Canadian Advanced Accounting

Question

DaVinci Inc. owns 75% of the common shares of Rembrandt Corp. On January 1, 2017, DaVinci issued bonds with a par value of $350,000 which will mature on January 1, 2022. The bonds bear interest at an annual rate of 8%, with annual interest payments made each December 31st. At the date of issue of the bonds, DaVinci received proceeds of $360,000. On January 1, 2019, Rembrandt purchased 40% of DaVinci’s bonds on the open market for $134,000. Both companies use the effective interest method. Both companies have a December 31st year- end and pay income taxes at a rate of 40%. Bond gains and losses are to be allocated to each company. During 2019, Rembrandt earned a net income of $80,000 and paid dividends of $20,000.

Market rates (Yield) for these bonds was 7.39% at issue date January 1, 2017 for DaVinci.

Market rate (Yield) for Rembrandt at investment date January 1, 2019 was 9.33%

REQUIRED:

a) Calculate the amount of the gain or loss that will appear as a separate item on the 2019 consolidated income statement, as a result of the bond transaction. (2 marks)

b) Calculate the after-tax gain or loss to Rembrandt on the purchase of the Bonds. (2 marks)

c) Calculate the after-tax gain or loss to DaVinci on the purchase of the Bonds. (2 marks)

d) What amount of after-tax interest expense (if any) would have to be eliminated in 2019 as a result of the purchase of the Bonds? (3 marks)

e) Calculate the non-controlling interest’s share of Rembrandt’s income for the year-ended December 31, 2019. (3 marks)

f) What value would be shown on DaVinci’s December 31, 2019 Consolidated Balance Sheet for the Bond issue? (3 marks)

Answer 1

First determine DaVinci’s carrying value of the bonds on January 1, 2019.

Original carrying value = $360,000

2017 interest expense:

$360,000(7.39%) = $26,604

Cash interest:

$350,000(8%) = $28,000

Premium amortization:

$28,000 - $26,604 = $1,396

Carrying value, Dec. 31, 2017:

$360,000 - $1,396 = $358,604

2018 interest expense:

$358,604(7.39%) = $26,500.84

Premium amortization:

$28,000 - $26,500.84 = $1,499.16

Carrying value, Jan. 1, 2019:

$358,604 - $1,499.16 = $357,104.84

Rembrandt purchased 40% of the bonds, so the carrying amount of the bonds constructively retired is:

$357,104.84(40%) = $142,841.93

Rembrandt paid $134,000.

Therefore, the consolidated constructive-retirement gain is:

$142,841.93 - $134,000

= $8,841.93 gain

A) Gain on the 2019 consolidated income statement

Gain = $8,841.93

B) After-tax gain allocated to Rembrandt

40% of the bonds have a face value of:

$350,000(40%) = $140,000

Rembrandt purchased them for only $134,000.

Gain attributable to Rembrandt:

$140,000 - $134,000 = $6,000

After tax:

$6,000(1 - 0.40)

= $3,600 after-tax gain

C) After-tax gain allocated to DaVinci

DaVinci's portion of the constructive gain is the unamortized premium on the 40% portion:

$142,841.93 - $140,000

= $2,841.93

After tax:

$2,841.93(0.60)

= $1,705.16 after-tax gain

Check:

$6,000 + $2,841.93 = $8,841.93 total pre-tax gain.

D) After-tax interest expense eliminated in 2019

Interest expense on the 40% portion held by Rembrandt:

$142,841.93(7.39%)

= $10,556.02

After tax:

$10,556.02(0.60)

= $6,333.61

Therefore, the after-tax interest expense eliminated is:

$6,333.61

For comparison, Rembrandt's 2019 interest income on its bond investment is:

$134,000(9.33%)

= $12,502.20

After tax:

$12,502.20(0.60)

= $7,501.32

E) Non-controlling interest's share of Rembrandt's 2019 income

DaVinci owns 75%, so the NCI owns:

100% - 75% = 25%

Start with Rembrandt's reported income:

$80,000

Add Rembrandt's after-tax constructive-retirement gain:

+ $3,600

Eliminate the after-tax intercompany interest income:

1. $7,501.32

Adjusted Rembrandt income:

$80,000 + $3,600 - $7,501.32

= $76,098.68

NCI share:

$76,098.68(25%)

= $19,024.67

F) Bonds shown on the December 31, 2019 consolidated balance sheet

First calculate DaVinci's 2019 interest expense on the entire bond issue:

$357,104.84(7.39%)

= $26,390.05

2019 premium amortization:

$28,000 - $26,390.05

= $1,609.95

December 31, 2019 carrying value:

$357,104.84 - $1,609.95

= $355,494.89

Since 40% of the bonds are held within the consolidated entity, only the 60% held by outsiders remains as a consolidated liability:

$355,494.89(60%)

= $213,296.93

Therefore, the consolidated balance sheet reports bonds payable of approximately:

$213,297

FINAL ANSWERS:

a) Consolidated gain = $8,841.93

b) Rembrandt after-tax gain = $3,600.00

c) DaVinci after-tax gain = $1,705.16

d) After-tax interest expense eliminated = $6,333.61

e) NCI share of Rembrandt income = $19,024.67

f) Consolidated bonds payable = $213,296.93 (approximately $213,297)