The term discounting refers to an arrangement in which a debtor is allowed to pay a creditor at a later date. The delay is not indefinite and must be agreed on.
At the same time, such an arrangement brings with it a certain fee to compensate for the late payment. In this context, the term discount is used for the difference between the original debt and the actual amount owed that will have to be settled on the agreed date.
The imposition of an additional charge is in keeping with the assumption that the money which has not yet been paid could have already earned interest had it been received on time and invested. As such, the discount yield, which is sometimes referred to as the discount rate, ideally corresponds with the returns that should have been received if the funds had been invested. Of course, for such a computation to be fair and as accurate as possible, its basis must be an investment with a similar level of risk. The loss from not being able to use the funds during the entire delay period is known as Opportunity Cost. This is what discounting seeks to make up for. Therefore, the actual discount imposed is determined by a computation based on these factors.
This argument is in keeping with the concept of TVM, or the time value of money. This simply means that the value of money which is received now is greater than the same amount of money received in the future.
