In many purchases, interest is explicitly stated. For example, the contract to buy this patent could have required payment of $1 million after five years plus interest at a 7 percent rate to be paid each year. Once again, the accounting is not complicated. The $1 million is the historical cost of the patent while the annual $70,000 payments ($1 million × 7 percent) are recorded each year by the buyer as interest expense. The two amounts are clearly differentiated in the terms of the agreement. A problem arises if the interest is not explicitly identified in the contract. In the current illustration, the company agrees to make a single $1 million payment in five years with no mention of interest. According to U.S., interest is still present because payment has been delayed.
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The assertion stands: there is always a charge for using money over time. Payment has been deferred for five years; some part of that payment compensates the seller for having to wait for the money. Even if a rate is not mentioned, the assumption is made that interest for this period of time was taken into consideration when the $1 million figure was set. However, the specific allocation of the $1 million between patent and interest is not readily apparent. To calculate the interest included within the price, an introduction to present value computations is necessary. In simple terms, the present value of future cash flows is the amount left after all future interest is removed (hence the term “present value”). The present value is the cost within the $1 million paid for the patent. The remainder—the interest—will be recognized as expense over the five-year period until payment is made. To determine the present value of future cash flows, a reasonable interest rate is needed. Then, the amount of interest for these five years can be mathematically calculated. An appropriate interest rate is often viewed as the one the buyer would be charged if this money were borrowed from a local bank.
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