We often find that the money consequences of any alternative occur over a substantial period of time such as a year or more. When money consequences occur in a short period of time, we simply add up the various sums of money and obtain a net result but can we treat money on same way when the time span is greater? Which would you prefer, $100 cash today or the assurance of receiving $100 a year from now?
Time Value of Money
We often find that the money consequences of any alternative occur over a substantial period of time such as a year or more. When money consequences occur in a short period of time, we simply add up the various sums of money and obtain a net result but can we treat money on same way when the time span is greater?
Which would you prefer, $100 cash today or the assurance of receiving $100 a year from now? You might decide you would prefer the $100 now because that is one way to be certain of receiving it and you suppose that you were convinced that you would receive the $100 one year hence. Now what would be your answer? A little thought should convince you that it still would be more desirable to receive the $100 now. If you had the money now, rather than a year hence, you would have the use of it for an extra year and if you had no current use for $100, you could let someone else use it.
Money is quite a valuable asset so valuable that people are willing to pay to have money available for their use. Money can be rented in roughly the same way, one rents an apartment due to money consideration, the charge for its use is called interest instead of rent. The importance of interest is demonstrated by banks and savings institutions continuously offering to pay for the use of people’s money to pay interest.
If the current interest rate is 9% per year, and you put $100 into the bank for one year, how much will you receive back at the end of the year? You will receive your original $100 together with $9 interest, for a total of $109. This example demonstrates the time preference for money: we would rather have $100 today than the assured promise of $100 one year hence but we might well consider leaving the $100 in a bank if we knew it would be worth $109 one year hence. This is because there is a time value of money in the form of the willingness of banks, businesses, and people to pay interest for the use of money.
In accounting (finance), the term time value of money is used to indicate a relationship between time and money that a dollar received today is worth more than a dollar promised at some time in the future. Why? Because of the opportunity to invest today’s dollar and receive interest on the investment. When you have to decide among various investment or borrowing alternatives, it is important to be able to compare today’s dollar and tomorrow’s dollar.
Time Value of Money Concepts in Practices
Financial reporting uses different measurements in different situations. Present value is one of these measurements (other concepts such as compound interest, annuity) and its usage has been increasing. FASB (Financial Accounting Standard Board) has issued a concepts statement that provides a framework for using expected future cash flows and present values as a basis for measurement? Why is a new concepts statement in this area needed? In the past, most accounting calculations of present value have been based on the most likely cash flow amount and a single discount factor.
For example, if there is a 30% probability that the cash flow will be $100, a 50% probability that it will be $200, and a 20% probability that it will be $300, the expected cash flow is $190 [($100x0.30)+($200x0.5)+($300x0.2)]. Under traditional present value approaches, the most likely estimate ($200) would be used, but that estimate does not consider the different probabilities of the possible cash flows. As a result, the expected cash flow measure should provide more relevant present value measurements. Although the expected cash flow method is currently used in some accounting measurements, such as pensions and other post-retirement benefits, the concepts statement can be extended to other present value based on accounting measurements.
Some of the applications of present value-based measurement to accounting topics are listed as following: (1). Notes : valuing noncurrent receivables and payables that carry no stated interest rate or a lower than market interest rate; (2). Leases : valuing assets and obligations to be capitalized under long-term leases and measuring the amount of the lease payments and annual leasehold amortization; (3). Amortization of Premiums and Discounts : measuring amortization of premium or discount on both bond investments and bonds payable; (4). Pensions and other Post retirement Benefits : measuring service cost components of employer’s postretirement benefits expense and postretirement benefits obligation; (5). Long-Term Assets : evaluating alternative long-term investments by discounting future cash flows. Determining the value of assets acquired under deferred payment contracts. Measuring impairments of assets; (6). Sinking Funds : determining the contributions necessary to accumulate a fund for debt retirements; (7). Business Combinations : determining the value of receivables, payables, liabilities, accruals, and commitments acquired or assumed in a “purchase”; (8). Disclosures : measuring the value of future cash flows from oil and gas reserves for disclosure in supplementary information; (9). Installment Contracts : measuring periodic payments on long-term purchase contracts.
In addition to accounting and business applications, compound interest, annuity, and present value concepts apply to personal finance and investment decisions. In purchasing a home or car, planning for retirement, and evaluating alternative investments, you will need to understand time value of money concepts.
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2. Accountant’s Responsibility as an Expert
3. How to Conduct Physical Inventory Counting Successfully
4. The Environment of Financial Accounting
5. Ethics in the Accounting profession