Textbook Problem

Income, Cash Flow, and Future Losses

On January L 2017, Cermack National Bank loaned 55,000,000 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, 20201 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:

Which figure, net income or net cash flow, does the better job of telling the bank’s stock-holders about the effect of these notes on the bank? Explain by reference to the schedules prepared in Requirements 1 and 2.