Accounting and the Time Value of Money

Chapter

6
Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield

Chapter 6-1

Prepared by Coby Harmon, University of California, Santa Barbara

Learning Objectives
1. 2. 3. 4. 5. 6. 7. 8. 9.
Chapter 6-2

Identify accounting topics where the time value of money is relevant. Distinguish between simple and compound interest. Use appropriate compound interest tables. Identify variables fundamental to solving interest problems. Solve future and present value of 1 problems. Solve future value of ordinary and annuity due problems. Solve present value of ordinary and annuity due problems. Solve present value problems related to deferred annuities and bonds. Apply expected cash flows to present value measurement.

Accounting and the Time Value of Money

Basic Time Value Concepts

Applications The nature of interest Simple interest Compound interest Fundamental variables

Single-Sum Problems
Future value of a single sum Present value of a single sum Solving for other unknowns

Annuities

More Complex Situations

Deferred annuities Valuation of long-term bonds Effectiveinterest method of bond discount/ premium amortization

Present Value Measurement

Expected cash flow illustration

Future value of ordinary annuity Future value of annuity due Examples of FV of annuity Present value of ordinary annuity Present value of annuity due Examples of PV of annuity

Chapter 6-3

Basic Time Value Concepts

Time Value of Money
In accounting (and finance), the term indicates that a dollar received today is worth more than a dollar promised at some time in the future.

Chapter 6-4

LO 1 Identify accounting topics where the time value of money is relevant.

Basic Time Value Concepts

Applications to Accounting Topics:
1. Notes 2. Leases 3. Pensions and Other 5. Sinking Funds 6. Business Combinations 7. Disclosures 8. Installment Contracts

Postretirement Benefits

4. Long-Term Assets

Chapter 6-5

LO 1 Identify accounting topics where the time value of money is relevant.

Basic Time Value Concepts

Nature of Interest
Payment for the use of money. Excess cash received or repaid over the amount borrowed (principal).

Variables involved in financing transaction:

1. Principal - Amount borrowed or invested. 2. Interest Rate - A percentage. 3. Time - The number of years or portion of a year

that the principal is outstanding.

Chapter 6-6

LO 1 Identify accounting topics where the time value of money is relevant.

Simple Interest
Interest computed on the principal only.
ILLUSTRATION: On January 2, 2007, Tomalczyk borrows $20,000 for 3 years at a rate of 7% per year. Calculate the annual interest cost. Principal $20,000 x 7%

FULL YEAR

Interest rate

Annual interest

$ 1,400

Federal law requires the disclosure of interest rates on an annual basis in all contracts.
Chapter 6-7

LO 2 Distinguish between simple and compound interest.

Simple Interest
ILLUSTRATION continued: On March 31, 2007, Tomalczyk borrows $20,000 for 3 years at a rate of 7% per year. Calculate the interest cost for the year ending December 31, 2007.

PARTIAL YEAR

Principal Interest rate Annual interest Partial year

Interest for 9 months

$20,000 x 7% $ 1,400 x 9/12

$ 1,050

Chapter 6-8

LO 2 Distinguish between simple and compound interest.

Compound Interest
Computes interest on
the principal and
on interest earned to date (assuming interest

is left on deposit).

Compound interest is the typical interest computation applied in business situations.

Chapter 6-9

LO 2 Distinguish between simple and compound interest.

Compound Interest
ILLUSTRATION: On January 2, 2007, Tomalczyk borrows $20,000 for 3 years at a rate of 7% per year. Calculate the total interest cost for all three years, assuming interest is compounded annually.
Compound Interest Calculation $20,000 x 7% $21,400 x 7% $22,898 x 7% $ Accumulated Balance $ 20,000 21,400 22,898 24,501

Date Jan. 2007 2007 2008 2009

Interest 1,400 1,498 1,603 4,501

$
Chapter 6-10

LO 2 Distinguish between simple and compound interest.

