Accounting, Financial, Taxation

Businesses keep two types of accounts, i.e., “Real Accounts” and “Nominal Account”. What is Real Accounts? What is Nominal Accounts? The following explanations may deliver easier understanding for you:

Real Accounts

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

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 a 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.

Example:

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)

Though it is not necessary to include an entire dictionary of accounting terms in any general accounting manual, but it is useful to include those that are commonly used within the company’s transactions, as well as those that appear in its accounting software. Of particular importance are those terms that are unique to the industry within which the company operates. For example, the oil and gas, software, and movie industries have special terminology that cannot be learned through regular accounting classes.

Definitions should be concise and meaningful. One or two sentences of definition are usually sufficient. Because the definitions are references sources, they should be developed for quick and easy look-up. For example, the definition for “fixed asset” may be listed under “A,” using the header “Asset, fixed.” If a user goes to the “F” section of the definitions, there should be a referral statement, such as “Fixed asset, see Asset, fixed. This standard indexing method should make it as easy as possible to find a specific definition.

A different approach to the inclusion of accounting term definitions in the manual is to define every account listed in the chart of accounts. By doing so, any accounting personnel who are responsible for entering transactions into either the general ledger or its supporting journals will have a better idea of which accounts should be used. This can save a great deal of time later on, when incorrectly applied transactions must be researched and corrected.

The following sample definitions are used for the three-digit sample chart of accounts that was described in my previous post (Chart Of Accounts):

010 - Cash - Money deposited at the bank. If there are restrictions on deposited cash, then it is accounted for as a long-term asset.

020 - Petty cash - Money retained in the petty cash box.

030 - Accounts receivable - Money due from customers for services received or products shipped, but not yet received. If there are amounts due from officers or employees, these moneys are listed under “other accounts receivable.”

040 - Reserve for bad debts - A reserve fund that is held as a contingency against the Non-payment of outstanding accounts receivable. This account should always have a credit balance.

050 - Marketable securities - Cash that is invested in easily traded equity or debt securities. The cost of acquiring these securities is included in the account.

060 - Raw materials inventory - The amount of materials kept on hand for eventual inclusion in finished goods. All freight costs associated with the acquisition of raw materials are included in this account.

070 - Work-in-process inventory - The cost of partially completed units of production. Costs stored in this account include raw materials, and any raw materials or overhead used to date.

080 - Finished goods inventory - The cost of completed products that have not yet been shipped to customers. Costs stored in this account include all raw materials, direct labor, and overhead used during the production process.

090 - Reserve for obsolete inventory - A reserve fund that is held as a contingency against the eventual write-off of any types of inventory that no longer have a resale value.

100 - Fixed assets—Computer equipment - Purchased computer equipment exceeding the corporate capitalization limit that has an expected life of greater than one year.

110 - Fixed assets—Computer software - Purchased computer software exceeding the corporate capitalization limit that has an expected life of greater than one year.

120 - Fixed assets—Furniture and fixtures - Purchased furniture exceeding the corporate capitalization limit that has an expected life of greater than one year.

130 - Fixed assets—Leasehold improvements - Improvements made by the company to its leased properties, exceeding the corporate capitalization limit, that has an expected life of greater than one year.

140 - Fixed assets—Machinery - Purchased production equipment exceeding the corporate capitalization limit that has an expected life of greater than one year.

150 - Accumulated depreciation—Computer equipment - The total of all depreciation charged against the computer equipment fixed asset account, net of disposed assets. This account has a credit balance.

160 - Accumulated depreciation—Computer software - The total of all depreciation charged against the computer software fixed asset account, net of disposed assets. This account has a credit balance.

170 - Accumulated depreciation—Furniture and fixtures - The total of all depreciation charged against the furniture and fixtures fixed asset account, net of disposed assets. This account has a credit balance.

180 - Accumulated depreciation—Leasehold improvements - The total of all depreciation charged against the leasehold improvement fixed asset account, net of disposed assets. This account has a credit balance.

190 - Accumulated depreciation—Machinery - The total of all depreciation charged against the machinery fixed asset account, net of disposed assets. This account has a credit balance.

200 - Other assets - An account in which minor asset items are stored that do not fit into any other asset account categories.

