Intercompany Profit Transactions—Bonds
Transactions in which a corporation acquires the outstanding bonds of an affiliate on the open market result in constructive gains and losses except when an affiliate purchases bonds at book value. The consolidated entity realizes constructive gains and losses when an affiliate purchases another affiliate’s bonds. The constructive gains and losses should be reflected in the income of the parent (under the equity method) and consolidated net income in the year of purchase. Constructive gains and losses on parent bonds purchased by a subsidiary are similar to unrealized gains and losses on downstream sales and do not require allocation between non-controlling and controlling interests. However, constructive gains and losses on subsidiary bonds purchased by the parent company should be allocated between the controlling and non-controlling interests. Constructive gains or losses on intercompany bonds are recognized on the books of the purchaser and issuer as they amortize differences between the book value and par value of bonds.
A summary illustration comparing effects of constructive gains and losses from intercompany bond transactions on parent and consolidated net incomes is presented in the link below.
US intercompany transaction: bonds
1. What reciprocal accounts arise when one company borrows from an affiliate?
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. Do direct lending and borrowing transactions between affiliates give rise to unrealized gains or losses and unrecognized gains or losses?
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. What are constructive gains and losses? Describe a transaction having a constructive gain.
Constructive gains and losses are gains and losses from the viewpoint of the consolidated entity but not from the viewpoint of the separate affiliates involved. The purchase of a parent’s outstanding bonds by its subsidiary at a price below the book value of the bonds on the parent’s books results in a constructive gain. Although the bonds are not actually retired, they are constructively retired from the viewpoint of the consolidated entity because they are no longer liabilities of the consolidated entity to outside parties.
4. A company has a $1,000,000 bond issue outstanding with unamortized premium of $10,000 and unamortized issuance cost of $5,300. What is the book value of its liability? If an affiliate purchases half the bonds in the market at 98, what is the gain or loss? Is the gain or loss actual or constructive?
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. Compare a constructive gain on intercompany bonds with an unrealized gain on the intercompany sale of land.
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. Describe the process by which constructive gains on intercompany bonds are realized and recognized on the books of the affiliates. Does recognition of a constructive gain in consolidated financial statements precede or succeed recognition on the books of affiliates?
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 recorded book value, is the gain or loss attributed to the parent or the subsidiary? Explain.
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.
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