Accounting: The Language of Business - Vol. 2 (Intermediate: Part 88)

There is no company - no corporation on earth that engages in accounting fraud to the extent the Imperial Federal Government of the United Sates does. Not many congressmen are willing to come forward with the details.

Neal Boortz

Accounting and the Time Value of Money (Part A) 

by

Charles Lamson

Introduction

To determine the value of money you have in the bank today, you simply check the account balance. Yet how would you determine the amount of money you need to save each year in order to purchase a new car in the future? You first need to determine when you want to buy the car. Then, you have to decide when you will start saving. You will also have to estimate how much interest your savings will earn based on the interest rate on your savings account. After you make these estimates, mathematical techniques involving the time value of money enable you to compute the total amount you must save to purchase the car. 

Companies use time value of money techniques in a variety of areas---from capital budgeting to assessing financing needs to determining pension obligations. Consider Adidas, the German sports footwear, apparel, and accessories company. In its 2016 annual report, Adidas stated that it used present value techniques to evaluate returns on planned capital expenditures. In its footnotes to the financial statements, Adidas disclosed that it used present values in accounting for receivables, leases, pensions, and asset impairments. For example, Adidas reports its receivables and other financial assets at fair value, estimating the fair value as the present value of future cash flows. In financial reporting, time value of money concepts are critical to understanding these areas and others such as long-term liabilities and the valuation of certain types of financial instruments.

The next several parts of this analysis discuss the fundamental concepts needed to work with the time value of money throughout the remainder of this analysis. We begin with the basics of the time value of money, including simple and compound interest. We then illustrate several problems involving the future and present values of a single sum. Next, we convert problems involving the future and present values of ordinary annuities and annuities due. Finally, we discuss more complex areas such as deferred annuities before a highlighting of the time value of money.

 

Time Value of Money Basic Concepts

The time value of money concept means that a dollar received today is worth more than a dollar received at some time in the future. This statement is true because a dollar received today can be invested to provide a return. For example, if you invest $1,000 in a savings account and the savings account is 2% annually, then you will have $1,020 one year from today. The $20 earned on the initial investment is your interest, the return on money over time. 

Time Value of Money in Accounting

The time value of money concept is critical in several areas of accounting, particularly when valuing many of the assets and liabilities reported in the financial statements. For example, measuring assets and liabilities at fair value may require time value of money computations. Time value of money concepts determine the asset's value today based on the future cash flows it will generate. To illustrate, consider a company that leases equipment to a customer. In return, the customer pays the company periodic cash payments in the future for the use of the leased equipment. The value of the net investment in the lease today can be measured using the future cash flows the company will receive and time value of money concepts.

The same approach applies to determining the fair value of a liability. For example, a pension liability today can be measured using time value of money concepts and the future cash outflows a company promises to make to its employees when they retire. The future cash flows depend on many estimates and assumptions, such as when the employee will retire, how long the employee employee will live after retirement, and the inflation rate.

The measurements of many financial statement items such as leases, pensions, and bonds payable are based on estimates of future cash flows and time value of money computations. Exhibit 7.1 illustrates several financial statement items and the type of future cash flows used to measure them. 

EXHIBIT 7.1 Examples of Financial Statement Items Measured at the Present Value of Future Cash Flows 

We begin our discussion of the time value of money in Part 89 by distinguishing between two types of Interest---simple and compound. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 315-317*

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