Chapter 6 Class Notes

Chapter 6 Class Notes - Chapter 6 ACCOUNTING AND THE TIME...

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Chapter 6 ACCOUNTING AND THE TIME VALUE OF MONEY In accounting the phrase “time value of money” indicates a relationship between time and money – that a dollar received today is worth more than a dollar promised at some time in the future. Why? Because of the opportunity to invest today’s dollar and receive interest on the investment. When deciding among investment or borrowing alternatives, it is essential to be able to company today’s dollar and tomorrow’s dollar on the same footing – to compare “apples to apples.” Investors do that by using the concept of present value, which has many applications in accounting. Financial reporting uses different measurements in different situations – historical cost for equipment, net realizable value for some inventories, fair value for investments. The FASB is increasingly requiring the use of fair values in the measurement of assets and liabilities. According to the FASB’s recent standard on fair value measurements, the most useful fair value measures are based on prices established in active markets. However, for many assets and liabilities, market-based fair value information is not readily available. In these cases, fair value can be estimated based on the expected future cash flows related to the asset or liability. Using present value techniques, these future cash flows then can be converted into present values. Some Time Value of Money Applications to Accounting Topics 1. Notes Receivable and Notes Payable (Chapter 7, Chapter 14 ACC 372) 2. Leases (Chapter 21) 3. Pensions and Other Postretirement Benefits (Chapter 20) 4. Long-term Assets (Chapter 11) 5. Sinking Funds (Chapter 14 ACC 372) 6. Business Combinations (ACC 416) 7. Disclosures (various chapters) 8. Installment Contracts 1
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The Nature of Interest Interest is payment for the use of money. It is the excess cash received or repaid over and above the amount lent or borrowed (principal). Interest is expressed as a percentage rate and is usually determined based on the credit risk Other factors being equal, the higher the risk, the higher the interest rate. The amount of interest involved in any financing transaction is a function of three variables: Principal – the amount borrowed or invested Interest rate – a percentage of the outstanding principal Time – the number of years or fractional portion of a year that the principal is outstanding Simple interest is computed on the amount of the principal only. Look at the illustration on page 266. Simple interest usually applies only to short-term investments and debts that involve a time span of one year or less. Compound interest is computed on principal and on any interest earned that not been paid
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Chapter 6 Class Notes - Chapter 6 ACCOUNTING AND THE TIME...

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