Every business has to ensure transparent and accurate accounts. Knowledge of the underlying principles governing the transactions forms a basis for proper accounting practice. In fact, the three rules most considered to be part of the golden rules in accounting all aim at ensuring accuracy and consistency in financial statements.
In this blog, we are going to understand the golden rules of accounting with examples and journal entries, explaining their application, the relation to the type of account, and its importance.
Introduction
Accounting is far more than just bookkeeping today. Two vital parts of accounting are debit and credit. We should only make an entry after knowing the word-for-word meaning of which account should be debited or credited.
When a transaction occurs in any financial transaction, it will involve two accounts. This dual-entry system of accounting has two columns in which we have two columns to enter our transactions. We all know one is the debit side and another is the credit side. For such uniformity and for correct accounting of transactions, three Golden Rules of Accounting exist.
So, it is of great importance knowing the three accounting golden rules with examples, which makes it easier to simplify a very complicated task of recording financial transactions.
Understanding the Golden Rules of Accounting
Financial accounting is more than book-keeping. Golden rules of account crates the basis for bookkeeping. The dual entry system has been provided by accountancy to all the transactions occurring in the business. Every transaction has a debit and a credit. It is very important to decide which account should be credited and which one is to be debited.
Financial accounting is based on three rules. This set of three rules is simply called the golden rule of accounting. These rules support uniformity and systematic recording of financial transactions. The golden rules represent a set of simple-to-understand principles that make complicated book-keeping rules well-understood, studied, and followed practices.
Here are the three golden rules of accounting:
- Debit What Come In, Credit What Goes Out
- Debit All Expense and Losses, Credit all Incomes and Gains.
- Debit the Receiver, Credit the Giver.
Types of Accounts
The golden rules of accounting in India helps in recording the financial transactions in ledgers. These golden rules are on the basis of type of account. Every transaction will have debit entry as well as credit entry and fall into any of the three types of accounts.
1. Real Account
A real account is an aggregation of ledger account that represents the total transactions regarding assets and liabilities. The assets have been categorized into two groups. Tangible assets and intangible assets. Tangible assets include furniture, land, building, machinery, etc. Intangible assets include goodwill, copyrights, patents, etc.
Such accounts are carried forward to the next year and do not close at the end of the financial year. Additionally, a real account appears on the balance sheet. A furniture account is one kind of real account.
Accounting Rule- Debit what comes into the business
Credit what goes out of the business
2. Personal Account
It is the account where personal transactions of persons, firms, and companies are recorded. The individual customers or creditors, corporations or institutions, and outstanding expenses and incomes appear in journal entries of personal accounts.
There are three types of personal accounts-
- Natural personal Account- This type of accounts records the financial transaction for individuals that are natural persons, like creditors, customers, debtors and capital account etc.
- Artificial Personal Account- This type of personal account records the transactions of sperate legal entities that are not humans. For example, accounts of Banks, Hospitals, Firms and companies etc.
- Representative Personal Account- Such personal account records transaction for the individual representing others. The transaction may belong to previous years or next year. Like salary due or paid in advance.
Accounting Rule- Debit the receiver
Credit the giver
3. Nominal Account
This account considered as general ledger account containing business transaction like income, expenses, profit and losses. Examples of such accounts are rent accounts, sales accounts and wages accounts etc.
Such an account works on the principle of income and expenses. This account contains all the financial transactions for a business that occur in one fiscal year. Additionally, it resets to zero and a fresh start when the new fiscal year begins.
Accounting Rule- Debit the loss or expenses of the business
Credit the profit or income of the business
The Golden Rules of Accounting and their Examples
Debit What Come In, Credit What Goes Out
This rule applies for real accounts. Real accounts comprise furniture, land, buildings, machinery, etc. They have, by default a debit balance. Therefore, when what is coming inside is debited, it increases the account balance. Similarly, crediting what is going out diminishes the account balance when the tangible asset leaves the firm.
Example– Suppose you have Hydraulic Machine for your business from a supplier to boost your production for Rs 2,05,000. Since this machine will be coming in, the machinery account will going to be Debited. On the other side cash will go out for the purchase of it, the cash account will be Credited.
Debit the Receiver, Credit the Giver
It applies to personal accounts. When the real or artificial person gives something to the organization, then it is regarded as an inflow, and the person should be given a credit in the books. On the contrary, he who receives should be debited.
Example– If a company, M/s Tarzon Ltd. buys Rs 20,500 value of goods from company M/s Zedx. In the financial books of company Tarzon, the accountant will Debit the purchase account of the company and Credit company Zedx.
This is because company Tarzon will have to incur an expenditure of Rs 20,500 to buy the goods from Zedx, which must be debited as per this rule.
Debit All Expense and Losses, Credit all Incomes and Gains
This rule is applicable to nominal accounts. Capital is a liability of a company. Hence, it is maintained with a credit balance. All the incomes and gains are credited. Thus, the capital increases. However, the capital gets reduced when all the expenses and losses are debited.
Example- If you have purchased raw materials of Rs 100000 from company M/s PK ltd. Since you have made an expense of Rs 100000, according to golden rule, you will be going to Debit the expenditure and Credit the income in the accounts of the company.
Significance of Golden Rules of Accounting
The following can be the significance of the golden rules of accounting-
- Analysis– The management of the company can clearly analyse its performance throughout the years with well-maintained accounts.
- Proper Maintenance of Books of Accounts– The above said golden rules of accounting will assure the consistent maintenance of accounts and business records of the company.
- Valuation– While performing valuation of a company, these financial statements will facilitate to identify the business revenues and expenses.
- Budgeting– For the purpose of budgeting and estimation of future projections of the company, it is required to maintain the financial transactions and follow the accounting practices properly.
- Taxation and Regulatory Affairs– By way of these golden rules in accounting, any deficit tax and regularity issues can be prevented. Absence of accounting discipline will invite penalties and other regulatory obstacles.
Conclusion
Golden rules of accounting provide a basis for the preparation of financial accounts. In fact, the accounting company should record every single transaction. However, any transaction is recorded in a journal entry and then as a ledger. Such entries are passed based on the Golden Rules of accounting. For the application of these rules, one must first ascertain the categories of accounts and then apply these rules.
These form the basis of accounting and, therefore, are known as the Golden Rules of Accounting. They are like the alphabet of the English language. If one doesn’t know the alphabet, he can’t frame words and, hence, cannot make use of the language. Similarly, for accounting, if one doesn’t know the golden rules, he cannot pass journal entries and thus won’t be able to account correctly for the transactions.
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