Accounting Principles – Nominal Accounts

Nominal accounts reflect changes in either assets or liabilities. Assets like liabilities may either increase or decrease.

An increase in an asset, without a corresponding increase in a liability, or a decrease in a liability, without a corresponding decrease in an asset, increases capital.

A decrease in an asset, without a corresponding decrease in a liability, or an increase in a liability without a corresponding increase in an asset, decreases capital.

The increase of capital is called profit. The decrease of capital is called loss. Profit may be the result of actively employing the assets in the business enterprise, or it may result from an increase in value, due to economic conditions and subsequent sale of the asset. That class of profit which results from the employment, with the object of direct or specific return, of the assets in the business enterprise is distinguished from the rest by being called income.

Income may be defined as the increase in capital resulting from its employment in a business enterprise or other investment. It is sometimes called revenue and earnings. The capital may be either actively or passively employed. Capital invested in goods, sold at a price which is an increase over what the goods cost, for the purpose of profit, is an example of the active employment of capital. Capital invested in securities for purposes of income is a passive employment of capital.

A business organization usually engages in some particular line of business. The efforts of the organization are devoted to the securing of income in that particular line; from the sale of goods; the sale of services; the use of property; or combinations in part or whole of these. It is for the income from these that operations are conducted. This income is the principal or primary income of the organization. It is called the income from operations. It is the income which arises from the assets actively employed in the business. A concern employing its capital in buying and selling goods, derives its principal income from trading. Incidentally some capital in the form of cash may not be constantly required for use and is allowed to remain on deposit with some bank. The interest which the bank pays for use of such money does not result from operations. It is income but it does not come from trading. No more does interest on funds, which have been invested in securities because the return therefrom might be greater than if such funds were invested in goods, come from trading. The hypothetical organization under discussion is not in the business of loaning money. It has earned certain income from the employment of surplus funds in a manner other than that embraced in the operations of the principal business in which it is engaged. Such income is distinguished from the principal income by being called secondary income, or income from sources other than operation. The two combined constitute the income of the organization, or the net income from all sources.
The decrease in capital is called loss. Loss may be of a permanent or a temporary nature. The decline in the value of an asset due to economic conditions, from which it does not recover; its becoming unsuited to the requirements of the business, or its deterioration owing to lapse of time, may all cause a permanent loss. The decrease of certain assets, or the incurring of a liability, both of which have the same effect upon capital, may result in a temporary loss which presumably will be restored by the income from operations for which the loss was sustained. Temporary losses are distinguished from permanent ones by being called expense.

Expense may be defined as that temporary decrease in capital which has as its object the increase of capital through income. Expense is sometimes called outgo.

Expense may be divided into that which pertains specifically to operations and that which is of the organization as a whole. That in the first group, is called operating expense or expense of operation; that in the second, on account of being an expense applicable to the business as a whole is called an income charge, or a deduction from income. The operating expense may be further divided. It falls naturally into three classes; the direct expense of securing the goods, services, or maintaining the property which produces the income; the expense of obtaining the business or selling the product; and the expense of administration. The so-called deductions from income embrace expenses as a rule in connection with capital, either the expense of securing it, or protecting it, such as interest, rent, taxes, insurance, etc.
From the foregoing, we may classify nominal accounts as follows:
(a) Profits (Increases of Capital).
(1) Income.
(a) Primary (from operations).
(6) Secondary (from sources other than operation).

(2) Miscellaneous.
(6) Losses (Decreases of Capital).
(1) Expense.
(a) Operation.
(1) Prime.
(2) Selling.
(3) Administration.
(6) Capital (other than expense of operation).
(2) Miscellaneous.

It is of course impossible to attempt a detailed classification of nominal accounts which will be completely exhaustive. What may be done is to give a classification as adapted to a typical manufacturing and selling organization, including all the accounts which might ordinarily appear therein. Such an organization may well be selected, since the accounts involved include a wide range. Where accounts are met with which differ in name from those appearing in the classification presented, it would seem only to be necessary to determine the real meaning of the account in question and classify it by means of comparison with other accounts, similar in their purpose and about the names of which there is no question.

Dividends have not been included in the above for specific reason. They are analogous to the distribution of profits in a sole-proprietorship or copartnership.

If a proprietor withdraws $10,000 from his business, it is true the amount has been lost so far as the business is concerned. The capital has been accordingly reduced. We should not, however, consider it as a loss to the business, if at the same time of the withdrawal, it had been determined that the profits for the year were $12,000. We should look upon the withdrawal as the distribution of profit rather than a loss. So should dividends be regarded as a distribution of profit, rather than a loss, since they will not be distributed as such unless a profit has resulted from the business operations.