On January 1, 2017, Cermack National Bank loaned $5,000,000 under a 2-year, zero coupon note to a

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On January 1, 2017, Cermack National Bank loaned $5,000,000 under a 2-year, zero coupon note to a real estate developer. The bank recognized interest revenue on this note of approximately $400,000 per year. Due to an economic downturn, the developer was unable to pay the $5,800,000 maturity amount on December 31, 2018. The bank convinced the developer to pay $800,000 on December 31, 2018, and agreed to extend $5,000,000 credit to the developer despite the gloomy economic outlook for the next several years. Thus, on December 31, 2018, the bank issued a new 2-year, zero coupon note to the developer to mature on December 31, 2020, for $6,000,000. The bank recognized interest revenue on this note of approximately $500,000 per year.
The bank's external auditor insisted that the riskiness of the new loan be recognized by increasing the allowance for uncollectible notes by $1,500,000 on December 31, 2018, and $2,000,000 on December 31, 2019. On December 31, 2020, the bank received $1,200,000 from the developer and learned that the developer was in bankruptcy and that no additional amounts would be recovered.
Required:
1. Prepare a schedule showing annual cash flows for the two notes in each of the 4 years.
2. Prepare a schedule showing the effect of the notes on net income in each of the 4 years.
3. Which figure, net income or net cash flow, does the better job of telling the bank's stockholders about the effect of these notes on the bank? Explain by reference to the schedules prepared in Requirements 1 and 2.
4. A commonly used method for predicting future cash flows is to predict future income and adjust it for anticipated differences between net income and net cash flow. Does the Cermack National Bank case shed any light on the justification for using net income in this way rather than simply predicting future cash flows by reference to past cash flows?
Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a...
Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...
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