300 - Accounts payable - Both billed and accrued commitments to pay suppliers for services rendered or products shipped to the company.

310 - Accrued payroll liability - An obligation to pay wages to employees, but which has not yet been paid.

320 - Accrued vacation liability - An obligation to pay for earned vacation time to employees, but which has not yet been paid.

330 - Accrued expenses liability—Other - An account in which minor accrued expenses are stored, or those accrued expenses are stored, that do not occur on a recurring basis.

340 - Un-remitted sales taxes - Sales taxes to government entities that are a company obligation to make as a result of selling products or services into the geographic areas governed by those entities, but which have not yet been made.

350 – Un-remitted pension payments - Pensions payments that are an obligation of the company to make into the employee pension fund, but which have not yet been made.

360 - Short-term notes payable - Debt obligations that are due for payment in less than one year.

370 - Other short-term liabilities - An account in which minor liability items are stored that do not fit into any other liability account categories.

400 - Long-term notes payable - Debt obligations that are due for payment in more than one year.

500 - Capital stock - The amount of funds received from investors in exchange for the issuance of common or preferred stock.

510 - Retained earnings - Total corporate earnings since the creation of the company, less dividends and any prior period adjustments.

600 - Revenue - The sale of products or services, or receipts from investments, such as interest, royalties, or dividends.

700 - Cost of goods sold—Materials - The direct cost of materials associated with the sale of a tangible product. This includes all materials listed on a product’s bill of materials, plus all scrap incurred during production, less the resale value of any by-products.

710 - Cost of goods sold—Direct labor - The labor expense required to produce a product or service, which is limited to assembly labor.

720 - Cost of goods sold—Manufacturing supplies - The cost of supplies consumed when a product is manufactured. This includes all incidental machinery maintenance supplies and packaging materials.

730 - Cost of goods sold—Applied overhead - The cost of manufacturing, excluding materials, direct labor, and supplies. Includes depreciation on manufacturing equipment and facilities, as well as factory administration, indirect labor, maintenance, production
Employee’s benefits, quality control and inspection, production facility rent, repair expenses, rework labor, and spoilage.

800 - Bank charges - The expense associated with credit card fees, bank service charges, and the cost of printing checks.

805 - Benefits - The expense associated with medical insurance, dental insurance, long-term and short-term disability insurance, and health club reimbursement fees. All employee payroll deductions to co-pay benefits should be credited against this account.

810 - Depreciation - The expense associated with the periodic reduction of the value of fixed assets, in accordance with a standard value-reduction methodology.

815 - Insurance - The expense associated with key-man life insurance, business insurance, and workers’ compensation insurance.

825 - Office supplies - The expense associated with miscellaneous tangible office purchases, such as paper products, printer cartridges, and diskettes.

830 - Salaries and wages - The expense associated with employee pay, which includes salaries, wages, severance payments, signing bonuses, and accrued wages.

835 - Telephones - The expense associated with “800” phone service, incoming phone lines, and cell phones. The cost of phone equipment is charged either to office supplies or to fixed assets, depending upon the dollar-value purchased.

840 - Training - The expense associated with outsourced training suppliers, tests, and purchased training materials. It does not include travel costs associated with employee travel to training classes, nor the salary cost of in-house training personnel.

845 - Travel and entertainment - The expense associated with the travel of either employees or reimbursed contractors. Includes air fare, lodging, parking, and meals.

850 - Utilities - The expense associated with water, heat, waste removal, and electricity fees charged by utilities.

855 - Other expenses - Includes all incidental expenses under $500 that do not readily fall into any other category. Consult with the assistant controller before making entries into this account.

860 - Interest expense - The expense associated with the interest cost of revolving debt, interest on late payments to suppliers, and outstanding company bonds. Also includes accrued interest on unpaid interest expenses.

900 - Extraordinary items - Any expense that is both unusual and infrequent, such as a gain on a troubled debt restructuring or the loss of foreign assets due to governmental expropriation. No entries to this account are allowed without the controller’s approval.

Other definitions for accounts that are commonly used by the accounting staff include:

Travel and Subsistence

Meals and lodging: Includes meals and lodging costs (hotel, motel, etc.) in accordance with company policy for reimbursement. Per diem allowances for meals and lodging are included here.

