Accounting rules are statements that establish guidance on how to record transactions. According to accounting rules, all accounting transactions must be recorded in the entity’s books using the double-entry accounting method. The double-entry accounting method means that for each transaction, two (or more) accounts are involved; one account is debited and the other is credited with the same amount. Accounting rules serve as the foundation for any accounting framework. Before applying accounting principles, a person must understand the basic accounting rules that govern transactions, including which accounts should be debited and which accounts should be credited. Accounting rules are uniformly applied by all entities, resulting in consistent and comparable financial reports. Each record made in an account comes under one of the two categories, namely-
- Credit
- Debit
A debit is an increase in the value of assets. For example, if you purchase some land for your company, that would be termed as a debit. It increases the value of your assets, but it also decreases your capital amount.
A credit, on the other hand, is a decrease in the value of assets. Following the same example, if you sell the land you acquired, there is a decrease in the value of your assets, whereas there is an increase in the capital of your company.
Types of accounts
Every economic entity must present its financial information to all its stakeholders. 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 ensure uniformity and accuracy in accounting transactions, there are three Golden Rules of Accounting. These rules form the foundation of passing journal entries, which in turn serve as the basis of accounting and bookkeeping. Accounting’s golden rules are based on the accounts mentioned below, which are divided into three categories:
- Personal Account
- Real Account
- Nominal Account
1. Personal Account:
The rule related to the Personal account states that debits are made to the receiver and credits are made to the giver. In other words, if a person receives something, the receiver’s account shall be debited, and if a person gives something, the giver’s account shall be credited.
Personal accounts record transactions with individuals or businesses. Those accounts that record transactions that don’t affect a particular person but affect the business in general are called impersonal accounts. Personal accounts may be further classified into three categories:
- Natural Personal Account
- Artificial Personal Account
- Representative Personal Account
2. Real Account:
The rule related to real accounts states that debit is for what comes in, and credit is for what goes out. In other words, if something comes into business, it shall be debited, and if something goes out of business, it shall be credited. There are two types of real accounts:
- Tangible Account
- Intangible Account
Tangible assets are tangible assets that have physical substance, such as machinery, stock, plant, furniture, and cash. Intangible assets, on the other hand, are non-tangible assets, including patents, goodwill, and copyrights.
3. Nominal Account:
The rule related to nominal account states that debit all expenses and losses, and credit all incomes and gains. In other words, if any expense or loss is incurred for the business, the expense or loss account shall be debited, and if any income or gain is earned in a business, the income account or gain/profit account shall be credited.
It relates to income, expenses and gains or losses of a business concern. For example, accounts include salaries, advertising, discounts, sales, and commissions received, among others. These accounts do not exist, have no form, or take any shape. All kinds of expense accounts, loss accounts, gain accounts, or income accounts come under the category of nominal accounts.
Role of Accounting in Business and its Importance
Accounting provides clarity in business, helping to make informed decisions based on expenses, tax liabilities, and cash flow. There are three critical financial statements generated through “accounting”.
- A profit and loss statement gives clarity on the income and expenses.
- A balance sheet helps to understand a business’s financial position.
- The cash flow statement helps keep track of cash generated and is used by investors to assess a business’s financial health.
Modern Rules of Accounting
The modern approach has become standard for classifying accounts in developed countries. There is also the modern approach to accounting, which classifies accounts into six different heads:
1. Assets
An increase in assets is referred to as a debit in the account, and a decrease in assets is referred to as a credit.
2. Liabilities
A decrease in liabilities is recorded as a debit in the account, and vice versa.
3. Capital
Similarly, a decrease in the company’s capital is recorded as a debit, and an increase in the same is a credit.
4. Revenue
A decrease in revenue is a debit entry in the account, and an increase is a credit entry.
5. Expenditure
An increase in expenditure results in debt, while a decrease in expenditure leads to credit.
6. Withdrawal
An increase in withdrawal will be classified as a debit, and a decrease will be classified as a credit.
Benefits of Accounting in Business
Maintaining the accounts of financial transactions according to the golden rules of accounting gives certain benefits.
- Maintenance of Business Records – The maintenance of business records is crucial to a business’s success. The practice of accounting ensures that all your business transactions are recorded in a secure location, in the correct order, and, more importantly, in a systematic manner.
- Preparation of Financial Statements – If the golden rules of accounting are applied, then financial transactions will be recorded accurately. Financial statements, such as the profit and loss account, the trading account, and the balance sheet, can all be prepared quickly if the accounting is done correctly.
- Comparison of financial results – Accounting done in accordance with the golden rules will make it easy to compare one year’s financial results against those of another year. Analysis of year-on-year financial results becomes easier and trustworthy.
- Corporate decision-making – An accounting process based on the three golden rules of accounting makes financial results trustworthy and valuable in senior management and leadership’s decision-making process.
- Evidence in Legal matters – Business matters need to be recorded systematically and filed away in an organised fashion for quick reference in legal issues.
- Regulatory compliance – For businesses, accounting is of paramount importance in helping comply with regulatory authorities. Without the basic foundation laid down by the three golden rules of accounting, it would be difficult to achieve regulatory compliance.
- Helps in Taxation Matters – Due to incorrect accounting practices, a shortfall in taxes could attract heavy penalties from government authorities, negatively impacting the image and brand value.
