Real Accounts and Nominal Accounts: Differences and Practical Examples

In the world of accounting, accounts are classified into different types to understand their nature and their impact on the financial statements. One of the most important classifications is the division of accounts into Real Accounts and Nominal Accounts: Differences and Practical Examples Understanding the difference between these two types is crucial for correctly recording and understanding accounting entries and account types, and for accurately preparing financial reports. In this article, we will explore the world of real accounts and nominal accounts, clarifying the fundamental differences between them, and supporting the explanation with practical examples to enhance understanding and reinforce the information.

What are Real Accounts?

Real accounts, also known as permanent accounts or balance sheet accounts, are accounts that are not closed at the end of the financial period. Instead, their balances are carried forward to the next financial period. These accounts represent an entity’s assets, liabilities, and equity – that is, everything that appears on the balance sheet (statement of financial position).

Real accounts include:

• Assets: Everything the entity owns that has future economic value. Assets are divided into:
  • Current Assets: Assets expected to be converted into cash or used up within one year, such as cash, bank, accounts receivable, notes receivable, and inventory.
  • Fixed Assets (Non-Current Assets): Assets owned by the entity for use, not for sale, and expected to be used for more than one year, such as land, buildings, machinery, equipment, and vehicles.
  • Intangible Assets: Assets that have no physical presence but have economic value, such as patents, trademarks, copyrights, and goodwill.
• Liabilities: Debts and financial obligations that the entity owes to others. Liabilities are divided into:
  • Short-Term Liabilities (Current Liabilities): Liabilities due within one year, such as accounts payable, notes payable, and short-term loans.
  • Long-Term Liabilities: Liabilities due after more than one year, such as long-term loans and bonds.
• Equity: The owners’ rights to the entity’s assets after liabilities are settled. This includes capital, retained earnings, and reserves.

Characteristics of Real Accounts:

• Permanent: They are not closed at the end of the financial period; their balances are carried forward to the next period.
• Represent the Entity’s Financial Position: They reflect the entity’s assets, liabilities, and equity at a specific point in time.
• Appear on the Balance Sheet (Statement of Financial Position).
• Affected by the Going Concern Principle: It is assumed that the entity will continue to operate in the foreseeable future, so its real accounts remain open.

What are Nominal Accounts?

Nominal accounts, also known as temporary accounts or income statement accounts, are accounts that are closed at the end of the financial period. Their balances are reset to zero, and their net effect is transferred to retained earnings (or the owner’s capital account). These accounts represent an entity’s revenues and expenses over a specific period.

Nominal accounts include:

• Revenues: Cash inflows to the entity from primary or other activities. Revenues are divided into:
  • Operating Revenues: Revenues resulting from the entity’s main activity, such as sales revenue and service revenue.
  • Other Revenues (Non-Operating Revenues): Revenues resulting from non-core activities, such as interest revenue and gains on the sale of assets.
• Expenses: The cost of generating revenue. Expenses are divided into:
  • Cost of Goods Sold: The cost of goods that were sold during the period.
  • Operating Expenses: Expenses related to the entity’s main activity, such as salaries expense, rent, marketing, and electricity.
  • Other Expenses: Expenses not related to the main activity, such as interest expense and losses on the sale of assets.

Characteristics of Nominal Accounts:

• Temporary: They are closed at the end of the financial period, and their balances are reset to zero.
• Represent the Entity’s Operating Results: They reflect the entity’s profitability or loss over a specific period.
• Appear on the Income Statement.
• Affected by the Accounting Period Principle: Revenues and expenses of each financial period are measured independently of other periods.

Key Differences Between Real Accounts and Nominal Accounts:

Practical Examples of Real Accounts and Nominal Accounts:

Real Accounts:

• Cash:Real Accounts and Nominal Accounts representing cash on hand or in the entity’s bank accounts.
• Inventory: Real Accounts and Nominal Accounts representing goods held for sale.
• Machinery and Equipment: Real Accounts and Nominal Accounts representing machinery and equipment used by the entity in its operations.
• Vehicles: Real Accounts and Nominal Accounts that represents the value of vehicles that are owned by the business.
• Accounts Receivable:Real Accounts and Nominal Accounts representing amounts owed to the entity by customers.
• Notes Receivable:Real Accounts and Nominal Accounts representing promissory notes or bills of exchange owed to the entity.
• Short-term Investments: Real Accounts and Nominal Accounts representing the investments in shares and bonds that will be held for under a year.
• Land and Buildings (Property): Real Accounts and Nominal Accounts representing the value of land and buildings owned by the entity.
• Accounts Payable:Real Accounts and Nominal Accounts representing amounts owed to suppliers.
• Short-Term Loans: A real account (liability) representing amounts borrowed by the entity from banks or financial institutions and due within one year.
• Long-Term Loans: A real account (liability) representing amounts borrowed by the entity and due over more than one year.
• Notes Payable: A real account (liability) representing promissory notes or bills of exchange owed by the entity.
• Capital: A real account (equity) representing the investments of the entity’s owners.
• Retained Earnings: A real account (equity) representing the accumulated profits of the entity that have not been distributed.

