Question

How does the concept of Time Value of Money applied in accounting and finance?

Answer 1

Solution: ‘A bird in hand is worth two in the bush’ – this saying applies to transactions too.
let me explain this to you through a simple example:
Say,someone borrowed a certain sum of money from you and it is due.
you are expecting money to be credited to your account when you received a call from the borrower saying
that he will pay the amount after 3 months.
Now if you had received the amount today, you would have invested it in bank and earning interest income
or you would have invested it in your business and made money from money.
So, money you have in hand is worth more than the money you may get in future. The reason for this is the inflation or the
earning capacity.

So the relationship between the present value and the future value can be defined as:
FV = PV x [ 1 + (I/ N) ] (N*T)
Where,
FV is Future value of money,
PV is Present value of money,
I is the interest rate,
N is the number of compounding periods annually and
T is the number of years in the tenure.

For instance, if you invest $ 100000 for 5 years at 10% interest,
the future value of this $100000  will be $ 161,051 as per the formula.

Now let's understand how does the concept of time value of money applies in accounting and Finance.

In accounting:
Let's assume that a company provides consulting services today and agrees to an $11,000 payment one year later. The $11,000 represents:

an amount for the services performed today, and
interest to compensate the company for waiting 365 days for the $11,000
Under the accrual basis of accounting and a time value of money of 10%, the service revenues that were earned today are $10,000. The difference of $1,000 will be reported as interest income over the 365 days that the company waits for the $11,000.

The time value of money is important in accounting because of the accountant's cost principle and revenue recognition principle.
However, the concepts of materiality and cost/benefit allow the accountants to ignore the time value of money for the routine accounts receivable
and accounts payable having credit terms of 30 or 60 days.

In Finance:
Suppose you have to take a finance related capital budgeting decision, that whether to buy a particular machine worth $50000 or not?
so how you going to make a decision?
The answer is we have to pull all the current and future cashflows at today's cost.
say we'll going to earn $10,000 for 3 years if we sold goods made from that machine.
and at the end of three years that machine can be sold at $1,000. The opportunity cost of capital is 10%

1 Cash outflow at 0th year= $50,000
2 cash inflow:$10,000(Present value annuity factor @10% for 3 years)
       =$24,869 (this shows that today's $30,000 is equal to future's $24,869, if we discount it at 10%)
3 Cash Inflow in the 3rd year= $1,000 (Present value factor @10% for 3rd year)
               = $751
4 Net present value= present values of inflows - present values of ouutflows
           = (24869+751)-50000
           = $-24380

So NPV is negativeso we shouldn't invest in this machine.

Summary: we cannot run a business or invest in any asset without taking into account time value of money. Because what we can purchase
in today's $100, we have to pay $110 in future for that.