University:
California State University, Northridge
Course:
ACCT 220 | Introduction to Financial Accounting
Academic year:

2024
Views:

364

Pages:

2
Author:

lorenzops0

In accounting we are practically never interested in asking how much something will be worth in the future. Instead we want to know how much something that will be paid (or received) in the future is worth today. Remember, what we try to do in accounting: Determine income for the current year (NOW). Determine the value of assets and liabilities at the end of the current year (NOW). In other words, we do not case much about future value, instead we want to know Present Value. Does this mean all the talk about Future Value was wasted? Not at all. Remember the equation used to answer the question: "If $100 are invested for three years to earn 10%, how much money will we have at the end of three years?" Equation: 100 x FV (10%,3) = X In that example, we solved for Future Value and determined that X = $ 133.10. Now, let's rephrase this. What if we know how much we will receive three years from now? A customer promises to pay us $133.10 at the end of three years. This will is in payment for a purchase made this year. We need to know how much of the $133.10 is principal (REVENUE) and how much should be considered interest income which we will earn over the three year period. By the miracles of algebra, we use the same equation that was used above for Future Value, we just rewrite it a little: Question: "If three years from now we are to receive $133.10 and if we want to earn 10% on any investment (compounded annually), what is the value of the promised payment today?" Equation: • • • • X x FV(10%,3) = $133.10 X x 1.331 = $133.10 (X x 1.331)/1.331= $133.10/1.331 X = $100 TA DA! Present Value is the reciprocal of Future Value or PV = 1/FV. Therefore: PV(10%,3) = 1/FV(10%,3) = 1/(1+.1) 3 = The question again: What is the value today of $133.10 to be received in three years, if we want to earn 10% on our investment? 0.751 Equation: $133.10 x PV(10%, 3) = X $133.10 x .751315 = X $ 100.00 =X This is the question (and equation) you must know. You will not use the formula to determine the present value factor. Instead use the present value tables in your text. Note that different present value tables round to different decimal places. Some tables, for example would give PV(3, 10%) as .751, others might go as far as .7513148. Don't worry about that. These are rounding "errors" and we ignore them. Important Present value tables are to be used for text book problems and exam problems (Yes, you will receive necessary tables). Some cases (or real life situations) involve interest rates such as 7.25%, compounded semi-annually (a typical bond - see Chapter 13). In cases like that you use either the computer spreadsheet program or a calculator with present value capabilities. At this time, however, it is important that you learn the concept and not "data entry" and therefore I will only give you credit if your answer is written in the equation form shown above.