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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 status, 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.
So, get to know the three accounting golden rules that simplify the complicated task of recording financial transactions. Let’s dive deeper.
To put it in simple terms, the golden rules of accounting are a set of guidelines that accountants can follow for the systematic recording of financial transactions. They revolve around the system of dual entry i.e., debit and credit. You have to know which accounts have to be charged and which need to be credited.
These rules will assist in identifying which account to credit and which one to debit. The accounting golden rules are a set of three principles that allow one in simplifying the complex rules of bookkeeping.
According to these rules, you must determine the type of account for each transaction. Now, each account type has its own set of principles that needs to be applied for every single transaction.
To get a better idea, let’s take a look at the types of accounts.
In financial accounting, every debit or credit transaction entry will belong to one of the three types of accounts:
A nominal account is a general ledger containing the transactions of a business, namely – expenses, incomes, profits and losses. It contains all the transactions that occur in one fiscal year. Furthermore, it resets to zero and starts afresh when the next fiscal year begins.
Examples of nominal accounts are Commission Received, Salary Account, Rent Account and Interest Account.
You can think of a personal account as a general ledger that relates to people, associations and companies.
It can be divided into three subcategories:
An artificial personal account represents bodies which are not human beings but act as separate legal entities according to the law. For example, government bodies, hospitals, banks, companies, cooperatives, partnerships, etc.
A natural personal account represents human beings—for example, a Capital account, a Drawings account, Creditors, Debtors, etc.
This type of personal account represents the accounts of natural or artificial entities. However, the transactions in this type of account either belong to the previous or the coming year.
For example, a representative personal account can contain information on an employee’s due salary from last year. Also, it can represent the amount of rent a company paid in advance for the coming year.
Like the other two, a real account is also a general ledger, but it contains transactions related to the liabilities and assets of a company. The assets, in this case, can be further subdivided into tangible and intangible assets.
Tangible assets include land, buildings, machinery, furniture, etc. Alternatively, intangible assets include goodwill, patents, copyrights, etc.
Unlike a nominal account, a real account does not close when a financial year completes. Rather, it is carried forward to the following year. In addition, a real account also appears in the company’s balance sheet.
Now that you have a clear idea of the types of accounts, let’s take a look at how they relate to the golden rules of accounting.
Rule 1: Debit all expenses and losses, credit all incomes and gains
This golden accounting rule is applicable to nominal accounts. It considers a company’s capital as a liability and thus has a credit balance. As a result, the capital will increase when gains and income get credited. Inversely, this capital gets reduced when losses and expenses are debited from it.
Rule 2: Debit the receiver, credit the giver
The “Debit the receiver, Credit the giver” rule is applicable for personal accounts. When a natural or artificial entity makes a donation to a company, it becomes an inflow. Thus, the receiver must be debited, and the company receiving the donation must be credited in the books.
|xx/xx/xxxx||Amount of Purchase||Rs.19,000||–|
Rule 3: Debit what comes in, credit what goes out
This rule is applicable for real accounts where tangible assets like machinery, buildings, land, furniture, etc., are taken into account. They have a debiting balance by default and debit everything that comes in, adding them to the existing account balance.
In a similar way, the account balance needs to be credited when a tangible asset leaves the company.
|xx/xx/xxxx||Cash Account||–||Rs. 1,90,000|
These three accounting rules form the basis of bookkeeping. Let’s take an example to put things into perspective.
Take a look at the following transactions:
Now, let’s take a look at the different accounts that will be involved and also the types of accounts for each case:
|Transactions||Involved Accounts||Accounts Types|
|Initial capital of Rs. 2,00,000||Capital Account, Cash Account||Personal Account, Real Account|
|Rents worth Rs.50,000||Cash Account, Rent Account||Real Account, Nominal Account|
|Purchase of goods worth Rs.1,00,000 from Mahadev Stone Works||Mahadev Stone Works Account, Purchases Account||Personal Account, Nominal Account|
|Sale of goods worth Rs.1,50,000||Sales Account, Cash Account||Nominal Account, Real Account|
|Cash payment to Mahadev Stone Works for goods purchased||Cash Account, Mahadev Stone Works Account||Real Account, Personal Account|
|Salary payment to employees worth Rs.1,00,000||Cash Account, Salary Account||Real Account, Nominal Account|
Applying the golden rules of accounting, your journal entries will be in the following ways:
As cash is a tangible asset, it will be a part of the company’s real account. Also, capital belongs to the personal account.
Therefore, applying the golden rules, you have to debit what comes in and credit the giver.
Rent is considered as an expense and thus falls under the nominal account. Additionally, cash falls under the real account. So, according to the golden rules, you have to credit what goes out and debit all losses and expenses.
When a firm purchases something, it falls under its expenses, and so it falls under the nominal account. Moreover, Mahadev Stone Works will be a part of the personal account. Hence, you have to credit the giver and debit all expenses and losses.
|Mahadev Stone Works Account||–||Rs.1,00,000|
Income generated from the selling of goods falls under the nominal account. Furthermore, cash forms a part of the real account. Therefore, you have to credit all incomes and gains and debit what comes in.
As Mahadev Stone Works falls under the personal account and cash forms a part of the real account, you have to credit what goes out and debit the receiver.
|Mahadev Stone Works Account||Rs.1,00,000||–|
Salary is considered as an expense to a business and thus falls under the nominal account. In addition, cash forms a part of the real account. So, according to the accounting golden rules, you have to credit what goes out and debit all expenses and losses.
Following the golden rules of accounting has these benefits:
For a company’s success, the proper maintenance of its records is critical. Doing so will make sure that the company’s records are stored in a safe, and systematic manner.
The golden rules ensure that financial records are properly recorded. So, businesses can compare their year-over-year financial results in an easier and more efficient way.
When a firm properly calculates its financial statements, it assists in proper business valuation. Furthermore, it helps in getting more investments and thereby expanding the business.
If a business has a sound budget based on proper accounting practices, it can act as a strong foundation for growth. In addition, it assists in more accurate future projections.
For quick reference during lawsuits, companies need to record their financial data in a systematic manner. Using accounting golden rules comes in handy in this regard.
Properly accounting a firm’s financial statements helps avoid shortfalls in taxes. Improper accounting practices attract huge penalties. It can also impact the firm’s brand value and image.
Proper accounting is of utmost importance when it comes to complying with regulatory authorities. Without proper accounting discipline, it will be difficult for any business to achieve regulatory compliance.
Now that you have a clear idea of the golden rules of accounting, you know which type of transaction belongs under which specific account. So, the journal entries on financial transactions shall be accurate and appropriate.
Ledger books are records of crucial information that is needed to create financial statements.
The golden rules of accounting were created by an Italian mathematician named Fra Luca Pacioli and Leonardo da Vinci.
Accounting is the process of recording a business’ financial transactions. It also includes providing a summary, analysis and report of these transactions to oversight or tax collection agencies.
An accounting cycle is a process in which a business accepts, records, sorts and credits payments made and received within a particular accounting period.
Businesses that have gross receipts worth over Rs.1.5 lakh in the last 3 years of a particular profession have to maintain financial transaction records. As per Rule 6F of IT Act, these are the professions that have to maintain the account of their transactions:
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.
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.