Travel in private vehicle: Includes travel in employee-owned vehicles at the
currently approved mileage reimbursement rate.

Travel in rented vehicle: Includes daily car rental fees from outside providers.

Travel in public carrier: Includes air, bus, and train travel.

Travel in motor pool vehicles: Includes charges for the use of company-owned vehicles at the approved rates. Costs of air travel for the company-owned air plane are included here.

Other travel costs: Includes such incidental expenses as tips, telephone calls, taxis, tolls, and parking while on a company-authorized trip. Tips on meals are included in meal costs.

Conference and registration fees: Includes registration fees for seminars, work shops, conferences, and similar meetings. Tuition for schools and workshops is included here. If meals and lodging fees included in registration fees cannot be separated, then they are included here.

Communications

Postage: Includes postage charges for mailing, as well as service and rental fees for postage machines, and periodic service fees charged by online postage providers.

Express postage: Includes all freight costs for express delivery services, including
pickup fees.

Cell phones: Includes the basic monthly fees, as well as roaming charges, for all issued cell phones.

Telephone local service: Includes the basic monthly charges for all phones.

Telephone long distance: Includes the charges for all long distance services, including the WATS line, line rentals, and telegraph charges.

Telephone installation and maintenance: Includes all charges for the installation of phones and subsequent maintenance of the phone system.

Marketing

Advertising: Includes the cost of classified advertising for employee hiring, as well as required advertising for published purchasing bids.

Publicity and public information: Includes the cost of radio, television, and live shows promoting the company, as well as related layout and copy costs.

Rents

Rental of buildings and floor space: Includes payments to others for buildings, rooms for events, and floor space in buildings for special events. Rental of housing facilities and meeting rooms is included here.

Rental of computer equipment: Includes the rental or lease cost of computer software and equipment, such as payments on operating leases.

Other rentals: Includes any rental that cannot be recorded in other rental accounts.

Repairs and Maintenance

Repairs, streets and parking: Includes repairs and other maintenance on roads, streets, drives, and parking lots.

Repairs, building and grounds: Includes wages and material costs of repairing, cleaning, and maintaining buildings and grounds. Outside contractor costs for this purpose are recorded here.

Repairs, office equipment: Includes the costs of repairing and maintaining office equipment such as furniture, copiers, and facsimile machines. It does not include maintenance on the phone system.

Maintenance contracts, equipment: Includes the annual contract costs for maintenance contracts on office equipment.

Repairing and servicing other equipment: Includes the costs of repairing and servicing machinery, engineering equipment, laboratory equipment, shop equipment, and other equipment not classified in the preceding repair accounts.

Fees, Professional

Engineering fees: Includes out-of-pocket fees for professional engineering services.

Auditing fees: Includes the costs of auditing fees to outside independent auditors. Other incidental costs of the audit, such as supplies, telephone, postage and printing charges related to the audit, are included here.

Medical fees: Includes direct payments to others for medical services, including pre-employment physicals and lab tests.

Legal fees: Includes all fees paid to attorneys, appraisers, notaries, and witnesses, in addition to court costs and legal document recording fees.

Laboratory and testing fees: Includes outside laboratory fees and fees paid to outside agencies for testing services other than medical services.

Consultant expense reimbursements: Includes travel costs paid to consultants and other non-employees.

Other Contractual Services

Insurance and fidelity bonds: Includes the cost of all casualty and liability insurance and fidelity bond coverage.

Dues: Includes approved dues for company memberships in professional organizations.

Subscriptions: Includes the cost of subscriptions to newspapers, magazines, and periodicals.

Computer software acquisitions: Includes the initial cost of acquiring operating or systems software packages. Included is the purchase price, related freight, and software manuals.

Computer software maintenance: Includes the annual maintenance fees to maintain purchased software systems.

Maintenance Supplies

Land improvement supplies: Includes asphalt, cement, joint fillers, curbing, and so forth used in repairing or replacing roads, sidewalks, and parking lots on company property.

Building construction supplies: Includes lumber, caulking, steel, fabricated metal parts, flooring, ceiling tiles, plaster, lime, and other materials used in repairing or renovating buildings.

