assets. In consolidating these transactions, all resulting gains were deferred until earned through either the use of the asset or its resale to outside parties. Deferral was necessary because these gains, although legitimately recognized by the individual companies, were unearned from the perspective of the consolidated entity.
The separate financial information of each company was adjusted on the worksheet to be consistent with the view that the related companies actually composed a single economic concern.
This same objective applies in consolidating all other intercompany transactions. The financial statements must represent the business combination as one enterprise rather than as a group of independent organizations. Consequently, in designing consolidation procedures for intercompany transactions, the effects recorded by the individual companies first must be isolated.
After the impact of each action is analyzed, the worksheet entries necessary to recast these events from the vantage point of the business combination are developed. Although this process involves a number of nuances and complexities, the desire for reporting financial information solely from the perspective of the consolidated entity remains constant.
We introduced the intercompany sales of inventory, land, and depreciable assets together because these transfers result in similar consolidation procedures. In each case, one of the affiliated companies recognizes a gain prior to the time the consolidated entity actually earned it. The worksheet entries required by these transactions simply realign the separate financial information to agree with the viewpoint of the business combination. The gain is removed and the inflated asset value is reduced to historical cost.
Although accounting for the related companies as a single economic entity continues to be the central goal, the consolidation procedures applied to intercompany debt transactions are in diametric contrast to the process utilized for asset transfers.
Before delving into this topic, note that direct loans used to transfer funds between affiliated companies create no unique consolidation problems. Regardless of whether bonds or notes generate such amounts, the resulting receivable/payable balances are necessarily identical. Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation. A worksheet entry simply offsets the two corresponding balances. Furthermore, the interest revenue/expense accounts associated with direct loans also agree and are removed in the same fashion.
The difficulties encountered in consolidating intercompany liabilities relate to a specific type of transaction- the purchase from an outside third party of an affiliate s debt instrument. A parent company, for example, could acquire a bond previously issued by a subsidiary on the open market.
Despite the intercompany nature of this transaction, the debt remains an outstanding obligation of the original issuer but is recorded as an investment by the acquiring company. Thereafter, even though related parties are involved interest payments pass periodically between the two organizations.
Although the individual companies continue to report both the debt and the investment, from a consolidation viewpoint this liability is retired as of the acquisition date. From that time forward the debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intercompany cash transfers. To create consolidated statements, worksheet entries must be developed to adjust the various balances to report the debt’s effective retirement.
Acquiring an affiliate’s bond or note from an unrelated party poses no significant consolidation problems if the purchase price equals the corresponding book value of the liability. Reciprocal balances within the individual records would always be identical in value and easily offset in each subsequent consolidation.
Realistically, though, such reciprocity is rare when a debt is purchased from a third party. A variety of economic factors typically produces a difference between the price paid for the investment and the carrying amount of the obligation. The debt is originally sold under market conditions at a particular time.
Any premium or discount associated with this issuance is then amortized over the life of the bond creating a continuous adjustment to book value. The acquisition of this instrument at a later date is made at a price influenced by current economic conditions, prevailing interest rates, and myriad other financial and market factors.
Therefore, the cost paid to purchase the debt could be either more or less than the book value of the liability currently found within the issuing company’s financial records. To the business combination, this difference is a gain or loss because the acquisition effectively retires the bond; the debt is no longer owed to an outside party. For external reporting purposes, this gain or loss must be recognized immediately by the consolidated entity.
The accounting problems encountered in consolidating intercompany debt transactions are fourfold:
1. Both the investment and debt accounts must be eliminated now and for each future consolidation despite containing differing balances.
2. Subsequent interest revenue/expense (as well as any interest receivable/payable accounts) must be removed although these balances also fail to agree in amount.
3. Changes in all of the preceding accounts occur constantly because of the amortization process.
4. The business combination must recognize the gain or loss on retirement of the debt, even though this balance does not appear within the financial records of either company.
To illustrate, assume that Alpha Company possesses an 80 percent interest in the outstanding voting stock of Omega Company. On January 1, 2007, Omega issued $1 million in 10-year bonds paying cash interest of 9 percent annually. Because of market conditions prevailing on that date, Omega sold the debt for $938,555 to yield an effective interest rate of 10 percent per year.
Shortly thereafter, the prime interest rate began to fall, and by January 1, 2009, Omega made the decision to retire this debt prematurely and refinance it at the currently lower rates. To carry out this plan, Alpha purchased all of these bonds in the open market on January 1, 2009, for $1,057,466. This price was based on an effective yield of 8 percent, which is assumed to be in line with the interest rates at the time.
