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Every economic entity must present its financial information to all its stakeholders.  The information provided in the financials must be accurate and present a true picture of the entity. For this presentation, it must account for all its transactions. Since economic entities are compared to understand their financial statuses, there has to be uniformity in accounting. To bring about uniformity and to account for the transactions correctly there are three Golden Rules of Accounting.
These rules form the very basis of passing journal entries which in turn form the basis of accounting and bookkeeping.

Types of accounts

To understand the Golden Rules of Accounting we must first understand the types of accounts. The account classification applies to all the types of general ledgers. In other words, every account will fall in one of the broad classifications given below.

There are three types of accounts:

  • Real Account
  • Personal Account
  • Nominal Account

A Real Account is a general ledger account relating to Assets and Liabilities other than people accounts. These are accounts that don’t close at year-end and are carried forward. An example of a Real Account is a Bank Account.

A Personal account is a General ledger account connected to all persons like individuals, firms and associations. An example of a Personal Account is a Creditor Account.

A Nominal account is a General ledger account pertaining to all income, expenses, losses and gains. An example of a Nominal Account is an Interest Account.

Golden rules of accounting

Looking at the nature of all the accounts,  the accounting rules have been devised. For each account there is a set of Golden Rules and hence there are three Golden Rules of Accounting. The Golden rules define the treatment of all transactions conducted by the business.

 

Golden Rules of Accounting

Illustration

An entity named Orange Ltd. has the following transactions.

  1. It deposits Rs.10,000 into Bank
  2. It buys goods worth Rs.50,000 from Apple Ltd.
  3. It sells goods worth Rs.35,000 to Melon  Ltd.
  4. It pays Rs.12,000 as Rent for its premises
  5. It earns Rs.3,000 as interest on a bank account.  

First of all,  let us identify the accounts involved in these transactions and classify them into the different types of accounts:

Transaction

Accounts involved

Type of Accounts

Deposit Rs.10,000 in Bank

Bank Account

Cash Account

Real Account – Asset account

Real Account – Asset account

Purchase goods worth Rs.50,000 from Apple Ltd.

Purchase Account

Apple Ltd. Account

Nominal Account – Expense account

Personal Account – Creditors account

Sale of goods worth Rs. 35,000 to Melon Ltd.

Sales Account

Melon Ltd. Account

Nominal Account -Income Account

Personal Account – Debtors Account

Pays Rs.12,000 as rent

Rent Account

Bank Account

Nominal Account

Real Account – Asset account

Earn Rs.3,000 as interest on Bank account

Interest received

Bank Account

Nominal Account – Income Account

Real Account – Asset Account

Now applying the golden rules to each of the transactions we will get the following journal entries :

  • Deposit Rs.10,000 in Bank

Both Bank and Cash are real accounts and so the Golden rule is:

  • Debit what comes into the business
  • Credit what goes out from the business

So the entry will be:

Bank A/C Dr. 10,000
    To Cash A/ C 10,000
  • Purchase goods worth Rs.50,000 from Apple Ltd.

The Purchase Account is a Nominal account and the Creditors Account is a Personal account.

Applying Golden Rule for Nominal account and Personal account:

  • Debit the expense or loss
  • Credit the giver

The entry will be:

Purchase A/C Dr    50,000
    To Apple Ltd. A/C 50,000
  • Sale of goods worth Rs.35,000 to Melon Ltd.

The sale account is a Nominal account and the Debtors Account is a Personal account.

Hence the Golden Rule to be applied is:

  • Debit the receiver
  • Credit the income or gain

Thus the entry will be:

Melon Ltd. A/C Dr 35,000
    To Sales A/C 35,000
  • Pays Rs.12,000 as rent

Rent is a Nominal account and Bank is a real account.  

The Golden Rule to be applied is:

  • Debit the expense or loss
  • Credit what goes out of business

The entry thus will be:

Rent A/C Dr. 12000
    To Bank A/C 12000
  • Earn Rs.3,000 as interest on Bank Account

Interest and Bank are Nominal account and Real Account.

The Golden rule to be applied is:

  • Debit what comes into the business
  • Credit the income or gain

Hence the entry will be:

Bank A/C Dr 3,000
    To Interest Received A/C 3,000

Conclusion

All transactions of an entity must be accounted for. To account these transactions the entity must pass journal entries which will then summarise into ledgers. The journal entries are passed on the basis of the Golden Rules of accounting.  To apply these rules one must first ascertain the type of account and then apply these rules.

  • Debit what comes in, Credit what goes out
  • Debit the receiver, Credit the giver
  • Debit all expenses Credit all income

These lay the foundation of accounting and hence are called the Golden Rules of accounting.  They are like the letters of the English alphabet. If one does not know the letters he cannot put words and hence, will not be able to use the language.  Similarly for accounting, if one does not know the golden rules, he cannot pass journal entries and hence won’t be able to accurately account for the transactions.

 

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