Permanent accounts: Meaning, Criticisms & Real-World Uses

What Are Permanent Accounts?

Permanent accounts, also known as real accounts, are accounts in a company's general ledger whose balances are carried forward from one accounting period to the next. These accounts represent the cumulative financial position of a business and are never closed out at the end of an accounting period. They form the core components of the balance sheet, a fundamental financial statement within the broader field of financial accounting. The key elements reflected in permanent accounts include assets, liabilities, and shareholders' equity.

History and Origin

The concept of permanent accounts is intrinsically linked to the historical development of double-entry accounting, a system that originated in medieval Italy and became formalized over centuries. The practice of carrying balances forward for assets, liabilities, and equity became essential for tracking a business's enduring financial health. While the precise origin of differentiating permanent from temporary accounts isn't attributed to a single inventor, it evolved as accounting principles aimed to provide a continuous view of a company's financial position beyond a single operating cycle. Modern accounting standards, such as Generally Accepted Accounting Principles (GAAP) in the United States, formalized this distinction to ensure consistent and comparable financial reporting. The Financial Accounting Standards Board (FASB), established in 1973, plays a significant role in defining and improving these accounting standards for U.S. entities. Globally, the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB), also uphold this fundamental distinction, often working towards convergence with U.S. GAAP⁶, ⁷.

Key Takeaways

Permanent accounts reflect a company's financial position at a specific point in time.
Their balances are carried forward from one accounting period to the next, unlike temporary accounts.
These accounts primarily include assets, liabilities, and equity, forming the basis of the balance sheet.
They provide a cumulative view of a business's long-term financial health.
Permanent accounts are essential for long-term financial analysis and decision-making.

Formula and Calculation

Permanent accounts do not have a specific "formula" in the traditional sense, as they represent balances rather than calculations. However, they are fundamental to the accounting equation, which must always remain in balance:

\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}

This equation is the foundation of the balance sheet and illustrates the relationship between a company's resources (assets) and the claims against those resources (liabilities and shareholders' equity). Each element within this equation is composed of various permanent accounts. For instance, assets might include Cash, Accounts Receivable, and Property, Plant, and Equipment, while liabilities could involve Accounts Payable and Long-Term Debt. Equity encompasses items like Common Stock and Retained Earnings.

Interpreting Permanent Accounts

Interpreting permanent accounts involves analyzing the balances within assets, liabilities, and equity to understand a company's financial structure and health. The balance sheet, which is composed entirely of permanent accounts, provides a snapshot of a company's financial standing at a particular moment. Analysts review trends in asset growth, the mix of debt versus equity financing, and the composition of working capital. For example, a significant increase in property, plant, and equipment might indicate recent capital expenditures and expansion, while a growing retained earnings balance suggests consistent profitability after dividends. These accounts provide insights into a company's liquidity, solvency, and operational efficiency over time. The Securities and Exchange Commission (SEC) requires public companies to file their financial statements, including balance sheets, through its EDGAR database, allowing public access and interpretation of these permanent account balances⁵.

Hypothetical Example

Consider "Horizon Innovations Inc." at the end of its fiscal year.

Assets:
- Cash: $150,000
- Accounts Receivable: $70,000
- Inventory: $120,000
- Property, Plant, and Equipment (net of depreciation): $500,000
- Total Assets = $840,000
Liabilities:
- Accounts Payable: $60,000
- Notes Payable (short-term): $40,000
- Long-Term Debt: $250,000
- Total Liabilities = $350,000
Shareholders' Equity:
- Common Stock: $300,000
- Retained Earnings: $190,000
- Total Shareholders' Equity = $490,000

At the close of the year, Horizon Innovations prepares its trial balance. Instead of being reset to zero, the balances of these permanent accounts (Cash, Accounts Receivable, Inventory, Property, Plant & Equipment, Accounts Payable, Notes Payable, Long-Term Debt, Common Stock, and Retained Earnings) are carried forward to begin the next accounting period. This ensures that the opening balance sheet of the new year accurately reflects the closing financial position of the previous year.

Practical Applications

Permanent accounts are central to various aspects of finance and business. They are the building blocks of the balance sheet, providing a cumulative record of a company's financial health.