Paints and preservatives: Includes interior and exterior paints, wood preservatives, and road striping materials used for remodeling or maintenance.

Hardware, plumbing, and electrical supplies: Includes all hardware, plumbing parts and accessories, and electrical wire or parts, including lights used in maintaining or renovating buildings.

Custodial supplies and cleaning agents: Includes all custodial supplies of an expendable nature, such as cloths, brooms, cleaning compounds, mops, or pails.

Office Supplies

Printing, binding, and padding: Includes the cost of printing, binding, and padding paid to outside contractors.

Duplication and reproduction: Includes the paper, toner, and other supplies used in the company copy machines.

Office supplies: Includes all office supplies and materials, such as pens, paper, pencils, staples, paper clips, and so forth.

Equipment Supplies

Fuels: Includes vehicle fuels (gasoline, diesel fuel, propane) purchased for motor pool vehicles or airplanes.

Lubricating oils and greases: Includes lubricating oils and greases used for all vehicles and machinery.

Tires and tubes: Includes the purchase of tires and tubes for all vehicles in the company motor pool.

Repair and replacement parts: Includes the purchase of vehicle and machinery repair and replacement parts and supplies.

Shop supplies: Includes the cost of shop supplies, such as shop rags, windshield cleaner, glues and cements, brushes, degreasers, solvents, and so forth, used in equipment repair and maintenance operations.

Small tools: Includes small tools used in manufacturing operations that are below the corporate capitalization limit.

This post covers the types of account numbering formats that can be used to construct a chart of accounts, and also lists sample charts of accounts that use each of the formats. All of the charts of accounts shown follow the same general sequence of account coding, which itemizes the accounts in the balance sheet first, and the income statement second. That sequence is as follows:

- Current assets
- Fixed assets
- Other assets
- Current liabilities
- Long-term liabilities
- Equity accounts
- Revenue
- Cost of goods sold
- Selling, general, and administrative expenses
- Income taxes
- Extraordinary items

Three-Digit Account Code Structure

A three-digit account code structure allows one to create a numerical sequence of accounts that contains up to 1,000 potential accounts. It is useful for small businesses that have no predefined departments or divisions that must be broken out separately. A sample chart of accounts using this format is shown below:

Notice how each clearly definable block of accounts begins with a different set of account numbers. For example, current liabilities begin with “300,” revenues begin with “600,” and cost of goods sold items begin with “700.” This not only makes it easier to navigate through the chart of accounts, but is also mandated by many computerized accounting software packages.

Five-Digit Account Code Structure

A five-digit account code structure is designed for those organizations with clearly defined departments, each of which is tracked with a separate income statement. This format uses the same account codes for the balance sheet accounts that we just saw for three-digit account codes, but replicates at least the operating expenses for each department (and sometimes for the revenue accounts, too). An example of this format is as follows, using the engineering and sales departments to illustrate the duplication of accounts:

In this example, all expense accounts are replicated for every department. This does not mean, however, that all accounts must be used for every department. For example, it is most unlikely that bank charges will be ascribed to either the engineering or sales departments. Accordingly, those accounts that are not to be used can be rendered inactive in the accounting system so that they never appear in the general ledger.

Seven-Digit Account Code Structure

A seven-digit account code structure is used by those companies that not only have multiple departments, but also multiple divisions or locations, for each of which the management team wants to record separate accounting information. This requires the same coding structure used for the five-digit system, except that two digits are placed in front of the code to signify a different company division. These new digits also apply to balance sheet accounts, because most organizations will want to track assets and liabilities by division.

The following chart of accounts, which identifies accounts for divisions in Atlanta and Seattle, continues to use the engineering and sales departments as an example of how the seven-digit account code structure is compiled

Any of the preceding account codes will be eventually used in a journal entry, for which a standard form should be used such as the one shown below:

 The form requires both an approval signature and description of the entry, thereby ensuring adequate documentation and evidence that the entry is necessary. There is also space at the bottom of the entry for references to additional exchange rate information, in case foreign exchange is involved.

Further worth reading about chart of accounts:

Accounting Term And Definitions For Chart Of Accounts