Businesses keep two types of account; Real Accounts and Nominal Accounts. What is Real Account? What is Nominal Account? The following explanations may deliver easier understanding for you. Read on…
Real accounts are those reported in the balance sheet, which is the summary of the assets, liabilities, and owners’ equities of a business. The label “real” refers to the continuous, permanent nature of this type of account.
Real accounts are active from the first day of business to the last day. (A real account could have a temporary zero balance, in which case it’s not reported in the balance sheet). Real accounts contain the balances of assets, liabilities, and owners’ equities at a specific point in time, such as at the close of business on the last day of the year.
A real account is a record of the amount of asset, liability, or owners’ equity at a precise moment in time. The balance in a real account is the net amount after subtracting decreases from increases in the account.
Nominal accounts are those reported in the income statement, which is the summary of the revenue and expenses of a business for a period of time.
Balances in nominal accounts are cumulative over a period of time. Take the balance in the sales revenue account at the end of the year, for example. This balance is the total amount of sales over the entire year.
Likewise, the balance in advertising expense is the total amount of the expense over the entire year. At the end of the period, the accountant uses the balances in the nominal accounts of a business to determine its net profit or loss for the period — this is the main reason for keeping the nominal accounts.
Differences Of Real and Nominal Accounts
Here’s is another rough analogy to help you understand the difference between real and nominal accounts:
Consider the lemon juice held inside a jar at a particular point in time. The lemon juice is real because you can dip your toe in it (and you can taste it if you put your toe on your tongue, of course).
Compare this body of lemon juice with the total amount of lemon juice that flowed through the pipe over the hours. This lemon juice isn’t there because it has already gone (you drink it already). This amount is the measure of total flow for a period of time. Assets are like the lemon juice in the jar, and sales revenue is like the flow of lemon juice over the hours.
Nominal (revenue and expense) accounts are closed at the end of the year. After these accounts have done their jobs accumulating amounts of sales and expenses for the year 2007, for example, their balances are closed. Their balances are reset to zero to start the year 2008. Nominal accounts are emptied out to make way for accumulating sales revenue and expenses during the following year.
A business has just released its financial report for the year just ended, which includes its balance sheet at year-end and its income statement for the year. You take the time to count the number of accounts in each statement and find 20 accounts in the balance sheet and 6 accounts in the income statement. These counts do not include calculated amounts, such as the total of assets in the balance sheet and gross profit in the income statement. “How many accounts does the business need?” This typical question may spin in your head.
Well, the absolute minimum number of accounts that business needs is 20 balance sheet (real) accounts and 6 income statement (nominal) accounts. Otherwise, it doesn’t have enough separation of information to prepare its two financial statements. In actual practice, businesses keep many more accounts than they report in their balance sheets and income statements.
If you were to look at the chart of accounts maintained by even a relatively small business, you’d find hundreds of accounts (maybe more). For example, a business may keep a separate account for each checking account it uses but, in its balance sheet, report only one cash account, which is the combined total of all its separate cash accounts. Similarly, the business may keep different notes payable accounts, one for each note payable obligation, but combine all notes into one total liability amount in its balance sheet. Another example is a business that keeps different sales revenue accounts, broken down by product lines, sales territories, and so on. It reports only one total sales revenue account in its income statement (Public businesses are subject to disclosure rules regarding segment reporting of sales, which is too technical to go into here)