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Dear Mike,
I understand that the deferred consideration of $5.4m paid a year later is the Present value of future collection which is $5.4m/1.08 since the interest is at 8%p.a. and the amount is $5m, is that why we include the $400 as the finance cost? I am a bit lost on this part. It doesn’t make sense to me to incur any finance cost since you only start paying 30 september 2011
If the present value of a future obligation is $5 ($5.4 x 1/1.08) and we record the obligation as $5 (correctly), yet in one year’s time we have to pay an obligation of $5.4, how does that double entry work? Dr Obligation $5.4, Cr Cash $5.4
But there was only $5 in the Obligation account, so where’s the other $400 coming from?
The concept is this: if I have to pay an amount in the future, effectively I’m borrowing money and the person to whom it is payable is lending money. In our example above, the lender is lending $5m and deserves compensation by way of loan interest. Similarly, I’m borrowing $5m and I should face the prospect of incurring loan interest.
And that’s where discounting and $400,000 finance charges come in
Better?
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