In accounting, different types of accounts follow specific rules for recording transactions. One of the fundamental principles in bookkeeping is the rule of nominal accounts, which applies to income, expenses, losses, and gains. Understanding this rule is essential for maintaining accurate financial records and ensuring compliance with accounting standards.
This topic explores the rule of nominal accounts, its significance, examples, and how it is applied in real-world accounting practices.
What Is a Nominal Account?
A nominal account is a type of account that records transactions related to revenues, expenses, gains, and losses within a specific accounting period. These accounts do not carry forward balances from one period to another; instead, they are closed at the end of each accounting cycle.
Examples of Nominal Accounts
Nominal accounts typically include:
- Revenue Accounts (e.g., Sales, Service Revenue)
- Expense Accounts (e.g., Rent Expense, Salary Expense)
- Gains and Losses (e.g., Profit on Sale of Assets, Loss Due to Fire)
At the end of the accounting period, the balances in these accounts are transferred to the profit and loss account, ensuring that a new financial period starts with a clean slate.
Rule of Nominal Account: Debit All Expenses and Losses, Credit All Incomes and Gains
The rule of nominal accounts is based on the golden rules of accounting and states:
“Debit all expenses and losses, credit all incomes and gains.”
This means:
- Expenses and losses are recorded on the debit side of the account.
- Income and gains are recorded on the credit side of the account.
This rule ensures that the financial statements accurately reflect a company’s financial performance over a given period.
Applying the Rule of Nominal Account
To understand how this rule works in practice, let’s look at some common accounting transactions.
1. Recording Revenue (Income Account)
When a company earns revenue from sales or services, it follows the nominal account rule:
Example: A business earns $5,000 from service revenue.
Journal Entry:
- Debit: Accounts Receivable (or Cash) $5,000
- Credit: Service Revenue $5,000
Since revenue is an income, it is credited.
2. Recording an Expense (Expense Account)
When a business incurs an expense, it is debited.
Example: A company pays $2,000 for rent.
Journal Entry:
- Debit: Rent Expense $2,000
- Credit: Cash $2,000
Since rent is an expense, it is debited.
3. Recording a Gain (Nominal Account – Gain)
A gain occurs when an asset is sold for more than its book value.
Example: A company sells machinery for $8,000 that had a book value of $6,000, making a profit of $2,000.
Journal Entry:
- Debit: Cash $8,000
- Credit: Machinery $6,000
- Credit: Gain on Sale of Machinery $2,000
Since the gain represents income, it is credited.
4. Recording a Loss (Nominal Account – Loss)
A loss occurs when an asset is sold for less than its book value.
Example: A company sells old equipment for $3,000, but its book value was $5,000, resulting in a $2,000 loss.
Journal Entry:
- Debit: Cash $3,000
- Debit: Loss on Sale of Equipment $2,000
- Credit: Equipment $5,000
Since the loss is an expense, it is debited.
Closing Nominal Accounts at the End of the Accounting Period
Nominal accounts are temporary accounts that are closed at the end of an accounting period. This process is known as closing entries and ensures that the next financial period starts with zero balances in revenue and expense accounts.
Steps to Close Nominal Accounts
- Transfer all revenue accounts to the Income Summary Account by debiting revenue accounts and crediting the income summary.
- Transfer all expense accounts to the Income Summary Account by debiting the income summary and crediting expense accounts.
- Determine the net profit or loss by balancing the income summary account. If revenue exceeds expenses, the difference represents net profit; otherwise, it represents net loss.
- Transfer net profit or loss to the capital account (for sole proprietorships) or retained earnings (for corporations).
Importance of the Rule of Nominal Accounts
1. Ensures Accurate Financial Reporting
By following the golden rule of nominal accounts, businesses can accurately track their financial performance, making it easier to prepare financial statements.
2. Helps in Tax Calculation
Since nominal accounts deal with revenues and expenses, they directly impact the calculation of taxable income for businesses.
3. Supports Decision-Making
Understanding income, expenses, gains, and losses helps management make strategic financial decisions based on the company’s profitability.
4. Prevents Errors in Accounting
Applying the correct debit and credit rules ensures that transactions are recorded systematically, reducing the risk of errors in financial records.
The rule of nominal accounts states that all expenses and losses are debited, while all incomes and gains are credited. This principle is essential for maintaining accurate accounting records and ensuring financial transparency.
By properly recording revenues, expenses, gains, and losses, businesses can prepare reliable financial statements, calculate taxable income, and make informed financial decisions. Understanding and applying this rule correctly helps maintain the integrity of accounting practices and supports overall business growth.