You are on page 1of 30

# CHAPTER 6

## Accounting and the Time Value of Money

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics 1. 2. 3. Present value concepts. Use of tables. Present and future value problems: a. Unknown future amount. b. Unknown payments. c. Unknown number of periods. d. Unknown interest rate. e. Unknown present value. 15, 18 8, 19 7, 19 10, 11, 12 1, 5, 13 6, 12, 15, 17 4, 9 3, 11, 16 2, 7, 8, 10, 14 2, 3, 4, 7 8, 16, 17 10, 15 9, 10, 11, 14 3, 4, 5, 6, 8, 12, 17, 18, 19 2, 6 2 2, 7 1, 4, 7, 9, 13, 14 3, 5, 8 Questions 1, 2, 3, 4, 5, 9, 17 13, 14 8 1 Brief Exercises Exercises Problems

4.

Value of a series of irregular deposits; changing interest rates. Valuation of leases, pensions, bonds; choice between projects. Deferred annuity. Expected Cash Flows. 6 15 7, 12, 13, 14, 15

5.

6. 7.

6-1

## ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives 1. 2. 3. 4. 5. 6. 7. 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. 1, 2, 3, 4, 7, 8 5, 6, 9, 13 10, 11, 12, 14, 16, 17 15 2, 3, 6, 9, 10, 15 3, 4, 6, 15, 16 3, 4, 5, 6, 11, 12, 17, 18, 19 7, 8, 13, 14 20, 21, 22 1, 2, 3, 5, 7, 9, 10 2, 7 1, 2, 3, 4, 5, 7, 8, 9, 10, 13, 14 6, 11, 12, 15 13, 14, 15 2 1 Brief Exercises Exercises Problems

8. 9.

6-2

## ASSIGNMENT CHARACTERISTICS TABLE

Level of Difficulty Simple Simple Simple Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Simple Simple Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Complex Complex Complex Moderate Moderate Moderate Complex Time (minutes) 510 510 1015 1520 1015 1520 1217 1015 510 1015 1015 1015 1520 1520 1520 1015 1015 1015 1015 510 1520 1520 1520 1520 2030 2030 2025 2530 3035 2030 3035 3035 2530 2025 2025 2025 2025

Item E6-1 E6-2 E6-3 E6-4 E6-5 E6-6 E6-7 E6-8 E6-9 E6-10 E6-11 E6-12 E6-13 E6-14 E6-15 E6-16 E6-17 E6-18 E6-19 E6-20 E6-21 E6-22 P6-1 P6-2 P6-3 P6-4 P6-5 P6-6 P6-7 P6-8 P6-9 P6-10 P6-11 P6-12 P6-13 P6-14 P6-15

Description Using interest tables. Simple and compound interest computations. Computation of future values and present values. Computation of future values and present values. Computation of present value. Future value and present value problems. Computation of bond prices. Computations for a retirement fund. Unknown rate. Unknown periods and unknown interest rate. Evaluation of purchase options. Analysis of alternatives. Computation of bond liability. Computation of pension liability. Investment decision. Retirement of debt. Computation of amount of rentals. Least costly payoff. Least costly payoff. Expected cash flows. Expected cash flows and present value. Fair value estimate. Various time value situations. Various time value situations. Analysis of alternatives. Evaluating payment alternatives. Analysis of alternatives. Purchase price of a business. Time value concepts applied to solve business problems. Analysis of alternatives. Analysis of business problems. Analysis of lease vs. purchase. Pension funding. Pension funding. Expected cash flows and present value. Expected cash flows and present value. Fair value estimate.

## (For Instructor Use Only)

6-3

LEARNING OBJECTIVES
1. 2. 3. 4. 5. 6. 7. 8. 9. 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.

