Do direct lending and borrowing transactions between affiliated companies give rise to unrealized gains or losses? To unrecognized gains or losses?

Intercompany Profit Transactions—Bonds 235 Assumptions 1 Parent Company’s income, excluding income from Subsidiary, was $100,000 for 2006.

2 90%-owned Subsidiary reported net income of $50,000 for 2006.

3 $100,000 of 10% bonds payable are outstanding with $6,000 unamortized premium as of January 1 2006 4 $50,000 par of the bonds were purchased for $51,500 on January 2,2006.

5 The bonds mature on January 1,2009.

S Acquires P’s P Acquires S’s Bonds Bonds

(similar to (similar to downstream) upstream)

P’s Net Income—Equity Method P’s separate income $100,000 $100,000 P’s share of S’s reported net income 45,000 45,000 Add: Constructive gain on bonds

($53,000 - $51,500) x 100% 1,500

($53,000 - $51,500) x 90% 1,350 Deduct: Piecemeal recognition of constructive gain

($1,500 gain ~ 3 years) x 100% (500)

($1,500 gain -f 3 years) x 90% _ (450)

P’s net income $146.000 $145.900 Consolidated Net Income P’s separate income plus S’s net income $150,000 $150,000 Add: Constructive gain on bonds 1,500 1,500 Eliminate: Interest expense (increase) 4,000 4,000 Interest income (decrease) (4.500) (4.500)

Total realized income 151,000 151,000 Less: Noncontrolling interest expense

($50,000x 10%) (5,000)

($50,000 + $1,500 - $500) x 10% _ (5.100)

Consolidated net income $146.000 $145.900 P’s net income and consolidated net income of $146,000 when S acquires P’s bonds are the same as if the bonds had actu¬ ally been retired by P at the end of 2006. In that case, P’s separate income would have been $101,000 ($100,000 plus $1,000 constructive gain), and S’s net income would have been unchanged. P’s $101,000 plus P’s $45,000 share of S’s reported net income equals $146,000. An assumption of retirement at year-end is necessary because the interest expense of P and the inter¬ est income of S are both realized and recognized during 2006. The amount of the gain is $1,000 ($1,500 less $500 realized and recognized during the current year).

P’s net income and consolidated net income of $145,900 when P acquires S’s bonds are the same as if the bonds had actu¬ ally been retired by S at the end of 2006. In that case, P’s separate income would have been unchanged at $100,000, and S’s reported net income would have been $51,000 ($50,000 plus $1,000 constructive gain). P’s $100,000 separate income plus P’s $45,900 share of S’s reported income ($51,000 x 90%) equals $145,900. Again, the assumption of retirement at year-end is necessary because the interest income of P and the interest expense of S are realized and recognized during the current year.

EXHIBIT 7-5 Summary Illustration— Constructive Gains and Losses on Intercompany Bonds AppendixLO1