Compound Interest Tables

Five Tables in Chapter 6
Table 1 - Future Value of 1 Table 2 - Present Value of 1

Table 3 - Future Value of an Ordinary Annuity of 1

Table 4 - Present Value of an Ordinary Annuity of 1 Table 5 - Present Value of an Annuity Due of 1
Number of Periods = number of years x the number of compounding periods per year. Compounding Period Interest Rate = annual rate divided by the number of compounding periods per year.
Chapter 6-11

LO 3 Use appropriate compound interest tables.

Compound Interest
Compounding can substantially affect the rate of return. A 9% annual interest compounded daily provides a 9.42% yield.
How compounding affects Effective Yield for a $10,000 investment.
Illustration 6-5

Chapter 6-12

LO 3 Use appropriate compound interest tables.

Compound Interest
Variables Fundamental to Compound Interest
Rate of Interest
Number of Time Periods Present Value

Future Value
Illustration 6-6

Chapter 6-13

LO 4 Identify variables fundamental to solving interest problems.

Single-Sum Problems
Generally Classified into Two Categories
Unknown Present Value

Unknown Future Value

Chapter 6-14

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Future Value of a Single Sum
Multiply the future value factor by its present value (principal). Illustration: BE6-1 Steve Allen invested $10,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years?

Chapter 6-15

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Present Value $10,000 Future Value?

BE6-1 Steve Allen invested $10,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years?

What table do we use?

Chapter 6-16

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-1
Number of Periods 1 2 3 4 5 Discount Rate 4% 6% 8% 1.04000 1.08160 1.12486 1.16986 1.21665 1.06000 1.12360 1.19102 1.26248 1.33823 1.08000 1.16640 1.25971 1.36049 1.46933

2% 1.02000 1.04040 1.06121 1.08243 1.10408

10% 1.10000 1.21000 1.33100 1.46410 1.61051

What factor do we use?

Chapter 6-17

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-1
Number of Periods 1 2 3 4 5 Discount Rate 4% 6% 8% 1.04000 1.08160 1.12486 1.16986 1.21665 1.06000 1.12360 1.19102 1.26248 1.33823 1.08000 1.16640 1.25971 1.36049 1.46933

2% 1.02000 1.04040 1.06121 1.08243 1.10408

10% 1.10000 1.21000 1.33100 1.46410 1.61051

$10,000
Present Value
Chapter 6-18

1.25971
Factor

$12,597
Future Value

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
PROOF - Future Value of a Single Sum
Beginning Balance Rate $ 10,000 x 8% 10,800 x 8% 11,664 x 8% Previous Year-End Interest Balance Balance = 800 + 10,000 = $ 10,800 = 864 + 10,800 = 11,664 = 933 + 11,664 = 12,597

Year 1 2 3

BE6-1 Steve Allen invested $10,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years?
Chapter 6-19

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Present Value $10,000 Future Value?

BE6-1 Steve Allen invested $10,000 today in a fund that earns 8% compounded semiannually. To what amount will the investment grow in 3 years?

What table do we use?

Chapter 6-20

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-1
Number of Periods 1 2 3 4 5 6 Discount Rate 4% 6% 8% 1.04000 1.08160 1.12486 1.16986 1.21665 1.26532 1.06000 1.12360 1.19102 1.26248 1.33823 1.41852 1.08000 1.16640 1.25971 1.36049 1.46933 1.58687

2% 1.02000 1.04040 1.06121 1.08243 1.10408 1.12616

10% 1.10000 1.21000 1.33100 1.46410 1.61051 1.77156

What factor do we use?

Chapter 6-21

6 compounding periods 4% interest per period

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-1
Number of Periods 1 2 3 4 5 6 Discount Rate 4% 6% 8% 1.04000 1.08160 1.12486 1.16986 1.21665 1.26532 1.06000 1.12360 1.19102 1.26248 1.33823 1.41852 1.08000 1.16640 1.25971 1.36049 1.46933 1.58687

2% 1.02000 1.04040 1.06121 1.08243 1.10408 1.12616

10% 1.10000 1.21000 1.33100 1.46410 1.61051 1.77156

$10,000
Present Value
Chapter 6-22

1.26532
Factor

$12,653
Future Value

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Present Value of a Single Sum
Multiply the present value factor by the future value. Illustration: BE6-2 Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually?

