Definition
Real Terms Accounting (RTA) is an accounting method that adjusts financial statements for inflation or changes in the price level to reflect the real purchasing power of money. It aims to provide more accurate financial information by eliminating distortions caused by fluctuating inflation rates, ensuring the financial statements present a truthful depiction of the firm’s financial health over time.
Examples
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Inflation Adjusted Income Statement:
- Nominal Terms: In 2000, a company had a revenue of $1,000,000 and expenses amounting to $500,000, resulting in a net income of $500,000.
- Real Terms: Adjusting for inflation (say, 30% over the years), the revenues and expenses would be adjusted to reflect the real value—let’s assume, $1,300,000 in revenues and $650,000 in expenses, thereby recalculating net income accordingly.
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Balance Sheet Adjustment:
- Nominal Terms: A piece of machinery was bought for $100,000 in 2010.
- Real Terms: Adjust for inflation to reflect its current value in today’s terms, say $130,000, to provide a more accurate total asset value.
Frequently Asked Questions (FAQs)
What is the primary benefit of Real Terms Accounting?
The primary benefit of Real Terms Accounting is that it provides a clearer and more accurate financial picture by accounting for the effects of inflation, thereby helping make more informed business decisions.
How does RTA differ from Historical Cost Accounting?
Historical Cost Accounting records assets and liabilities at their original purchase costs, while RTA adjusts those values to account for inflation or changes in the purchasing power of money over time.
Is Real Terms Accounting mandated by any accounting standards?
Real Terms Accounting is not universally mandated, but certain jurisdictions and circumstances may require or recommend it to present a more accurate financial position.
Can RTA be used for all types of financial statements?
Yes, RTA can be applied across all financial statements, including the income statement, balance sheet, and cash flow statement, to reflect the real monetary terms.
What tools are used to adjust financial statements for inflation in RTA?
The primary tool used is an appropriate inflation index or price level index, such as the Consumer Price Index (CPI) to make the necessary adjustments.
Related Terms
- Current Cost Accounting (CCA): A method of accounting in which assets and liabilities are recorded at their current replacement cost.
- Nominal Terms: Refers to the face value of money and financial items without adjusting for inflation.
- Historical Cost: The original purchase price of an asset, without any adjustments for inflation.
Online References
- Investopedia - Real Terms Accounting (RTA)
- The Balance - Understanding Inflation Adjustments in Accounting
Suggested Books for Further Studies
- “Inflation Accounting: An Introduction to the Debate” by Geoffrey Whittington
- “Financial Reporting in Hyperinflationary Economies” by David Cairns
- “The Theory and Practice of Inflation Accounting: Current Developments” by Geoffrey Whittington
Accounting Basics: “Real Terms Accounting” Fundamentals Quiz
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