Many reasons could exist for having Alpha, rather than Omega, reacquire this debt. For example, company cash levels at that date could necessitate Alpha’s role as the purchasing agent. Also, contractual limitations can prohibit Omega from repurchasing its own bonds.
In accounting for this business combination, an early extinguishment of the debt has occurred. Thus, the difference between the $1,057,466 payment and the January 1, 2009, book value of the liability must be recognized in the consolidated statements as a gain or loss. The exact account balance reported for the debt on that date depends on the amortization process.
Although the issue was recorded initially at the $938,555 exchange price, after two years the carrying value increased to $946,651, calculated as follows:
Because Alpha paid $110,815 in excess of the recorded liability ($1,057,466 – $946,651), the consolidated entity must recognize a loss of this amount. After the loss has been acknowledged, the bond is considered to be retired and no further reporting is necessary by the business combination after January 1, 2009.
Despite the simplicity of this approach, neither company accounts for the event in this manner. Omega retains the $1 million debt balance within its separate financial records and amortizes the remaining discount each year. Annual cash interest payments of $90,000 (9 percent) continue to be made. At the same time, Alpha records the investment at the historical cost of $1,057,466, an amount that also requires periodic amortization. Furthermore, as the owner of these bonds, Alpha receives the $90,000 interest payments made by Omega.
To organize the accountant’s approach to this consolidation, a complete analysis of the subsequent financial recording made by each company should be produced.
Omega records only two journal entries during 2009 assuming that interest is paid each December 31:
Concurrently, Alpha journalizes entries to record its ownership of this investment:
Even a brief review of these entries indicates that the reciprocal accounts to be eliminated within the consolidation process do not agree in amount. You can see the dollar amounts appearing in each set of financial records in Exhibit 6.3. Despite the presence of these recorded balances, none of the four intercompany accounts (the liability, investment, interest expense, and interest revenue) appears in the consolidated financial statements. The only figure that the business combination reports is the $110,815 loss created by the extinguishment of this debt.
Consolidation procedures convert information generated by the individual accounting systems to the perspective of a single economic entity. A worksheet entry is therefore required on December 31, 2009, to eliminate the intercompany balances shown in Exhibit 6.3 and to recognize the loss resulting from the repurchase.
Mechanically, the differences in the liability and investment balances as well as the interest expense and interest income accounts stem from the $110,815 deviation between the purchase price of the investment and the book value of the liability. Recognition of this loss, in effect, bridges the gap between the divergent figures.
The preceding entry successfully transforms the separate financial reporting of Alpha and Omega to that appropriate for the business combination. The objective of the consolidation process has been met. The statements present the bonds as having been retired on January 1, 2009. The debt and the corresponding investment are eliminated along with both interest accounts. Only the loss now appears on the worksheet to be reported within the consolidated financial statements.
Perhaps the most intriguing issue in accounting for intercompany debt transactions to be addressed concerns the assignment of any gains and losses created by the retirement. Should the $ 110,815 loss just reported be attributed to Alpha or to Omega? From a practical perspective, this assignment is important only in calculating and reporting non-controlling interest figures. However, at least four different possible allocations can be identified, each of which demonstrates theoretical merit.
First, a strong argument can be made that the liability hypothetically extinguished is that of the issuing company and, thus, any resulting income relates solely to that party. This approach assumes that the retirement of any obligation affects only the debtor. Proponents of this position hold that the acquiring company is merely serving as a purchasing agent for the bonds’ original issuer.
Accordingly, in the previous illustration, the benefits derived from paying off the liability should accrue to Omega because refinancing reduced its interest rate. It incurred the loss solely to obtain these lower rates. Therefore, under this assumption, the entire $110,815 is assigned to Omega, the issuer of the debt. This assignment is usually considered to be consistent with the economic unit concept.
Second, other accountants argue that the loss should be assigned solely to the investor (Alpha). According to proponents of this approach, the acquisition of the bonds and the price negotiated by the buyer created the income effect.
A third hypothesis is that the resulting gain or loss should be split in some manner between the two companies. This approach is consistent with both the parent company concept and proportionate consolidation. Because both parties are involved with the debt, this proposition contends that assigning income to only one company is arbitrary and misleading. Normally, such a division is based on the original face value of the debt.