Chapter 6-23

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Present Value?
Future Value $20,000

BE6-2 Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually?

What table do we use?

Chapter 6-24

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-2
Number of Periods 2 4 6 8 Discount Rate 6% 8% 10% .89000 .79209 .70496 .62741 .85734 .73503 .63017 .54027 .82645 .68301 .56447 .46651

4% .92456 .85480 .79031 .73069

12% .79719 .63552 .50663 .40388

What factor do we use?

Chapter 6-25

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-2
Number of Periods 2 4 6 8 Discount Rate 6% 8% 10% .89000 .79209 .70496 .62741 .85734 .73503 .63017 .54027 .82645 .68301 .56447 .46651

4% .92456 .85480 .79031 .73069

12% .79719 .63552 .50663 .40388

$20,000
Future Value
Chapter 6-26

.63552
Factor

$12,710
Present Value

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Present Value?
Future Value $20,000

BE6-2 Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded quarterly?

What table do we use?

Chapter 6-27

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-2
Number of Periods 4 8 12 16 Discount Rate 4% 6% 9% 0.85480 0.73069 0.62460 0.53391 0.79209 0.62741 0.49697 0.39365 0.70843 0.50187 0.35554 0.25187

3% 0.88849 0.78941 0.70138 0.62317

12% 0.63552 0.40388 0.25668 0.16312

What factor do we use?

Chapter 6-28

LO 5 Solve future and present value of 1 problems.

Single-Sum Problems
Table 6-2
Number of Periods 4 8 12 16 Discount Rate 4% 6% 9% 0.85480 0.73069 0.62460 0.53391 0.79209 0.62741 0.49697 0.39365 0.70843 0.50187 0.35554 0.25187

3% 0.88849 0.78941 0.70138 0.62317

12% 0.63552 0.40388 0.25668 0.16312

$20,000
Future Value
Chapter 6-29

.62317
Factor

$12,463
Present Value

LO 5 Solve future and present value of 1 problems.

Annuities
Annuity requires the following:
(1) Periodic payments or receipts (called

rents) of the same amount, rents, and interval.

(2) The same-length interval between such (3) Compounding of interest once each

Two Types
Chapter 6-30

Ordinary annuity - rents occur at the end of each period. Annuity Due - rents occur at the beginning of each period.
LO 6 Solve future value of ordinary and annuity due problems.

Annuities
Future Value of an Ordinary Annuity
Rents occur at the end of each period. No interest during 1st period. Present Value
$20,000 20,000 20,000 20,000 20,000 20,000

Future Value
20,000 20,000

Chapter 6-31

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Ordinary Annuity

Present Value
$20,000 20,000 20,000 20,000 20,000 20,000

Future Value
20,000 20,000

BE6-13 Bayou Inc. will deposit $20,000 in a 12% fund at the end of each year for 8 years beginning December 31, Year 1. What amount will be in the fund immediately after the last deposit?

What table do we use?

Chapter 6-32

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Ordinary Annuity

Table 6-3
Number of Periods 2 4 6 8 10 Discount Rate 8% 2.08000 4.50611 7.33592 10.63663 14.48656

4% 2.04000 4.24646 6.63298 9.21423 12.00611

6%

10% 2.10000 4.64100 7.71561 11.43589 15.93743

12% 2.12000 4.77933 8.11519 12.29969 17.54874

2.06000 4.37462 6.97532 9.89747 13.18079

What factor do we use?

