Present value concepts and how it applies to bonds payable in accounting
A common concept with money and finance is something referred to as “the time value
of money”. What this refers to is the idea that a dollar today has a different value than a
dollar in the future.
Example: Assume I offered you $1,000. Would you rather collect it today or wait for a
year. I hope you answered “today”. Why wait a year? There would be many things you
could do with the money today that you wouldn’t want to wait for a year.
Assume, instead, that I make you the following offer - $1,000 today, or $1,100 a year
from now. Which option would you choose? You may need to think about it, as now
there is a reward for waiting a year – an extra $100.
This demonstrates that there is a value in time when it comes to money. This is the
main reason interest exists. If you want to borrow money from me, I’d be happy to lend
it to you as long as you compensate me for not having access to that money myself.
That compensation is generally called “interest”.
Back to my last offer of $1,000 today or $1,100 in one year. What you decide to do will
depend on a few factors, but probably the most important one will be current interest
rates. Assume your bank offers interest of 8% on money in your account. If you took
$1,000 from me today and put it in the bank, 1 year from now you’d only have $1,080
($1,000 original amount + interest (1,000 x 0.08), and my offer would be better.
However, if your bank was offering 12% (and if it is, please let me know where you are
banking!), then you’d have $1,120 after one year, which is better than my offer. My offer
of $1,100 basically is offering you an interest rate of 10%.
This is all really just to point out why we say money in the future has a different “value”
from money today.
There are many times in both finance and accounting when we want to know today’s
value of future cash amounts. We call this “present value”. There are formulas to
calculate this, and there are also present value tables. A sample of tables is attached at
the end of this document.
Present value really tells us what amount of cash we would need today to invest at
current market rates to receive a certain amount of cash flows in the future.
Assume you want to purchase a $10,000, 3 year bond that pays interest at 5% every
year. At the time of the purchase, market interest rates are 7%. What is th