A nominal ledger is the primary source document for the accounting records of a business. It forms the basis of an accounting system in any business.
Nominal ledger records all financial transactions categorizes them into different classes and provides useful information to the users.
Let us discuss what is a nominal ledger, how it works, and what are its main components.
What is Nominal Ledger?
The nominal ledger is the primary record of transactions of a business. It keeps a track of every financial transaction a business makes.
A nominal ledger is also referred to as a general ledger commonly (more details below).
The nominal ledger classifies all transactions into accounts. Each account keeps a debit and credit balance. It follows the double-entry bookkeeping principles.
The nominal ledger is the primary record book that will keep a record of payments, receipts, expenses, and income of a business.
Thus, a nominal ledger sets the foundation of a financial department of a business. The business will then prepare financial statements using the data recorded in a nominal ledger.
How Does a Nominal Ledger Work?
The process of preparing a nominal ledger begins with the accounting cycle. The accounting cycle can be divided into four main stages.
The business keeps source documents for transactions incurred during the accounting period. For example, purchase receipts, invoices, bills, and other source documents.
Then, the bookkeeper creates journal entries using different journal accounts. Each transaction is categorized into a specific journal account.
A common practice is to record these transactions by date. Each transaction is recorded under the account title with date, transaction details, and other information.
Some businesses may keep different types of journals to keep full details of their financial transactions. For example, a special journal keeps a separate record of special journal accounts that are usually omitted from the general journal.
These journal entries are then summed up and posted in the nominal ledger. Each account shows a summary of transactions recorded throughout the period.
Transactions recorded in the nominal ledger are validated through a trial balance. It is the reconciliation process of a nominal ledger that ensures the accuracy of the account balances shown.
Finally, the nominal ledger is used to create financial statements of a business for a given accounting period.
Uses of Nominal Ledger
The nominal ledger sets the basics of a record-keeping system for any business. It is the foundation of the accounting and financial systems of a business.
The nominal ledger follows the double-entry bookkeeping system. It means its accounts will keep two sides of every transaction.
Also, it uses the basic accounting equation in its system:
Assets = Liabilities + Owners’ Equity
Therefore, this ledger will provide useful information about the assets, liabilities, and the owners’ equity at any given time. Though, the summarized reports will show up in the form of financial statements.
Moreover, a nominal ledger serves the following key purposes for any business:
- Creating journal entries to provide accurate records for all transactions.
- Recording revenue and expenses of the business.
- Organizing accounts to prepare budgets, forecasts, and other important reports.
- Help in filing taxes, compliance, and other regulatory requirements.
- Providing key information for the preparation of financial statements.
In short, a nominal ledger offers key input data for valuable accounting and financial documents for a business.
Components of a Nominal Ledger
A nominal ledger has four main components. These components help to record and organize the financial records of a business in one place.
Journal Entry
It is the serial number or reference number for each transaction recorded in the ledger. This reference will include the transaction date as well.
Transaction Detail or Description
This section records the transaction details. It is simply the description of each transaction.
For example, this column will record a transaction detail whether it is made on cash or credit, and for which account.
Debit and Credit Columns
Each transaction will have a debit or a credit side on the ledger book. So, these columns will either enter a debit or a credit entry.
Balance
The debit or credit entry will change the running balance of the ledger accounts. At the end of the accounting period (usually at month-end), the ending balance of each ledger account is summarized.
Account Categories of Nominal Ledger
The nominal ledger creates a separate account for different types of transactions. However, there are five main types of accounts used commonly in a nominal ledger.
Assets
These are resources used by a business to generate revenue. Common examples of asset accounts include cash, property, machines, receivables, and inventory.
Liabilities
These are the financial obligations of a business. Common examples include bank loans, payroll, taxes, and mortgages.
Equity
It is the net worth of shareholders in terms of ledger books. It is the assets minus liabilities of the business.
Equity accounts include common stocks, preferred stocks, and retained earnings.
Revenue
Revenue is the earning of a business that comes through different sources. Common revenue accounts include sales, interest income, royalties, service fees, and rentals.
Expense
These are transactions incurred by a business to generate revenue. Common expense accounts recorded on a ledger include salaries, wages, rent, advertising, and leases.
These five nominal ledger account categories can further be classified into balance sheet or income statement accounts.
The balance sheet accounts are assets, liabilities, and equity. These are permanent accounts on the ledger book.
The income statement accounts are revenue and expenses. These are temporary accounts and are closed out at the end of each accounting period.
Creating Financial Statements from Nominal Ledger
Every transaction of a business is related to one of the five main accounts mentioned above. These main nominal ledger accounts form the basis of financial statements as well.
Therefore, all transactions recorded in the nominal ledger are then carried forward to the financial statements.
Nominal ledger accounts are first reconciled and evaluated in the trial balance. The trial balance validates the accuracy of each transaction. It also confirms the accuracy of debit and credit balances.
Once the trial balance validates ledger accounts, these balances are moved to financial statements. Thus, the nominal ledger works as the source document for the preparation of the balance sheet and income statement.
Sub-Ledgers and Controlling Accounts
Large businesses may incur a large number of financial transactions. These transactions are difficult to record under the broader categories of nominal ledger accounts.
One way of handling the complexity of ledger accounts is to create subsidiary or sub-ledger accounts.
Sub-ledgers can be created linking transactions of a specific account, company, property, or type. For example, if a company has extended accounts receivable days, it will need to follow this account closely.
The company can use sub-ledger accounts for its different customers. These sub-ledger accounts will fall under the main accounts receivable account.
In this case, the accounts receivable becomes the controlling account of these sub-ledger accounts. Therefore, any nominal ledger account that has subsidiary accounts will be called the controlling account.
Nominal Ledger and Reconciliation
The reconciliation process refers to the verification of accounting records maintained in the nominal ledger. Bank reconciliation is an important task in this category.
A business can verify transactions recorded in the nominal ledger against those recorded in the bank statement. However, the reconciliation process can only be performed when all transactions go through bank accounts.
Cash transactions can be reconciled through cash books. A business can maintain cash receipt and payment logs separately for reconciliation purposes.
The reconciliation process ensures the accuracy and integrity of the transactions recorded in the nominal ledger. This process can also help in the audit of the financial statements of the business.
Nominal Ledger Vs General Ledger
Nominal and general ledger are the same documents. These terms are often used interchangeably.
The format, purpose, and components of a general ledger and a nominal ledger are the same. Thus, to avoid any confusion, a general and a nominal ledger should be considered the same document for a business.
Nominal Ledger Vs Trial Balance
A trial balance is a report that summarizes the balances of nominal ledger accounts. It shows the ending balances of ledger accounts at the end of an accounting period.
The purpose of the trial balance is to verify the accuracy of ledger account transactions by summarizing them. Thus, a trial balance shows that all debit and credit sides are equal at the end.
A nominal ledger contains lengthy records. It records each transaction a business incurs and provides detailed information about it.
Contrarily, a trial balance only shows the summary or ending balances of each ledger account. It is only used to verify the balance of debit and credit sides of all ledger accounts.
