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:

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 How. 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?