UN-WINDING DISCOUNT

When an amount of money is to be paid at some time in the future, we frequently have to calculate what the present value of that future amount is. The process is called “discounting” or “discounted cash flow” that you should have learned about at the F level!

As each year goes by and that future payment date gets closer and closer, we need to unravel that discounted amount so that, by the date that payment is due, the obligation has now been fully unwound and the carrying value is the correct amount to be paid

The process of discounting is effected by multiplying the amount to be paid by 1 / (1+r) for the number of years into the future that the payment is due (“r” is the company’s cost of capital)

So $133 payable in 3 years’ time at a cost of capital of 10% has a present value of $133 x 1/(1.10)(1.10)(1.10) = $100.

Next year we shall unroll that discounted amount by multiplying $100 by 110% = $110

The next year $110 x 110% (can you see that we are unrolling the discounted present value?) = $121

Next year (at the end of which we are due to pay the $133) we unroll the amount by another 10% so $121 x 110% = $ 133 – which amount we shall now pay

Ok?

Yes, I suppose you could look at it that way – that difference is the amount by which the future payment has been discounted and not yet unwound.

Incidentally, as we unwind each year, the double entry involved is Debit Finance Charges in the Profit or Loss and Credit the Obligation (the amount that is payable in the future)

You’re welcome