INCOME, CASH FLOW, AND FUTURE LOSSES

On January 1, 2007, Cermack National Bank loaned $5,000,000 under a two-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, 2008. The bank convinced the developer to pay $800,000 on December 31, 2008, 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, 2008, the bank issued a new two-year, zero coupon note to the developer to mature on December 31, 2010 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 Decem- ber 31, 2008, and $2,000,000 on December 31, 2009. On December 31, 2010, the bank received $1,200,000 from the developer and learned that the developer is 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 four years.

2. Prepare a schedule showing the effect of the notes on net income in each of the four 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 refer- ence to past cash flows?