EPFO APFC 2023 General Studies · Question 110 of 120

Correct — B, (b) Real Account. Under the traditional or British classification, every ledger account falls into one of three families. Personal accounts are the accounts of persons and of bodies treated as persons — natural persons such as a customer or a supplier, artificial persons such as a company, a firm, a bank or a club, and representative personal accounts, which stand in for a person or a group of persons, as an outstanding salaries account represents the employees to whom the salary is owed. Real accounts are the accounts of assets and properties. Nominal accounts are the accounts of expenses, losses, incomes and gains. Goodwill is an asset, so its account is a real account, and that is option (b). The refinement worth learning with it is that real accounts divide in two. Tangible real accounts are those of assets that can be touched — cash, building, machinery, furniture, stock. Intangible real accounts are those of assets that have value and are owned but have no physical form — goodwill, patents, trademarks, copyrights, designs. Goodwill belongs to the second group, and the point of the question is that having no physical existence does not stop an account being real. What makes it real is that it represents something the business owns and can realise value from, not that it can be handled. The golden rule that applies confirms the classification in practice. For real accounts the rule is: debit what comes in, credit what goes out. When a firm buys a business and pays more than the value of the identifiable net assets it acquires, the excess is goodwill and the entry made is to debit the Goodwill Account — because goodwill has come in — and credit the vendor or the bank. That is exactly how a real account behaves. It also appears in the balance sheet, under intangible assets, and not in the profit and loss account, which is where nominal accounts are closed. Goodwill itself is the value attaching to a business over and above its identifiable net assets, built out of reputation, the location of the business, the quality of its products, its relations with customers and suppliers, the skill of its management and the absence of effective competition. Indian practice recognises it in the books only when it has been paid for: purchased goodwill is recorded, and self-generated goodwill is not recognised as an asset at all, since no cost can be reliably measured for it.

• (a)Personal Account — A personal account is the account of a person or of an entity treated in law or in practice as a person — a debtor, a creditor, a bank, a company, a partner's capital account — or a representative personal account standing in for a person, such as outstanding wages, prepaid insurance or commission received in advance. Goodwill is none of those. The option is tempting for a reason that is worth naming: goodwill is created out of relationships with people, the loyalty of customers, the standing of the proprietor and the confidence of suppliers, so it can feel personal in origin. But the classification looks at what the account represents in the books, not where the value came from, and what the Goodwill Account represents is an asset of the business. The rule for personal accounts — debit the receiver, credit the giver — cannot sensibly be applied to it either, because goodwill neither receives nor gives anything; it comes in and goes out, which is the language of a real account.
• (c)Nominal Account — A nominal account records an expense, a loss, an income or a gain, is closed to the profit and loss account at the end of the accounting period and therefore begins each period with a nil balance. Goodwill does none of this: it carries forward from year to year and appears in the balance sheet among the intangible assets. The confusion this option exploits is genuine, because goodwill is frequently written off, and an amount written off does pass through the profit and loss account. But the account being debited in that entry is Goodwill Written Off, or the profit and loss account itself, and it is that expense account which is nominal — the Goodwill Account being credited remains a real account, exactly as machinery remains a real account when depreciation is charged on it. Amortisation or impairment of an asset does not convert the asset's own account into a nominal one; it merely reduces the balance standing in it.
• (d)Expense Account — Expense Account is not one of the three categories in the traditional classification at all, which makes this option wrong twice over. Under the traditional scheme the categories are personal, real and nominal, and an expense would fall within nominal accounts rather than form a class of its own. Under the modern or American classification, which does use the word, accounts are grouped as assets, liabilities, capital, revenues and expenses — and there goodwill is squarely an asset, so changing classification does not rescue the option. Goodwill is also not an expense in substance: an expense is a cost consumed in earning the revenue of the current period, while the price paid for goodwill buys a benefit expected to last well beyond it, which is why it is capitalised and carried in the balance sheet. The amount written off in any year is an expense of that year; the goodwill itself is not.

Classification of accounts is the foundation of double entry, because the rule for debiting and crediting depends on which class an account belongs to. The traditional classification recognises three: personal accounts, of persons natural, artificial and representative, governed by 'debit the receiver, credit the giver'; real accounts, of assets and properties, governed by 'debit what comes in, credit what goes out'; and nominal accounts, of expenses, losses, incomes and gains, governed by 'debit all expenses and losses, credit all incomes and gains'. Real accounts split into tangible — cash, stock, plant, land — and intangible — goodwill, patents, trademarks, copyrights. Personal and real accounts are carried forward from one accounting period to the next and appear in the balance sheet; nominal accounts are closed off to the trading and profit and loss account and start each period afresh, which is the quickest practical test of the class an account belongs to. The modern classification, used alongside it, divides accounts instead into assets, liabilities, capital, revenues and expenses, and applies the rule that assets and expenses increase by debit while liabilities, capital and revenues increase by credit. The two schemes are different languages for the same underlying system and give the same journal entries. Goodwill is an intangible real account in the first and an asset in the second; nothing about the item's treatment changes with the scheme chosen, but examiners take care to word the stem in the vocabulary of one or the other.