6-4

## (For Instructor Use Only)

CHAPTER REVIEW
1. (L.O. 1) Chapter 6 discusses the essentials of compound interest, annuities and present value. These techniques are being used in many areas of financial reporting where the relative values of cash inflows and outflows are measured and analyzed. The material presented in Chapter 6 will provide a sufficient background for application of these techniques to topics presented in subsequent chapters. 2. Compound interest, annuity, and present value techniques can be applied to many of the items found in financial statements. In accounting, these techniques can be used to measure the relative values of cash inflows and outflows, evaluate alternative investment opportunities, and determine periodic payments necessary to meet future obligations. Some of the accounting items to which these techniques may be applied are: (a) notes receivable and payable, (b) leases, (c) pensions, (d) long-term assets, (e) sinking funds, (f) business combinations, (g) disclosures, and (h) installment contracts. Nature of Interest 3. (L.O. 2) Interest is the payment for the use of money. It is normally stated as a percentage of the amount borrowed (principal), calculated on a yearly basis. For example, an entity may borrow \$5,000 from a bank at 7% interest. The yearly interest on this loan is \$350. If the loan is repaid in six months, the interest due would be 1/2 of \$350, or \$175. This type of interest computation is known as simple interest because the interest is computed on the amount of the principal only. The formula for simple interest can be expressed as p x i x n where p is the principal, i is the rate of interest for one period, and n is the number of periods. Compound Interest 4. (L.O. 2) Compound interest is the process of computing interest on the principal plus any interest previously earned. Referring to the example in (3) above, if the loan was for two years with interest compounded annually, the second years interest would be \$374.50 (principal plus first years interest multiplied by 7%). Compound interest is most common in business situations where large amounts of capital are financed over long periods of time. Simple interest is applied mainly to short-term investments and debts due in one year or less. How often interest is compounded can make a substantial difference in the level of return achieved. 5. In discussing compound interest, the term period is used in place of years because interest may be compounded daily, weekly, monthly, and so on. Thus, to convert the annual interest rate to the compounding period interest rate, divide the annual interest rate by the number of compounding periods in a year. Also, the number of periods over which interest will be compounded is calculated by multiplying the number of years involved by the number of compounding periods in a year.

## (For Instructor Use Only)

6-5

Compound Interest Tables 6. (L.O. 3) Compound interest tables have been developed to aid in the computation of present values and annuities. Careful analysis of the problem as to which compound interest tables will be applied is necessary to determine the appropriate procedures to follow. 7. The following is a summary of the contents of the five types of compound interest tables: Future value of 1 table. Contains the amounts to which 1 will accumulate if deposited now at a specified rate and left for a specified number of periods. (Table 1) Present value of 1 table. Contains the amount that must be deposited now at a specified rate of interest to equal 1 at the end of a specified number of periods. (Table 2) Future value of an ordinary annuity of 1 table. Contains the amount to which periodic rents of 1 will accumulate if the rents are invested at the end of each period at a specified rate of interest for a specified number of periods. (This table may also be used as a basis for converting to the amount of an annuity due of 1.) (Table 3) Present value of an ordinary annuity of 1 table. Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the end of regular periodic intervals for the specified number of periods. (Table 4) Present value of an annuity due of 1 table. Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the beginning of regular periodic intervals for the specified number of periods. (Table 5) 8. (L.O. 4) Certain concepts are fundamental to all compound interest problems. These concepts are: a. Rate of Interest. The annual rate that must be adjusted to reflect the length of the compounding period if less than a year. b. Number of Time Periods. The number of compounding periods (a period may be equal to or less than a year). c. Future Amount. The value at a future date of a given sum or sums invested assuming compound interest. d. Present Value. The value now (present time) of a future sum or sums discounted assuming compound interest. 9. (L.O. 5) The remaining review paragraphs pertain to present values and future values. The text material covers the following six major time value of money concepts: a. Future value of a single sum. b. Present value of a single sum. c. Future value of an ordinary annuity.

