Distinguishing Real and Nominal Business Accounts
A real account in a business is a record of the amount of asset, liability, or owners’ equity at a precise moment in time. Nominal accounts summarize a business’s revenue and expenses over a period of time, such as a year.
The recordkeeping process for bookkeepers is fundamentally the same: Adopt a chart of accounts, make original entries using debits and credits to keep the books in balance, make adjusting entries to get profit for the period right, and close the books at the end of the year.
Businesses keep two types of 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. 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.
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.
Here’s a rough analogy to help explain the difference between real and nominal accounts: Consider the water held behind a dam at a particular point in time. Compare this body of water with the total amount of water that flowed through the dam over the last year. This water isn’t there because it has already gone downriver. This amount is the measure of total flow for a period of time. Assets are like the water behind the dam, and sales revenue is like the flow of water over the year.
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, their balances are closed. Their balances are reset to zero to start the new year. Nominal accounts are emptied out to make way for accumulating sales revenue and expenses during the following year.