Nominal Accounts:

• Sales Revenue: A nominal account (revenue) representing the value of goods or services sold.
• Cost of Goods Sold: A nominal account (expense) representing the cost of goods that have been sold.
• Salaries Expense: A nominal account (expense) representing salaries and wages of employees.
• Rent Expense: A nominal account (expense) representing the cost of renting property.
• Interest Revenue: A nominal account (revenue) representing interest earned from investments or bank deposits.
• Depreciation Expense: A nominal account (expense) representing the allocation of the cost of a fixed asset over its useful life.
• Advertising Expense: A nominal account (expense) representing the costs incurred by the business’ advertising.
• Maintenance Expense: A nominal account (expense) representing the costs of maintaining the fixed assets.
• Dividend Income: A nominal account (revenue) representing the dividends the business receives from investments in shares of other businesses. Closing Nominal Accounts:

At the end of the financial period, nominal accounts are closed, meaning their balances are zeroed out, and their effect is transferred to real accounts. This is done through an intermediary account called the Income Summary account (or Profit and Loss account).

Steps to Close Nominal Accounts:

1. Close Expense Accounts: Debit the Income Summary account and credit each expense account for its balance. This transfers the expense balances to the Income Summary.
2. Close Revenue Accounts: Credit the Income Summary account and debit each revenue account for its balance. This transfers the revenue balances to the Income Summary.
3. Close the Income Summary Account:
   • If the Income Summary account has a credit balance (revenues > expenses), this represents a net profit. Close it by debiting the Income Summary and crediting Retained Earnings (or the owner’s capital account in a sole proprietorship).
   • If the Income Summary account has a debit balance (expenses > revenues), this represents a net loss. Close it by crediting the Income Summary and debiting Retained Earnings (or the owner’s capital account).

Example of Closing Nominal Accounts:

Assume an entity had sales revenue of 80,000 Riyals and total expenses of 55,000 Riyals during the period. The closing entries would be:

• Closing Expenses:
  • 55,000 Riyals Dr. Income Summary (Debit)
  • 55,000 Riyals Cr. Expenses (Credit)
• Closing Revenues:
  • 80,000 Riyals Dr. Sales Revenue (Debit)
  • 80,000 Riyals Cr. Income Summary (Credit)
• Closing Income Summary (Net Profit of 25,000 Riyals):
  • 25,000 Riyals Dr. Income Summary (Debit)
  • 25,000 Riyals Cr. Retained Earnings (Credit)

The Accrual Basis of Accounting:

The accrual basis of accounting links real and nominal accounts. It states that revenues should be recognized when earned and expenses should be recognized when incurred, regardless of when cash is received or paid.

Example: If an entity provides a service to a customer but has not yet received payment, the revenue should be recognized in the period the service was provided, not when the cash is received.

The Balance Sheet and Income Statement:

Real accounts are summarized in the balance sheet, while nominal accounts are summarized in the income statement.

• Balance Sheet (Statement of Financial Position): Shows an entity’s assets, liabilities, and equity at a specific point in time. It reflects the accounting equation (Assets = Liabilities + Equity).
• Income Statement: Shows an entity’s revenues and expenses over a specific period, resulting in net profit or loss.

Account Lifecycles:

• Real Accounts: Start with a beginning balance, are affected by financial transactions that either increase or decrease them during a period and result in an ending balance that carries over to the next financial period.
• Nominal Accounts: Start with a balance of zero at the beginning of the period. Affected by financial transactions that either increase or decrease them. Closed at the end of the period, resulting in a balance of zero again.

Impact of Incorrect Accounting Treatment:

Confusing real and nominal accounts can lead to significant errors in the financial statements.

Example: If rent expense (a nominal account) is mistakenly recorded as a fixed asset (a real account), this will overstate the value of assets on the balance sheet and understate expenses on the income statement, leading to an overstatement of profits.

Conclusion:

Distinguishing between Real Accounts and Nominal Accounts is one of the most fundamental concepts in financial accounting. Understanding the characteristics of each type of account, how they are recorded, and how they are closed greatly helps in understanding how financial statements are prepared and analyzed. By mastering the classification of accounts into real and nominal, you will have taken a significant step towards a deeper understanding of the language of finance and business, and a deeper understanding of accounting in general.