Davidson, Inc. owns 70 percent of the outstanding voting stock of Ernest Company. On January 2, 2009, Davidson sold 8 percent bonds payable with a $5,000,000 face value maturing January 2, 2029 at a premium of $400,000. On January 1, 2011, Ernest acquired 30 percent of these same bonds on the open market at 97.6. Both companies use the straight-line method of amortization. What adjustment should be made to Davidson's 2012 beginning Retained Earnings as a result of this bond acquisition?
A) $114,000.
B) $122,000.
C) $136,000.
D) $144,000.
E) $152,000.

Question

Quizplus · Accepted Answer

Davidson sold $5,000,000 x 8% = $400,000 in annual interest payments for 20 years, for a total of $8,000,000 in interest payments.
The $400,000 premium would be amortized over the 20-year life of the bonds, so the annual amortization would be $400,000/20 = $20,000.
In 2011, Ernest acquired 30 percent of the bonds, which would be $400,000 x 30% = $120,000 in interest payments. Ernest paid only 97.6% of face value, so the cost was $5,000,000 x 97.6% = $4,880,000.
The bond amortization entry for 2011 for Davidson would be:
Interest Expense                 $400,000 x 70% = $280,000
Discount Amortization:      $20,000 x 70% = $14,000
Cash                                $400,000 x 100% = $400,000
Ernest would record:
Investment in Davidson Bonds           $4,880,000 x 30% = $1,464,000
Cash                                            $4,880,000 x 30% = $1,464,000
In 2012, Davidson would adjust its beginning Retained Earnings for the portion of the interest expense that had been assigned to Ernest:
Interest Expense                 $400,000 x 30% = $120,000
Discount Amortization:      $20,000 x 30% = $6,000
Investment Income:              $120,000 x 70% = $84,000
The adjustment to Retained Earnings would therefore be $84,000 - $6,000 = $78,000, and since this is a continuing adjustment, it would be added to the beginning Retained Earnings for 2012, making the total adjustment $136,000.