The Time Value Of Money In Accounting
A significant difference in the two types of decisions, short-term and long-term is the time value of money, which does not need to be taken into account when making short-term decisions, but does so when making long-term, capital investment decisions. A dollar received today has greater value than a dollar to be received a year from now for three different reasons – risk, inflation and interest.
To illustrate, let’s say I buy some merchandise from you on credit for a hundred dollars. If I’m a regular customer and tell you that I will put a check in the mail tomorrow (assuming I’m an honorable person and telling the truth) there is little risk that you will not be paid. If, however, I tell you I’ll pay you in one year the risk goes up considerably. I might become bankrupt in the next 12 months, I might die or I might run off to Mexico. If I tell you I’ll pay you in two years, the risk level goes up even more. The longer the time between now and when you expect cash inflow from a project, the more the uncertainty and the greater the risk of not receiving the cash.
Another factor is inflation. It is one of the most important issues in the economics. Inflation erodes the purchasing power of money. If this coming year we have, say, 3 percent inflation, that means that the proverbial market basket of goods and services which costs $100 today will cost $103 this time next year. If I owe you $100 and don’t pay for a year, it has cost you $3 in purchasing power. You want your money now.
Economists like to assume all manner of things to make their argument, so let’s assume away risk and inflation for a moment. We’ll assume that I’m completely reliable and there will be no inflation during the next 12 months. Let’s further assume that you don’t have an immediate need for the hundred dollars I owe you. Now, would you be indifferent to whether I paid you now or in a year? No, you would not be indifferent. Even though I might be completely reliable and there will be no inflation, you still want your money now instead of later because of the institution of interest. If nothing else, you could take the money I owe you, buy a one-year certificate of deposit and earn some interest.