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CHAPTER 6 REVIEW
1.
(S.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)
longterm
assets,
(e)
sinking funds,
(f)
business combinations,
(g)
disclosures,
and (h)
installment contracts.
Nature of Interest
3.
(S.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.
(S.O. 2)
Compound interest
is the process of computing interest on the
principal plus any interest previously earned. Referring to the example in (2)
above, if the loan was for two years with interest compounded annually, the
second year’s interest would be $374.50 (principal plus first year’s 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 shortterm 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.
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 Spring '08
 Madlinger

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