Chapter 6-33

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Ordinary Annuity

Table 6-3
Number of Periods 2 4 6 8 10 Discount Rate 8% 2.08000 4.50611 7.33592 10.63663 14.48656

4% 2.04000 4.24646 6.63298 9.21423 12.00611

6%

10% 2.10000 4.64100 7.71561 11.43589 15.93743

12% 2.12000 4.77933 8.11519 12.29969 17.54874

2.06000 4.37462 6.97532 9.89747 13.18079

$20,000
Deposit
Chapter 6-34

12.29969
Factor

$245,994
Future Value

LO 6 Solve future value of ordinary and annuity due problems.

Annuities
Future Value of an Annuity Due
Rents occur at the beginning of each period.
Interest will accumulate during 1st period. Annuity Due has one more interest period than Ordinary Annuity. Factor = multiply future value of an ordinary Future annuity factor by 1 plus the interest rate.
Value
$20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

0
Chapter 6-35

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Annuity Due

Present Value
20,000 $20,000 20,000 20,000 20,000 20,000 20,000

Future Value
20,000

Bayou Inc. will deposit $20,000 in a 12% fund at the beginning of each year for 8 years beginning January 1, Year 1. What amount will be in the fund at the end of Year 8?

What table do we use?

Chapter 6-36

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Annuity Due

Table 6-3
Number of Periods 2 4 6 8 10 Discount Rate 8% 2.08000 4.50611 7.33592 10.63663 14.48656

4% 2.04000 4.24646 6.63298 9.21423 12.00611

6%

10% 2.10000 4.64100 7.71561 11.43589 15.93743

12% 2.12000 4.77933 8.11519 12.29969 17.54874

2.06000 4.37462 6.97532 9.89747 13.18079

What factor do we use?

Chapter 6-37

LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Annuity Due

Table 6-3
Number of Periods 2 4 6 8 10 Discount Rate 8% 2.08000 4.50611 7.33592 10.63663 14.48656

4% 2.04000 4.24646 6.63298 9.21423 12.00611

6%

10% 2.10000 4.64100 7.71561 11.43589 15.93743

12% 2.12000 4.77933 8.11519 12.29969 17.54874

2.06000 4.37462 6.97532 9.89747 13.18079

12.29969
$20,000
Chapter 6-38

x
x

1.12
13.775652
Factor

=
=

13.775652
$275,513
Future Value

Deposit

LO 6 Solve future value of ordinary and annuity due problems.

Present Value of an Ordinary Annuity

Present Value of an Ordinary Annuity
Present value of a series of equal amounts to be withdrawn or received at equal intervals. Periodic rents occur at the end of the period. Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0
Chapter 6-39

19

20

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Ordinary Annuity

Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0 1 2 3 4 19 20

Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

What table do we use?

Chapter 6-40

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Ordinary Annuity

Table 6-4
Number of Periods 1 5 10 15 20 Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

10% 0.90900 3.79079 6.14457 7.60608 8.51356

12% 0.89286 3.60478 5.65022 6.81086 7.46944

0.94340 4.21236 7.36009 9.71225 11.46992

What factor do we use?

Chapter 6-41

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Ordinary Annuity

Table 6-4
Number of Periods 1 5 10 15 20 Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

10% 0.90900 3.79079 6.14457 7.60608 8.51356

12% 0.89286 3.60478 5.65022 6.81086 7.46944

0.94340 4.21236 7.36009 9.71225 11.46992

$100,000
Receipt
Chapter 6-42

9.81815
Factor

$981,815
Present Value

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Annuity Due

Present Value of an Annuity Due
Present value of a series of equal amounts to be withdrawn or received at equal intervals. Periodic rents occur at the beginning of the period. Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0
Chapter 6-43

19

20

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Annuity Due

Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0 1 2 3 4 19 20

Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the beginning of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

What table do we use?

Chapter 6-44

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Annuity Due

Table 6-5
Number of Periods 1 5 10 15 20 Discount Rate 8% 1.00000 4.31213 7.24689 9.24424 10.60360

4% 1.00000 4.62990 8.43533 11.56312 14.13394

6%

10% 1.00000 4.16986 6.75902 8.36669 9.36492

12% 1.00000 4.03735 6.32825 7.62817 8.36578

1.00000 4.46511 7.80169 10.29498 12.15812

What factor do we use?