6-6

## (For Instructor Use Only)

d. Future value of an annuity due. e. Present value of an ordinary annuity. f. Present value of an annuity due. 10. Single-sum problems generally fall into one of two categories. The first category consists of problems that require the computation of the unknown future value of a known single sum of money that is invested now for a certain number of periods at a certain interest rate. The second category consists of problems that require the computation of the unknown present value of a known single sum of money in the future that is discounted for a certain number of periods at a certain interest rate. Present Value 11. The concept of present value is described as the amount that must be invested now to produce a known future value. This is the opposite of the compound interest discussion in which the present value was known and the future value was determined. An example of the type of question addressed by the present value method is: What amount must be invested today at 6% interest compounded annually to accumulate \$5,000 at the end of 10 years? In this question the present value method is used to determine the initial dollar amount to be invested. The present value method can also be used to determine the number of years or the interest rate when the other facts are known. Future Value of an Annuity 12. (L.O. 6) An annuity is a series of equal periodic payments or receipts called rents. An annuity requires that the rents be paid or received at equal time intervals, and that compound interest be applied. The future value of an annuity is the sum (future value) of all the rents (payments or receipts) plus the accumulated compound interest on them. If the rents occur at the end of each time period, the annuity is known as an ordinary annuity. If rents occur at the beginning of each time period, it is an annuity due. Thus, in determining the amount of an annuity for a given set of facts, there will be one less interest period for an ordinary annuity than for an annuity due. Present Value of an Annuity 13. (L.O. 7) The present value of an annuity is the single sum that, if invested at compound interest now, would provide for a series of equal withdrawals for a certain number of future periods. If the annuity is an ordinary annuity, the initial sum of money is invested at the beginning of the first period and withdrawals are made at the end of each period. If the annuity is an annuity due, the initial sum of money is invested at the beginning of the first period and withdrawals are made at the beginning of each period. Thus, the first rent withdrawn in an annuity due occurs on the day after the initial sum of money is invested. When computing the present value of an annuity, for a given set of facts, there will be one less discount period for an annuity due than for an ordinary annuity.

## (For Instructor Use Only)

6-7

Deferred Annuities 14. (L.O. 8) A deferred annuity is an annuity in which two or more periods have expired before the rents will begin. For example, an ordinary annuity of 10 annual rents deferred five years means that no rents will occur during the first five years, and that the first of the 10 rents will occur at the end of the sixth year. An annuity due of 10 annual rents deferred five years means that no rents will occur during the first five years, and that the first of the 10 rents will occur at the beginning of the sixth year. The fact that an annuity is a deferred annuity affects the computation of the present value. However, the future value of a deferred annuity is the same as the future value of an annuity not deferred because there is no accumulation or investment on which interest may accrue. 15. A long-term bond produces two cash flows: (1) periodic interest payments during the life of the bond, and (2) the principal (face value) paid at maturity. At the date of issue, bond buyers determine the present value of these two cash flows using the market rate of interest. 16. (L.O. 9) 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 to provide a more relevant measurement of present value. The FASB takes the position that after computing the expected cash flows, a company should discount those cash flows by the risk-free rate of return, which is defined as the pure rate of return plus the expected inflation rate. Financial Calculators *17. Business professionals, after mastering the above concepts, will often use a financial (business) calculator to solve time value of money problems. When using financial calculators, the five most common keys used to solve time value of money problems are:

PV

PMT

FV

where: N = number of periods. I = interest rate per period (some calculators use I/YR or i). PV = present value (occurs at the beginning of the first period). PMT = payment (all payments are equal, and none are skipped). FV = future value (occurs at the end of the last period).

6-8

## (For Instructor Use Only)

LECTURE OUTLINE
This chapter can be covered in two to three class sessions. Most students have had previous exposure to single sum problems and ordinary annuities, but annuities due and deferred annuities will be new material for most students. The first class session can be used for discussing Illustration 6-5.
TEACHING TIP

