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.
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:
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.
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.
Illustration An entity named Orange Ltd. has the following transactions.
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||Real Account - Asset account|
|Cash Account||Real Account - Asset account|
|Purchase goods worth Rs.50,000 from Apple Ltd.||Purchase Account||Nominal Account - Expense account|
|Apple Ltd. Account||Personal Account - Creditors account|
|Sale of goods worth Rs. 35,000 to Melon Ltd.||Sales Account||Nominal Account -Income Account|
|Melon Ltd. Account||Personal Account - Debtors Account|
|Pays Rs.12,000 as rent||Rent Account||Nominal Account|
|Bank Account||Real Account - Asset account|
|Earn Rs.3,000 as interest on Bank account||Interest received||Nominal Account - Income Account|
|Bank Account||Real Account - Asset Account|
Now applying the golden rules to each of the transactions we will get the following journal entries :
Both Bank and Cash are real accounts and so the Golden rule is:
So the entry will be:
|To Cash A/C||10,000|
The Purchase Account is a Nominal account and the Creditors Account is a Personal account. Applying Golden Rule for Nominal account and Personal account:
The entry will be:
|To Apple Ltd. A/C||50,000|
The sale account is a Nominal account and the Debtors Account is a Personal account. Hence the Golden Rule to be applied is:
Thus the entry will be:
|Melon Ltd. A/C||Dr||35,000|
|To Sales A/C||35,000|
Rent is a Nominal account and Bank is a real account. The Golden Rule to be applied is:
The entry thus will be:
|To Bank A/C||12000|
Interest and Bank are Nominal account and Real Account. The Golden rule to be applied is:
Hence the entry will be:
|To Interest Received A/C||3,000|
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.