One of the most important concepts of the study of finance is the time value of money. This holds that a dollar today is worth more than a dollar at some point in the future. In other words, the present value of money is worth more than its future value. This concept has important implications for accounting, and, when accounting for future value, a discount factor must be used.
The present value of money is simply the value of that money at the current point in time. For example, if you have $30 in your wallet, the present value of that money is $30. Present value can also be used to determine the value of future cash flows. For example, depending on the discount factor, $30 three years from today has a present value of less than $30.
The future value of a certain amount of money is always less than its present value. This is because there are opportunity costs of not having that money today. For example, if someone forgoes the chance to posses $10,000 for 10 years, she is missing out on the opportunity to invest that money for 10 years. Even if that $10,000 were simply placed in a bank savings account, the money would accrue interest.
Because of the time value of money, the present value of future cash flows must be calculated for accounting purposes. The tool used to account for these future cash flows is known as the discount factor. This depends entirely on the relevant interest rate. The formula for calculating a discount factor is (1+r) ^ n, where "r" is the interest rate and "n" is the relevant number of periods. For example, the discount factor in a situation in which the interest rate is 5 percent annually over 10 years would be 1.05 ^ 10 = 1.63.
Accounting for Future Payments
To account for the present value of future payments, simply divide the future payment by the relevant discount factor. Using the previous discount factor, a promise to pay $10,000 ten years from now when the interest rate is 5 percent would have a present value of $10,000 / 1.63 = $6,134.97.