Illustration 6-5 can be distributed to students as a self-contained 6-page handout. It uses 10 sample problems to demonstrate a 4-step solution method that can be used to solve any of the problems discussed in the chapter. Some students with a background in math or finance courses may prefer to use exponential formulas rather than interest tables to find interest factors. Other students with sophisticated calculators may prefer to let the calculator do the work. Remind students that whether they use interest tables, exponential formulas, or internal calculator routines, they cannot solve problems correctly unless they can correctly identify the type of problem, the number of periods, and the interest rate involved. Students often have no difficulty with problems that are worded: At 6%, what is the present value of an annuity due of 20 payments of \$10,000 each? but they may not know how to proceed if the same problem is worded: What amount must be deposited now in an account paying 12% if it is desired to make 20 semiannual withdrawals of \$10,000 each, beginning today? Emphasize to students the importance of properly setting up the problem. The second and third class sessions can be used for determining solutions to more complex problems, including deferred annuities, bond valuation and other accounting applications. Some of the journal entries for the accounting applications can be discussed briefly. The following lecture outline is appropriate for this chapter. A. (L.O. 1) Basic Time Value Concepts. 1. 2. Discuss the importance of the time value of money. Describe accounting applications of time value concepts: long-term assets, pensions, leases, long-term notes. Describe personal applications of time value concepts: purchasing a home, planning for retirement, evaluating alternative investments.

3.

B. (L.O. 1) Nature of Interest. 1. Interest is payment for the use of money. It is the excess cash received or repaid over and above the principal (amount lent or borrowed).

6-9

## C. (L.O. 2) Simple Interest.

TEACHING TIP

Illustration 6-1 can be used to distinguish between simple interest and compound interest. 1. 2. Simple interest is computed on the amount of the principal only. Simple interest = p X i X n where p = principal. i = rate of interest for a single period. n = number of periods. D. (L.O. 2) Compound Interest. 1. Compound interest is computed on the principal and on any interest earned that has not been paid or withdrawn. Discuss the power of time and compounding. (E.g., What do the numbers mean? on text page 313 indicates that at 5% compounded annually, \$1,000 grows to \$23,839 in 65 years. At 5% simple interest, \$1,000 would grow to only \$4,250 in 65 years.) \$4,250 = \$1,000 + (\$1,000 X .05 X 65). The term period should be used instead of years. a. Interest may be compounded more than once a year: If interest is compounded Annually Semiannually Quarterly Monthly b. Number of compounding periods per year 1 2 4 12

2.

3.

Adjustment when interest is compounded more than once a year. (1) Compute the compounding period interest rate: divide the annual interest rate by the number of compounding periods per year. (2) Compute the total number of compounding periods: multiply the number of years by the number of compounding periods per year.

6-10

## (For Instructor Use Only)

E. (L.O. 3) Use of Compound Interest Tables. 1. The tables contain interest factors that simplify the computation of compound interest. Example: If \$1,000 is deposited today at 9% compound interest, the balance in 3 years can be determined: a. By repetitive calculation First year: \$1,000 + (\$1,000 X .09) = \$1,090. Second year: \$1,090 + (\$1,090 X .09) = \$1,188. Third year: \$1,188 + (\$1,188 X .09) = \$1,295 (rounded). b. By use of exponential formulas \$1,000 X (1.09)3 = \$1,295 (rounded). c. d. By use of financial calculators or spreadsheet programs. By obtaining the 1.29503 interest factor from Table 6-1 for 3 periods at 9% and performing the appropriate computation \$1,000 X 1.29503 = \$1,295.03. 2. Describe the five interest tables provided in the text: a. b. c. d. e. Table 6-1: Future Value of 1. Table 6-2: Present Value of 1. Table 6-3: Future Value of an Ordinary Annuity of 1. Table 6-4: Present Value of an Ordinary Annuity of 1. Table 6-5: Present Value of an Annuity Due of 1.

F. (L.O. 4) Variables in Compound Interest Problems. 1. Describe the four fundamental variables in compound interest problems:
TEACHING TIP

Illustration 6-2 depicts a time diagram that identifies the four variables that are fundamental to all compound interest problems. Illustration 6-3 can be used to show students how the four fundamental variables relate to the time value of money concepts. a. b. Rate of interest: an annual rate, adjusted to reflect the length of the compounding period. Number of time periods: the number of compounding periods.

## (For Instructor Use Only)

6-11

c. d.

Future value: the value at a future date of a given sum(s) invested assuming compound interest. Present value: the value now of a future sum(s) discounted assuming compound interest.

