Advanced Accoutning: Variable Interest Entitie, Intra-Entity Debt, Consolidated

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Discussion 6.2: Who Lost this $300,000?

Several years ago, Penston Company
purchased 90 percent of the outstanding shares of Swansan Corporation. Penston
made the acquisition because Swansan produced a vital component used in
Penston’s manufacturing process. Penston wanted to ensure an adequate supply of
this item at a reasonable price. The former owner, James Swansan, retained the
remaining 10 percent of Swansan’s stock and agreed to continue managing this
organization. He was given responsibility for the subsidiary’s daily
manufacturing operations but not for any financial decisions.

Swansan’s takeover has proven to be a successful undertaking for Penston. The
subsidiary has managed to supply all of the parent’s inventory needs and
distribute a variety of items to outside customers.

At a recent meeting, Penston’s president and the company’s chief financial
officer began discussing Swansan’s debt position. The subsidiary had a
debt-to-equity ratio that seemed unreasonably high considering the significant
amount of cash flows being generated by both companies. Payment of the interest
expense, especially on the subsidiary’s outstanding bonds, was a major cost,
one that the corporate officials hoped to reduce. However, the bond indenture
specified that Swansan could retire this debt prior to maturity only by paying
107 percent of face value.

This premium was considered prohibitive. Thus, to avoid contractual problems,
Penston acquired a large portion of Swansan’s liability on the open market for
101 percent of face value. Penston’s purchase created an effective loss of
$300,000 on the debt, the excess of the price over the book value of the debt,
as reported on Swansan’s books.

Company accountants currently are computing the noncontrolling interest’s share
of consolidated net income to be reported for the current year. They are unsure
about the impact of this $300,000 loss. The subsidiary’s debt was retired, but
officials of the parent company made the decision. Who lost this $300,000?

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