Question

Pesto Company possesses 80 percent of Salerno Company's outstanding voting stock.Pesto uses the initial value method to account for this investment. On January 1, 2014, Pesto sold 9 percent 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 percent of these same bonds from an outside party at 96.6 percent of face value. Both companies use the straight-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

The adjustment to Pesto's beginning Retained Earnings as a result of this bond acquisition for a 2018 consolidation is a $340,000 increase.

Step-by-step explanation:

The adjustment that should be made to Pesto's beginning Retained Earnings as a result of this bond acquisition for a 2018 consolidation is an increase of $340,000.

Under the initial value method, Pesto would record the acquisition of the bonds at the original premium amount of $600,000. However, since Salerno acquired 40 percent of the bonds in 2017, the amortization of the premium should be adjusted based on the remaining 60 percent.

The amortization expense for 2018 would be $600,000 * 0.6 = $360,000. Since the original premium amount recorded was $600,000 and $360,000 has been amortized in 2018, the adjustment to Retained Earnings would be $360,000 - $20,000 (9% * $10 million * 0.6) = $340,000 increase.