Mercedes Benz (MB) incurs costs of $30,000 in manufacturing an automobile during Year 4. Assume that it incurs all of these costs in cash. MB sells this automobile to you on January 1, Year 5, for $45,000. You pay $5,000 immediately and agree to pay $14,414 on December 31 of Year 5, Year 6, and Year 7. Based on the interest rate appropriate for this note of 4 percent on January 1, Year 5, the present value of the note is $40,000. The interest rate appropriate to this note is 5 percent on December 31, Year 5, resulting in a present value of the remaining cash flows of $26,802. The interest rate appropriate to this note is 8 percent on December 31, Year 6, resulting in a present value of the remaining cash flows of $13,346.
Required
Ignore income taxes.
a. Assume for this part that MB accounts for this note throughout the three years using the historical market interest rate of 4 percent. Using the analytical framework discussed in the chapter, indicate the effect of the following events on the balance sheet and income statement.
(1) Manufacture of the automobile during Year 4.
(2) Sale of the automobile on January 1, Year 5.
(3) Cash received and interest revenue recognized on December 31, Year 5.
(4) Cash received and interest revenue recognized on December 31, Year 6.
(5) Cash received and interest revenue recognized on December 31, Year 7.
b. Assume for this part that MB accounts for this note using the current market interest rate each year. Changes in market interest rates affect the valuation of the note on the balance sheet immediately and the computation of interest revenue for the next year.
(1) Manufacture of the automobile during Year 4.
(2) Sale of the automobile on January 1, Year 5.
(3) Cash received and interest revenue recognized on December 31, Year 5.
(4) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, Year 5.
(5) Cash received and interest revenue recognized on December 31, Year 6.
(6) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, Year 6.
(7) Cash received and interest revenue recognized on December 31, Year 7.
c. Why is a retained earnings on December 31, Year 7, equal to $18,242 in both cases, despite showing a different pattern of income over time?