Chapter 6

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Chapter 6
2010-12-11 15:57:05
time value money

Accounting and the time value of money
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  1. What is the time value of money?
    Indicates a relationship between time and money- that a dollar received today is worth more than a dollar promised at some time in the future due to the opportunity to invest today's dollar and earn interest on the investment
  2. Define and Calculate Simple Interest
    Simple interest is money earned on the principal only

    Interest = p x i x n

    • where p= principal
    • i= annual interest rate
    • n= number of periods
  3. Define Compound Interest
    Interest is calculated on the principal AND the interest
  4. FV = PV (FVF n,i)
    Future Value of a single sum where

    • FV= future value
    • PV= present value
    • FVF n,i= future value factor for n periods at i interest
  5. Present value of a single sum
    PV = FV (PVF n,i)


    • PV= present value
    • FV= future value
    • PVF n,i= present value factor for n periods at i interest
  6. Future value of a single sum
    FV = PV (FVF n,i)
  7. Present Value of an Annuity Due
    PV-AD = R (1 + i) PVF-OA n,i
  8. Future value of an Annuity Due
    FV-AD = R (1 + i) (FVF-OA n,i)
  9. Future Value of an Ordinary Annuity
    FV-OA = R (FVF-OA n,i)
  10. Present value of an Ordinary Annuity
    PV-OA = R (PVF-OA n,i)
  11. The 3 components of interest
    PURE rate of interest

    EXPECTED INFLATION rate of interest

    CREDIT RISK rate of interest
  12. PURE rate of interest
    The amount a lender would charge if there were no possibilities of default and no expectation of inflation
  13. EXPECTED inflation rate of interest
    Interest rates are increased in an inflationary economy to compensate for the loss in purchasing power of the dollars they are being repaid.
  14. CREDIT RISK rate of interest
    The rate of interest based on an enterprise's financial stability, profitability, etc.
  15. What are the primary characteristics of an annuity?
    An annuity involves EQUAL payments, called RENTS, made at REGULAR time intervals and earns compounding interest. The rents can occur at the beginning (Annuity due) or end (OA) of the time period.
  16. How is the Future/Present value of an OA table used to determine the FV/PV of an Annuity Due?
    The factor (1 + i) is figured into the OA formulas.
  17. Applications of time value concepts in accounting
    • notes
    • leases
    • pensions
    • long-term assets
    • sinking funds
    • business combinations
    • disclosures
    • installment contracts
  18. How are the number of periods (n) and rate of interest for a single period (i) determined for the time value formulas?
    n is the # of compounding periods. For 3 years, annual n=3, semi ann n=6 and quarterly n=12

    i is the interest rate for a single period. For a 10% rate, if compounded annually, i = 10%, if semiannually, i = 5%
  19. What is effective yield/interest rate
    The interest earned divided by the principal gives the effective yield.
  20. What is discounting?
    The fact that the present value is always a smaller amount than the known future value because the company moves backward in time
  21. What is accumulation?
    The process of determining a future value by moving forward in time
  22. How are long-term bonds valued?
    • There are 2 cash flows:
    • periodic interest pmts
    • principle (face value) paid at maturity

    • The periodic pmts represent an annuity
    • The principal is a single sum problem

    Valuation sums the two
  23. How does the effective-interest method of amortization of a bond discount or premium work?
    The bond discount or premium is written off to interest expense over the life of the bond.