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Pesto Company possesses 80 percent of Salerno Company's outstanding voting stock. Pesto uses the initial value...

Pesto Company possesses 80 percent of Salerno Company's outstanding voting stock. Pesto uses the initial value method to account for this investment. On January 1, 2014, Pesto sold 6 percent bonds payable with a $14.0 million face value (maturing in 20 years) on the open market at a premium of $1,070,000. On January 1, 2017, Salerno acquired 40 percent of these same bonds from an outside party at 96.6 percent of face value. Both companies use the straight-line method of amortization. For a 2018 consolidation, what adjustment should be made to Pesto's beginning Retained Earnings as a result of this bond acquisition?

Multiple Choice

  • $543,000 increase

  • $521,600 increase

  • $554,200 increase

  • $532,300 increase

Solutions

Expert Solution

Solution

The correct answer is b) 521,600 increase

For 2018, the adjustment to beginning retained earnings should recognize
the gain on the retirement of the debt, the elimination of the 2017 interest
expense, and the elimination of the 2017 interest income.

Gain on Retirement of Bond:
Original book value $1,50,70,000 (140,00,000+10,70,000)
2014-2016 amortization ($10,70,000 ÷ 20 yrs. × 3 yrs.) (160,500)
Book value, January 1, 2013 $14,90,9500
Percentage of bonds retired 40%
Book value of retired bonds $59,63,800

140,00,000 x 40% = $ 56,00,000
Cash received ($56,00,000 × 96.6%) = $ 54,09,600
Gain on retirement of bonds $ 554,200 (59,63,800-54,09,600)

Interest Expense on Intra-Entity Debt—2013
Cash interest expense (6% × $56,00,000) $336,000

= $10,70,000/20 = $53,500 per year
Premium amortization ($53,500 per year total × 40%retired portion of bonds) = (21,400)
Interest expense on intra-entity debt $314,600 (336,000-21,400)

Interest Income on Intra-Entity Debt—2017
Cash interest income (6% × $56,00,000) $336,000
Discount amortization (.034 × $56,00,000 ÷ 17 years) 11,200
Interest income on intra-entity debt $347,200

Adjustment to 1/1/18 Retained Earnings
Recognition of 2017 gain on extinguishment of debt (above) $554,200
Elimination of 2017 intra-entity interest expense (above) 314,600
Elimination of 2017 intra-entity interest income (above) (347,200)
Increase in retained earnings, 1/1/18 $521,600

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ekkarill92 answered 2 years ago
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