Financial Analysis: Investors and analysts use the balances in permanent accounts to assess a company's liquidity, solvency, and overall financial strength. Trends in asset values, liability levels, and equity over multiple periods can indicate growth, financial stability, or potential risks.
Lending Decisions: Banks and other lenders rely heavily on permanent accounts to evaluate a borrower's capacity to repay debt. A strong asset base and manageable liabilities are crucial for obtaining favorable loan terms.
Valuation: In company valuations, the net asset value derived from permanent accounts often serves as a baseline, especially for asset-heavy businesses.
Compliance and Regulation: Regulators, such as the Federal Reserve for financial institutions, prescribe specific ways in which permanent accounts must be maintained and reported to ensure transparency and consistency in financial reporting. The Federal Reserve Banks, for example, have a detailed Financial Accounting Manual that outlines the accounting treatment for various balance sheet accounts⁴.

Limitations and Criticisms

While permanent accounts offer a continuous view of a company's financial standing, they are primarily based on the historical cost principle. This principle mandates that assets are recorded at their original purchase price, less any accumulated depreciation or impairment. A significant criticism of this approach is that it may not reflect the current market values of assets, especially for long-lived assets like real estate or equipment that can appreciate or depreciate significantly over time due to inflation, technological advancements, or market shifts², ³.

This can lead to a balance sheet that does not fully represent the current economic reality or true worth of a company's assets. For instance, a property purchased decades ago may be recorded at a much lower value than its current market value, potentially understating the company's net worth. This limitation can affect inter-firm comparisons and make it challenging for stakeholders to accurately assess the current financial position of a business in a rapidly changing economic environment¹. Although fair value accounting has gained traction in some areas to address these issues, historical cost remains a foundational principle for many permanent accounts due to its objectivity and verifiability.

Permanent Accounts vs. Temporary Accounts

The primary distinction between permanent accounts and temporary accounts lies in their treatment at the end of an accounting period.

Feature	Permanent Accounts	Temporary Accounts
Balance Carryover	Balances are carried forward from one accounting period to the next. They never reset to zero.	Balances are closed out (reset to zero) at the end of each accounting period. Their net effect is transferred to a permanent equity account, typically Retained Earnings.
Components	Represent assets, liabilities, and owner's equity. They appear on the balance sheet.	Represent revenues, expenses, and dividends. They appear on the income statement (revenues and expenses) and statement of retained earnings (dividends).
Purpose	Reflect a company's financial position at a specific point in time and provide a continuous view of financial health.	Reflect a company's financial performance over a specific period. They are used to calculate net income or loss for the period and prepare the income statement.
Example Accounts	Cash, Accounts Receivable, Inventory, Property & Equipment, Accounts Payable, Bonds Payable, Common Stock, Retained Earnings.	Sales Revenue, Rent Expense, Salaries Expense, Utilities Expense, Interest Income, Dividends Declared.
Closing Process	Not affected by closing entries at period-end.	Are part of the closing process, where their balances are transferred to Retained Earnings to prepare for the next period's financial reporting. This allows for a fresh start in measuring performance for the subsequent period.

FAQs

What is the main characteristic of a permanent account?

The main characteristic of a permanent account is that its balance is carried forward from one accounting period to the next. These accounts are never closed out at the end of the year.

Why are they called "permanent" or "real" accounts?

They are called "permanent" because their balances persist indefinitely on the books, reflecting the continuous existence of a company's assets, liabilities, and equity. They are called "real" because they represent the actual, enduring financial position of the entity at any given point in time.

Where can I find permanent accounts in a company's financial statements?

Permanent accounts are found on the balance sheet, which presents a company's assets, liabilities, and shareholders' equity at a specific date.

Do permanent accounts ever change their value?

Yes, the values in permanent accounts change constantly due to business transactions (e.g., purchasing assets, paying off liabilities, earning profits that increase retained earnings). However, the accounts themselves are never closed or reset to zero.

Are permanent accounts important for financial analysis?

Yes, permanent accounts are crucial for financial analysis as they provide a long-term view of a company's financial structure. They help analysts and investors assess solvency, liquidity, and capital structure, offering insights into a company's enduring financial strength.