Reference no: EM13901445
EFFECT OF VALUATION METHOD FOR MONETARY ASSET ON BALANCE SHEET AND INCOME STATEMENT. Alfa Romeo incurs costs of $30,000 in manufacturing a red convertible automobile during 2009. Assume that it incurs all of these costs in cash. Alfa Romeo sells this automobile to you on January 1, 2010, for $45,000. You pay $5,000 immediately and agree to pay $14,414 on December 31, 2010, 2011, and 2012. Based on the interest rate appropriate for this note of 4 percent on January 1, 2012, the present value of the note is $40,000. The interest rate appropriate for this note is 5 percent on December 31, 2010, resulting in a present value of the remaining cash flows of $26,802. The interest rate appropriate for this note is 8 percent on December 31, 2011, resulting in a present value of the remaining cash flows of $13,346.
Required
Ignore income taxes.
a. Assume that Alfa Romeo accounts for this note throughout the three years using its initial present value and the historical interest rate (Approach 1). Using the analyti- cal framework discussed in the chapter, indicate the effects of the following events on the balance sheet and income statement.
(1) Manufacture of the automobile during 2009.
(2) Sale of the automobile on January 1, 2010.
(3) Cash received and interest revenue recognized on December 31, 2010.
(4) Cash received and interest revenue recognized on December 31, 2011.
(5) Cash received and interest revenue recognized on December 31, 2012.
b. Assume that Alfa Romeo values this note receivable at fair value each year with fair value changes recognized in net income (Approach 3). Changes in market interest rates affect the valuation of the note on the balance sheet immediately and the com- putation of interest revenue for the next year.
(1) Manufacture of the automobile during 2009.
(2) Sale of the automobile on January 1, 2010.
(3) Cash received and interest revenue recognized on December 31, 2010.
(4) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, 2010.
(5) Cash received and interest revenue recognized on December 31, 2011.
(6) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, 2011.
(7) Cash received and interest revenue recognized on December 31, 2012.
c. Why is retained earnings on December 31, 2012, equal to $18,242 in both cases despite having shown a different pattern of income over time?
d. Discuss the trade-off in financial reporting when moving from Approach 1 in Part a to Approach 3 in Part b.
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