Financial Accounting: In an Economic Context

PRESENT VALUE AND FINANCIAL ACCOUNTING

We stated earlier that present value is the economic form of valuation. Investors, creditors, and managers use it to compare the values of alternative investments. Bankers, lawyers, and other business decision makers use it to derive the terms of contracts like mortgages, leases, pensions, and life insurance. Virtually any transaction that can be broken down into periodic cash flows utilizes the time value of money concept and can be reduced to present value, future value, and other equivalent values. The time value of money is covered in finance, economics, accounting, and other business courses. You may have already studied present value in previous courses, and you will probably see it again in the future. The uses of present value in business decision making are almost limitless.

The study of financial accounting and its reliance on the time value of money concept is no exception. As you already know, financial accounting information is useful because it helps investors, creditors, and other interested parties evaluate and control the business decisions of management. Such evaluation and control requires that financial accounting information be used to assess value: the value of entire companies, the value of individual assets and liabilities, and the value of specific transactions. Since present value is the economic form of valuation, financial accounting information must reflect present value if it is to be useful.

However, a critical ...