Determining Present Value of Annuities
Annuities involve a series of fixed payments to or from a company over a fixed period of time. Annuities may include loans, rent, mortgages, and interest payments. Payments typically occur on a monthly, quarterly, semi-annual, or annual basis. While an annuity is being built up or paid for, this is known as the accumulation period. Annuitization occurs when investments are converted into regular or irregular payments. Calculating the present value of annuities does not take the accrual method of accounting into consideration. Payments due at the end of a period are called ordinary annuities or annuities in arrear, while payments due at the beginning of a period are called annuity due. Note that calculations vary between ordinary annuities and annuities due.
Present value of annuity utilizes the concept of time value of money, which states that the same amount of money both today and in the future is worth more today than in the future because of investment opportunities. If a company must pay for products or services with the full amount paid in increments, the future installments should be calculated to determine how much of the payment is interest expense and how much is for product/service expense. Note that interest is compounded upon itself, resulting in interest on interest, which grows a loan or deposit faster than a flat rate.
To determine the present value of an annuity, the following information should be known: present value, identical cash payment amounts, time in between identical cash payments, the length of an annuity, and an interest rate used to discount payments over a length of time. If four out of five of these pieces of information are known, the missing piece can be calculated. The present value of an annuity is the value of payments, divided by interest rates. Accounting software can calculate this information for you.
If a product/service is sold to a customer and paid for in a series of installments, the total cannot be recorded as revenue at the beginning of that period, according to the cost principle and the revenue recognition principle. This is because part of that established sum will be in the form of interest. Though the full amount will be debited to notes receivable, the interest is credited to discount on notes receivable and the product/service is credited to product/service revenues. Note that the interest recorded in discount on notes receivable is amortized to the interest revenues account on the income statement over the duration of the payment.
Moving interest revenue from a balance sheet to an income statement can be conducted using two methods. The first is the straight-line method, which records interest at a static amount until the product/service is paid for. The second option is the effective interest rate method, which is typically used when interest revenue is moderate. This method factors in regular interest rate as well as compounded interest.