Difference between real and nominal accounts


Learning objective:
What is the Difference between real and nominal accounts?

Definition and meanings:

Real Account:

Real accounts are the accounts used to book transactions regarding various balance sheet items such as assets, liabilities and owner’s equity. The balances of all the real accounts are transferred to balance sheet as the accounting year of the business ends.

Real accounts are maintained from day one till the last day of business which means they are permanent accounts and are never closed even if the balance is zero. Management can deduce the performance and activity throughout the year of each class of account by comparing the initial and closing balances. The closing or final balance of a real account is transferred to the balance sheet as the current accounting period ends and carried forward as the opening balance of the same class of account for the next accounting period.

A few examples of real accounts are:

  • Cash and bank accounts
  • Accounts payable account
  • All fixed assets account
  • Accounts receivable account
  • Retained earnings account

For example, XYZ Ltd. commenced there business on 1st January 2019 with the following investments by the owners:

  • Fixed Asset = $100,000
  • Cash = $30,000
  • Inventory = $50,000

At the end of the year, the following balances were calculated:

  • Revenue = $40,000
  • Cost of sales = $20,000
  • Operating expenses = $10,000

The only relevant real accounts in the above example are fixed assets, inventory and cash and the following closing balances should be reflected through these:

Fixed assets = $100,000

Inventory = $50,000 – $20,000 = $30,000

Cash = $30,000 + $40,000 = $70,000

The golden rule for booking entries in a real account is as follows:

  • Everything that comes in should be debited
  • Everything that goes out should be credited

Nominal Account:

Nominal account is one of the three account-heads that an accounting transaction can be booked under. It includes the owner’s drawing account and all other accounts that are reported on the income statement i.e. gain, loss, income earned and revenue expenditures incurred. Nominal accounts are a cumulative of the balances of a particular account head over a single period of time. In other words, nominal accounts are opened and closed every fiscal year with an opening balance of zero. Instead of carrying forward to the next accounting period, the balances in these accounts are summed up and transferred to the income statement/profit and loss account for the current year.

A few examples of nominal accounts would be:

  • Revenue
  • Cost of goods sold
  • Gain or loss on disposal of asset
  • Salary and wages
  • Commission received

We shall illustrate the above concept with an example. For example, ABC Company earned $5,000 as sales and incurred $3,000 as administrative expenses during the year ended 2019. The nominal accounts affected by this transaction are Sales Account and Admin Expense Account. The following journal entries will be passed to record these transactions:

Transfer sales to income statement account from the nominal account at the end of the year.

Debit Credit
Sales 5000
Income Statement 5000

 

Transfer expense from nominal account i.e. admin expense account to income statement.

Debit Credit
Income Statement 3000
Admin Expense 3000

Transfer the net profit on income statement account to retained earnings account.

Debit Credit
Income Statement 2000
Retained Earnings 2000

As shown above, at the end of accounting period the nominal account (temporary account) balances are indirectly transferred to real accounts (permanent account) i.e. retained earnings account.

Rules for booking entries in a nominal account:

  • All the expenses and losses incurred should be debited to nominal account
  • All incomes and gains earned should be credited to nominal account.

The relationship between nominal accounts and real accounts is that any increase or decrease in nominal account will result in an increase or decrease in real account. All the normal account balances are either directly or indirectly transferred to the real account balances.

Difference between real account and nominal account

The notable difference between real and nominal accounts is explained below:

  1. All the nominal accounts (except for the owner’s drawing account) are posted on the income statement whereas all the real accounts are posted on the balance sheet.
  2. Nominal accounts are temporary accounts that are closed at the end of every accounting period whereas real accounts are permanent accounts that exist from day one of business and continue till its last day. In other words, nominal accounts have no closing balance whereas real accounts have a closing balance every year.
  3. Nominal account debits expenses and losses whereas real account debits whatever comes into the business.
  4. Nominal account credits income and gains whereas real account credits whatever goes out of business.
  5. Nominal account balances are either directly or indirectly transferred to real account whereas real account balances are transferred nowhere.
  6. Nominal accounts are prepared to determine the profitability of the business whereas real accounts are prepared to determine the financial position.
Real account vs Nominal account
Definition
Accounts that continue throughout the business from day one till the last day and are reported in the balance sheet. Accounts which are closed periodically and are reported on the income statement.
Which financial statement used?
Statement of financial position Income Statement
Closing balance or Carried forward balance?
Yes. No.
It debits
Everything that flows into the business during a particular period of time. Every expense or loss incurred during a particular period of time.
It credits
Everything that flows out of the business during a particular period of time. Every income or gain earned.
Objective
To determine the financial position i.e. total assets, liabilities and equity. To determine the annual net profitability of the business.

Conclusion:

Both the account-heads are equally important in the world of financial accounting and have their own respective purposes. Accounting is all about discipline and management of transactions, grouping and categorizing them into different classes and head of accounts. In order to be able to achieve accurate income statements as per the IFRS, it’s crucial to have an understanding of nominal accounts. Similarly, to be able to prepare accurate balance sheet, it is equally vital to have an understanding of real accounts.

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