## G. Steps in Solving Compound Interest Problems.

TEACHING TIP

Use Illustration 6-4 to discuss the 5-step solution method that can be used to solve any compound interest problem. 1. Emphasize the importance of performing Steps 1 and 2 correctly. Whether students use interest tables, exponential formulas, or financial calculators, they cannot solve problems correctly unless they can correctly identify the type of problem, the number of periods, and the interest rate involved.

## H. (L.O. 5) Single-Sum Problems.

TEACHING TIP

Problems 1, 2, and 3 in Illustration 6-5 demonstrate single-sum problem situations. 1. Formula for future value: Future value = present value (or amount) X future value factor for n periods at i % FV = PV(FVFn, i) 2. Formula for present value: Present value = future value x present value factor for n periods at i % PV = FV(PVFn, i) 3. 4. Point out that the present value is always a smaller quantity than the future value. The process of finding the future value is called accumulation. The process of finding the present value is called discounting.

6-12

## (For Instructor Use Only)

5.

The factors in Table 6-2 are the reciprocal of corresponding factors in Table 6-1. Therefore, all single-sum problems can be solved by using either Table 6-1 or 6-2. For example, if the future value is known and the present value is to be solved for, the present value can be found: a. b. by multiplying the known future value by the appropriate factor from Table 6-2, or by dividing the known future value by the appropriate factor from Table 6-2.

I. (L.O. 6 and 7) Ordinary Annuities. 1. Annuity problems involve a series of equal periodic payments or receipts called rents. a. b. In an ordinary annuity the rents occur at the end of each period. The first rent will occur one period from now. In an annuity due the rents occur at the beginning of each period. The first rent will occur now.
TEACHING TIP

Problems 4, 5, and 8 in Illustration 6-5 demonstrate ordinary annuity problem situations. 2. Formula for future value of an ordinary annuity: Future value of ordinary annuity (FVOA) = periodic rent X future value of ordinary annuity factor for n periods at i % FVOA = R (FVFOAn, i) 3. Formula for present value of an ordinary annuity: Present value of ordinary annuity (PVOA) = periodic rent X present value of ordinary annuity factor for n periods at i % PVOA = R (PVFOAn, i) 4. 5. 6. Point out that the present value of an ordinary annuity is always smaller than the future value of a similar annuity. The factors in Tables 6-3 and 6-4 are not reciprocals of each other. In annuity problems, the rents, interest payments, and number of periods must all be stated on the same basis. For example, if interest is compounded semiannually, then n = the number of semiannual rents paid or received, i = the annual interest rate divided by 2, and R = the amount of rent paid or received every 6 months.

## (For Instructor Use Only)

6-13

7.

Some confusion may arise in annuity problems because of two different meanings of the word period. a. For the purpose of looking up interest factors, n equals the number of periods and is always equal to the number of rents. In the phrase when computing the future value of an ordinary annuity the number of compounding periods is one less than the number of rents, the term periods refers to compounding periods or interest-bearing periods. This refers to the number of times interest is earned on the principal and any accumulated interest. This usage of the term period is useful for distinguishing between ordinary annuities and annuities due. This usage is intended to explain why the adjustment of factors from Table 6-3 is done the way it is when the problem involves the future value of an annuity due.

b.

## J. (L.O. 6 and 7) Annuities Due.

TEACHING TIP

Problems 6 and 7 in Illustration 6-5 demonstrate annuity due problem situations. 1. Formula for future value of annuity due: Future value of annuity due (FVAD) = periodic rent x future value of ordinary annuity factor for n periods at i % X (1 + i ) FVAD = R (FVFOAn, i ) X (1 + i ) a. b. An interest table is not provided for the future value of an annuity due. Example: At 9%, what is the future value of an annuity due of 7 payments of \$3,000 each? \$3,000 X 9.20044 X 1.09 = \$30,085.44 2. Formula for present value of annuity due: Present value of annuity due (PVAD) = periodic rent x present value of annuity due factor for n periods at i % PVAD = R (PVFADn, i )

6-14

## (For Instructor Use Only)

3.

