Question

Pesto Company possesses 80% of Salerno Company's outstanding voting stock. Pesto uses the intial value method to account for this investment. On January 1, 2014, Pesto sold 9% bonds payable with a $10 million face value (maturing in 20 years) on the open market at a premium of $600,000. On January 1, 2017, Salerno acquired 40% of these same bondsfrom an outside party at 96.6% of fave value. Both companies use the straigh-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?

A) $320,000 Increase

B) $326,000 Increase

C) $331,000 Increase

D) $340,000 Increase

Answer 1

Solution: $320,000 Increase

Working:

Cash Received	10,600,000
2014–2016 amortization ($600,000 /20 yrs. * 3 yrs.)	-90,000
Book value, January 1, 2017	10,510,000
%	40%
Book value of retired bonds	4,204,000
Cash received ($4,000,000 * 96.6%)	3,864,000
Gain earned	340,000
Interest Expense on Intra-Entity Debt - 2017
Cash interest expense (9% * $4,000,000)	360,000
Premium amortization ($30,000 * 40% retired portion of bonds)	-12,000
Interest expense on intra-entity debt	348,000
Interest Income on Intra-Entity Debt - 2017
Cash interest income (9% * $4,000,000)	360,000
Discount amortization (.034 * $4,000,000 / 17 years)	8,000
Interest income on intra-entity debt	368,000
Adjustment to 1/1/18 Retained Earnings
Recognition of 2017 gain on extinguishment of debt (computed above)	340,000
Elimination of 2017 intra-entity interest expense (computed above)	348,000
Elimination of 2017 intra-entity interest income (computed above)	-368,000
Increase in retained earnings, 1/1/18	320,000