Required:
(a) Determine who lost the $300,000.
(b) Explain how the loss should be allocated on the consolidated financial statements.
Several years ago, the Penston Company purchased 90% of the outstanding shares of Swansan Corporation. The acquisition was made 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, who agreed to continue managing this organization, retained the remaining 10% of Swansan's shares. He was given responsibility over the subsidiary's daily manufacturing operations but not for any of the financial decisions.
At a recent meeting, the president of Penston 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% 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% of face value. Penston's purchase created an effective loss on the debt of $300,000: the excess of the price over the carrying amount of the debt as reported on Swansan's books.
Company accountants are currently computing the non-controlling 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.