Accounting: The Language of Business - Vol. 2 (Intermediate: Part 90)

Although we all realize that monotony is boring, almost every form of industrial work- banking, accounting, mass-producing, service- is monotonous, and most people are paid for simply putting up with monotony

Alan Watts

 Accounting and the Time Value of Money (Part C)

by

Charles Lamson

Effective Interest Rates 

Many investments earn interest compounded daily (for example, bank accounts).  Daily compounding increases the interest earned on the investment. Note that interest rates are always stated as an annual amount. When interest is compounded more than once per year, we determine the interest rate used in computations by dividing the annual rate by the number of compounding periods in a year. If interest is compounded more than once a year, then the effective interest rate, which is the amount of Interest actually earned, will be higher than the stated interest rate. Example 7.3 illustrates computing an effective interest rate. 

Types of Time Value of Money Problems

The first step in most business decision models is to identify the value of the cash flows to be received or paid at two different terminal time periods. The cash flow values at these two terminal time periods are the present value and the future value:

1. The present value (PV) is the value today of a cash flow or a series of cash flows to be received or paid in the future.

2. The future value (FV) is the value at some specified point in time in the future of a cash flow or a series of cash flows to be paid or received between the current date and the specified point in the future.

A business problem can involve having knowledge of either the PV or the FV and solving for the other using the interest rate and the time period. The process of moving from the PV to the FV is known as compounding. The process of moving from the FV to the PV is known as discounting. The time period begins at time (t) zero, and ends at some future time (t), which we represent with a capital T. Exhibit 7.3 presents the distinction between compounding and discounting using a timeline.

In analyzing the time value of money, there are two types of cash flows to identify: single cash flows and annuities. An annuity is a series of periodic payments or receipts of equal amounts that occur at equal time intervals between each cash flow.

Annuity payments can occur at the beginning or the end of a period. When payments take place at the beginning of the period, the series of cash flows is called an annuity due or an annuity in advance. Rent is an example of a payment made at the beginning of a period. If the payments occur at the end of the period, the series of periodic payments is known as ordinary annuity or an annuity in arrears. Interest paid at the end of the month on a bank deposit is an illustration of an ordinary annuity. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 318-319*

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