Chapter 6-45

LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Annuity Due

Table 6-5
Number of Periods 1 5 10 15 20 Discount Rate 8% 1.00000 4.31213 7.24689 9.24424 10.60360

4% 1.00000 4.62990 8.43533 11.56312 14.13394

6%

10% 1.00000 4.16986 6.75902 8.36669 9.36492

12% 1.00000 4.03735 6.32825 7.62817 8.36578

1.00000 4.46511 7.80169 10.29498 12.15812

$100,000
Receipt
Chapter 6-46

10.60360
Factor

$1,060,360
Present Value

LO 7 Solve present value of ordinary and annuity due problems.

Deferred Annuities
Rents begin after a specified number of periods.

Future Value - Calculation same as the future value of an annuity not deferred.
Present Value - Must recognize the interest that accrues during the deferral period. Present Value
100,000 100,000

Future Value
100,000

.....
0
Chapter 6-47

19

20

LO 8 Solve present value problems related to deferred annuities and bonds.

Valuation of Long-Term Bonds

Two Cash Flows:

Periodic interest payments (annuity).

Principal paid at maturity (single-sum).

Bonds current market value is the combined present values of the both cash flows.
1,000,000 $70,000 70,000 70,000 70,000 70,000 70,000

.....
0
Chapter 6-48

10

LO 8 Solve present value problems related to deferred annuities and bonds.

Valuation of Long-Term Bonds

Present Value
$70,000 70,000 70,000 70,000 70,000 1,070,000

.....
0 1 2 3 4 9 10

BE6-15 Arcadian Inc. issues $1,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds is 8%. What amount will Arcadian receive when it issues the bonds?

Chapter 6-49

LO 8 Solve present value problems related to deferred annuities and bonds.

Valuation of Long-Term Bonds

Table 6-4
Number of Periods 1 5 10 15 20

PV of Interest
10% 0.90900 3.79079 6.14457 7.60608 8.51356 12% 0.89286 3.60478 5.65022 6.81086 7.46944

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

0.94340 4.21236 7.36009 9.71225 11.46992

$70,000
Chapter 6-50

6.71008
Factor

$469,706
Present Value

Interest Payment

LO 8 Solve present value problems related to deferred annuities and bonds.

Valuation of Long-Term Bonds

Table 6-2
Number of Periods 1 5 10 15 20

PV of Principal
10% 0.90909 0.62092 0.38554 0.23939 0.14864 12% 0.89286 0.56743 0.32197 0.18270 0.10367

4% 0.96154 0.82193 0.67556 0.55526 0.45639

6%

Discount Rate 8% 0.92593 0.68058 0.46319 0.31524 0.21455

0.94340 0.74726 0.55839 0.41727 0.31180

$1,000,000
Principal Payment
Chapter 6-51

.46319
Factor

$463,190
Present Value

LO 8 Solve present value problems related to deferred annuities and bonds.

Valuation of Long-Term Bonds

BE6-15 Arcadian Inc. issues $1,000,000 of 7% bonds due in 10 years with interest payable at year-end. Present value of Interest Present value of Principal Bond current market value $469,706 463,190 $932,896

Date Account Title Cash Discount on Bonds Bonds payable

Chapter 6-52

Debit 932,896 67,104

Credit

1,000,000

LO 8 Solve present value problems related to deferred annuities and bonds.

Present Value Measurement

Concepts Statement No. 7 introduces an expected cash flow approach that uses a range of cash flows and incorporates the probabilities of those cash flows. Choosing an Appropriate Interest Rate Three Components of Interest: Pure Rate Expected Inflation Rate Credit Risk Rate
Chapter 6-53

Risk-free rate of return. FASB states a company should discount expected cash flows by the risk-free rate of return.

LO 9 Apply expected cash flows to present value measurement.

Copyright
Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Chapter 6-54