CHAPTER 6 Basic Concepts

# CHAPTER 6 Basic Concepts - Time Value of Money Concepts...

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Time Value of Money Concepts BASIC CONCEPTS TIME VALUE OF MONEY A. Present Value-Based Accounting Measurements The time value of money is used extensively in accounting. The textbook lists a number of applications. As accounting moves more and more toward fair value accounting we can expect this list to get longer. B. Variables in Interest Computation There are several terms that we need to understand. 1. Principal -the amount borrowed or invested on which interest is to be charged 2. Interest rate -the percentage that is applied to the principal 3. Time -the periods that the principal is outstanding C. Components of Interest The rate of interest is actually comprised of three components. 1. Pure rate (risk free) -the amount of interest charged on risk free investments 2. Credit risk rate -the risk associated with credit worthiness of the borrower 3. Inflation risk rate -the expected rate of inflation during the time period D. Simple Interest The computation of simple interest is based on the original principal amount. It is the same amount each period. For example, if Spencer Company borrows \$100,000 at 10% simple interest for five years the interest would be computed as follows: Principal \$100,000 Interest rate 10 % Interest per year \$ 10,000 Number of years outstanding 5 Total interest expense \$ 50,000 E. Compound Interest The computation of compound interest takes into account retention of the interest. In effect, the interest is added to the principal balance each period to derive a new principal balance. Using the same example, the computation of compound interest for Spencer Company would be computed as follows: Beginning Interest Ending Balance Rate Balance End of Year 1 \$100,000 10% \$110,000 End of Year 2 110,000 10% \$121,000 End of Year 3 121,000 10% \$133,100 End of Year 4 133,100 10% \$146,410 End of Year 5 146,410 10% \$161,051 By compounding the interest, the total interest over the life of the contract is \$61,051.

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## This note was uploaded on 02/01/2012 for the course ACF ACC220 taught by Professor Fiona during the Spring '08 term at Seneca.

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CHAPTER 6 Basic Concepts - Time Value of Money Concepts...

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