Point out that: a. b. The present value of an annuity due is always smaller than the future value of a similar annuity due. The future value (present value) of an annuity due is always larger than the future value (present value) of a similar ordinary annuity with the same interest rate and number of rents.

## K. (L.O. 8) Deferred Annuities.

TEACHING TIP

Problems 9 and 10 in Illustration 6-5 demonstrate deferred annuity problem situations. 1. A deferred annuity does not begin to produce rents until two or more periods have expired. A deferred annuity problem can occur in either an ordinary annuity situation or an annuity due situation. a. b. In order to keep the presentation straightforward, only the ordinary annuity situation has been illustrated in the text and in Illustration 6-5. The differences between the two situations are as follows: Ordinary Annuity of n Rents Deferred for y Periods (y + 1) periods from now (y + n) periods from now immediately after the last rent Annuity Due of n Rents Deferred for y Periods y periods from now (y + n 1) periods from now one period after the last rent

2.

## First rent occurs Last rent occurs Future value is measured as of c.

If a deferred annuity involves solving for a present value, the distinction between an ordinary annuity and an annuity due has no practical significance. (i.e., see Problem 10 in Illustration 6-5. This can be set up either as the present value of an ordinary annuity of 4 rents deferred 3 periods, as was done in Illustration 6-5, or it can be set up as the present value of an annuity due of 4 rents deferred 4 periods. If the latter is done, different combinations of factors will be used, but the same answer will be obtained.)

## (For Instructor Use Only)

6-15

d.

However, if a deferred annuity involves solving for a future value, the distinction between an ordinary annuity and an annuity due is important. The following formula is required: FVAD d = R (FVFOAn, i ) X (1 + i ) where FVAD d = future value of an annuity due of n rents deferred for y periods R = periodic rents (FVFOAn, i ) = factor from Table 6-3 for n periods at i % (1 + i ) = 1 plus the interest rate To illustrate, suppose Problem 9 in Illustration 6-5 had been worded as follows: As of the beginning of his first year in college, a student plans to deposit \$1,000 in an 8% account at the end of his third, fourth, and fifth years in school. What will be the balance in the account one year after the last deposit? The time diagram for this revised problem is:

The revised problem involves solving for the future value of an annuity due of 3 rents deferred for 3 periods. The solution is FVAD d = R (FVFOA3,.8%) (1.08) = \$1,000 X 3.24640 X 1.08 = \$3,506.11. To sum up: In solving for the future value of a deferred annuity (1) If the future value is to be determined immediately after the last rent, the problem may be thought of as an ordinary annuity. The computation described in the text and in Illustration 6-5 is adequate. (2) If the future value is to be determined one period after the last rent, the problem should be thought of as an annuity due. An adjustment must be made to accumulate interest for one more period.

6-16

## (For Instructor Use Only)

L. (L.O. 8) Bond Valuation Problems. 1. Discuss the distinction between the stated interest rate and the market or effective interest rate: a. The stated interest rate is used to determine the periodic amount of cash interest paid. The market or effective interest rate is used to value the bonds. This is the rate which is looked up in the present value tables.

b.

2.

The example in the text demonstrates valuation of bonds which pay interest annually.
TEACHING TIP

Illustration 6-6 provides an example of a bond valuation problem in which bond interest is paid semiannually. M. (L.O. 9) Expected Cash Flow Approach. 1. 2. Introduced by Concepts Statement No. 7. Uses a range of cash flows and their related probabilities to provide a more relevant measurement of present value. Choosing an appropriate interest rate: a. b. is not always obvious. three components of interest: (1) pure rate of interest (2%4%). (2) expected inflation rate of interest (0%?%). (3) credit risk rate of interest (0%5%).
TEACHING TIP

3.

Use Illustration 6-7 to provide a basis for discussing how to apply the expected cash flow approach. 4. After computing the expected cash flows, a company discounts these cash flows by the risk-free rate of return. This rate is the pure rate of return plus the expected inflation rate.

6-17

6-18

6-19

6-20

6-21

6-22

6-23

6-24

6-25

6-26

6-27

6-28

6-29