Definition of Time Value of Money
The time value of money recognizes that receiving cash today is more valuable than receiving cash in the future. The reason is that the cash received today can be invested immediately and begin growing in value. For instance, if a company receives $1,000 today and is able to invest the amount immediately at a rate of 10% per year, the company will have $1,100 after 365 days.
If the time value of money is 10%, it also means that receiving $1,100 in one year is comparable to receiving $1,000 today. Accountants will state that the future value of $1,100 has a present value of $1,000. The difference of $100 will become interest income as over the 365 days that the company waits for the cash.
Time Value of Money | Practical Example
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.
Importance of the Time Value of Money in Accounting
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.