Questions on the classification of accounts appear in the accountancy block of these papers because they are compact, unambiguous and impossible to answer by reasoning alone — either the three-fold scheme has been learned with its examples or it has not. This item is the standard hard case within that scheme, and it is hard for one specific reason: candidates absorb the phrase 'real account' as meaning something physical and then hesitate over an asset that cannot be touched. Fixing the sub-division of real accounts into tangible and intangible removes the difficulty permanently and answers a whole family of questions about patents, trademarks and copyrights at the same time. The topic also connects to work an Assistant Provident Fund Commissioner actually does. Reading an employer's balance sheet to judge capacity to pay, or examining the accounts of an establishment being amalgamated or sold, means telling assets that represent real recoverable value from balances that represent nothing more than an unwritten-off cost, and goodwill is the classic borderline entry in that judgement. One point of printing is worth noting: the stem is an incomplete sentence completed by the options and ends without a question mark, as several accountancy and current-affairs stems in this booklet do. It is the Commission's style, not an omission, and the sentence should be read straight through into each option in turn.

• The traditional classification of accounts has three classes: personal accounts, of natural, artificial and representative persons; real accounts, of assets and properties; and nominal accounts, of expenses, losses, incomes and gains. Goodwill is an asset, so the Goodwill Account is a real account, and specifically an intangible real account.
• Real accounts divide into tangible — cash, stock, building, machinery, furniture — and intangible — goodwill, patents, trademarks, copyrights and designs. Having no physical form does not make an account nominal; what makes an account real is that it represents property owned by the business and carried forward in the balance sheet.
• The golden rules attach to the classes: debit the receiver and credit the giver for personal accounts; debit what comes in and credit what goes out for real accounts; debit all expenses and losses and credit all incomes and gains for nominal accounts. Buying a business for more than its net assets is recorded by debiting the Goodwill Account, which is a real account behaving as one.
• Personal and real accounts are carried forward from period to period and appear in the balance sheet; nominal accounts are closed to the trading and profit and loss account and open each period at nil. That single test — does the balance survive into the next year — settles most classification questions in seconds.
• Goodwill is the value of a business over and above its identifiable net assets, arising from reputation, location, product quality, customer and supplier relations, managerial skill and the absence of effective competition. Indian practice records purchased goodwill only; self-generated goodwill is not recognised as an asset because no reliable cost can be attached to it.

• Reading 'real' as 'physical'. Real accounts include intangible assets such as goodwill, patents, trademarks and copyrights; the class is defined by the account representing property of the business, not by the property being touchable.
• Classifying goodwill as nominal because it is often written off. The write-off is an expense of the year and passes through the profit and loss account, but the Goodwill Account being credited is still a real account, just as machinery remains real when depreciation is charged on it.
• Reaching for Expense Account because the word appears in the option list. It is not a class in the traditional three-fold scheme at all, and under the modern classification, which does use the word, goodwill is an asset rather than an expense.
• Thinking goodwill is personal because it arises out of relationships with customers and suppliers. The classification depends on what the account represents in the books, which is an asset of the business, not on the source of the value.

Classification questions come up in almost every accountancy block and take three forms. The first names one account and asks which class it belongs to, which is this item; the accounts chosen are nearly always the borderline ones — goodwill, patents, outstanding salary, prepaid rent, drawings, capital, bank overdraft, discount received. The second reverses it, naming a class and asking which of four accounts belongs to it. The third gives a transaction and asks which account is debited or credited, which requires the class first and the golden rule second. Preparation is a single table learned once: three classes, the sub-division of real into tangible and intangible, the representative personal group, one golden rule per class, and four or five example accounts under each. Because these items are short and certain, they are among the cheapest marks in the paper for a candidate who has that table, and among the easiest to lose for one who reasons from the English meaning of the words instead.

No directly related past PYQ was found.

• practice — not a real PYQ

  Which one of the following is an intangible real account?

  • (a)Outstanding Salary Account
  • (b)Patents Account
  • (c)Discount Received Account
  • (d)Machinery Account

  Answer(b) Patents Account — a patent is an asset owned by the business with no physical form, so its account is an intangible real account, in the same family as goodwill, trademarks and copyrights. Outstanding Salary is a representative personal account standing for the employees who are owed, Discount Received is a nominal account of a gain closed to the profit and loss account, and Machinery is a tangible real account.

• practice — not a real PYQ

  Under the traditional classification of accounts, Prepaid Rent Account is which one of the following?

  • (a)A nominal account
  • (b)A representative personal account
  • (c)A tangible real account
  • (d)An intangible real account

  Answer(b) A representative personal account — prepaid rent represents the landlord, who has received money for a period not yet run and therefore owes the business the use of the premises, so the account stands in for a person. Rent Account itself is nominal and is closed to the profit and loss account, which is the contrast the item is built on; prepaid and outstanding balances are carried into the next period and belong to the personal class.