Hence, $57,466 of the loss would be allocated to Alpha with the remaining $53,349 assigned to Omega:
Allocating the loss in this manner is an enticing solution; the subsequent accounting process creates an identical division within the individual financial records. Because both Alpha’s premium and Omega’s discount must be amortized the loss figures eventually affect the respective companies’ reported earnings. Over the life of the bond, Alpha records the $57,466 as an interest income reduction, and Omega increases its own interest expense by $53,349 because of the amortization of the discount.
A fourth perspective takes a more practical view of intercompany debt transactions. The parent company ultimately orchestrates all repurchases. As the controlling party in a business combination, the ultimate responsibility for retiring any obligation lies with the parent. The gain or loss resulting from the decision should thus be assigned solely to the parent regardless of the specific identity of the debt issuer or the acquiring company.
In the current example, Alpha maintains control over Omega. Therefore, according to this theory, the financial consequences of reacquiring these bonds rest with Alpha so that the entire $110,815 loss must be attributed to it.
Each of these arguments has conceptual merit, and if the FASB eventually sets an official standard, any one approach (or possibly a hybrid) could be required. Unless otherwise stated, however, all income effects relating to intercompany debt transactions are assigned solely to the parent company, as discussed in the final approach. Consequently, the results of extinguishing debt always are attributed to the party most likely to have been responsible for the action.
Even though the preceding Entry B correctly eliminates Omega’s bonds in the year of retirement, the debt remains within the financial accounts of both companies until maturity. Therefore, in each succeeding time period all balances must again be consolidated so that the liability is always reported as having been extinguished on January 1, 2009. Unfortunately, a simple repetition of Entry B is not possible.
Developing the appropriate worksheet entry is complicated by the amortization process that produces continual change in the various account balances. Thus, as a preliminary step in each subsequent consolidation, current book values, as reported by the two parties, must be identified.
To illustrate, the 2010 journal entries for Alpha and Omega follow. Exhibit 6.4 shows the resulting account balances as of the end of that year.
After the information in Exhibit 6.4 has been assembled, the necessary consolidation entry as of December 31, 2010, can be produced. This entry removes the balances reported at that date for the intercompany bonds, as well as both of the interest accounts, to reflect the extinguishment of the debt on January 1, 2009. Because retirement occurred in a prior period, the worksheet adjustment must also create an $110,815 reduction in Retained Earnings to represent the original loss.
Analysis of this latest consolidation entry should emphasize several important factors:
1. The individual account balances change during the present fiscal period so that the current consolidation entry differs from Entry B. These alterations are a result of the amortization process. To ensure the accuracy of the worksheet entry, the adjusted balances are isolated in Exhibit 6.4.
2. As indicated previously, all income effects arising from intercompany debt transactions are assigned to the parent company. For this reason, the adjustment to beginning Retained Earnings in Entry *B is attributed to Alpha as is the $10,967 increase in current income ($95,132 interest expense elimination less the $84,165 interest revenue elimination). Consequently, the non-controlling interest balances are not altered by Entry *B.
3. The 2010 reduction to beginning Retained Earnings in Entry *B ($100,747) does not agree with the original $110,815 retirement loss. The individual companies have recorded a net deficit balance of $10,068 (the amount by which previous interest expense exceeds interest revenue) at the start of 2010. To achieve the proper consolidated total, an adjustment of only $100,747 is required ($110,815 – $10,068).
The periodic amortization of both the bond payable discount and the premium on the investment impacts the interest expense and revenue recorded by the two companies. As this schedule shows, these two interest accounts do not offset exactly; a $10,068 net residual amount remains in Retained Earnings after the first year.
Because this balance continues to increase each year, the subsequent consolidation adjustments to record the loss decrease to $100,747 in 2010 and constantly lesser thereafter. Over the life of the bond, the amortization process gradually brings the totals in the individual Retained Earnings accounts into agreement with the consolidated balance.
4. Entry *B as shown is appropriate for consolidations in which the parent has applied either the initial value or the partial equity method. However, a deviation is required if the parent uses the equity method for internal reporting purposes. Properly applying the equity method ensures that the parent’s income and hence, its retained earnings are correctly stated prior to consolidation.
Alpha would have already recognized the loss in accounting for this investment. Consequently, no adjustment to Retained Earnings is needed. In this one case, the $100,747 debit in Entry *B is made to the Investment in Omega Company because the loss has become a component of that account.