Three Golden Rules of Accounting – Overview, Types, Benefits
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 there is a decrease in 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 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. 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 Personal account states debit the receiver and credit the giver. In other words, if a person receives something, receiver’s account shall be debited and if a person gives something, giver’s account shall be credited.
Personal accounts are recording transaction with persons or firms. Those accounts recording transactions, which don’t affect particular person, but effects 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:
- Tangible Account
- Intangible Account
Tangible assets are touchable assets having physical substance, such as machinery, stock, plant, furniture, cash, etc., and intangible assets are non-touchable assets such as patent, goodwill, copyrights, etc.
3. Nominal Account:
The rule related to nominal account states that debit all expenses and losses, 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, income account or gain/profit account shall be credited.
It relate to income, expense and gains or losses of a business concern. For example, salaries account, advertising account, discount account, sales account, and commission received account etc. These accounts do not have any existence, form or shape. All kinds of expense account, loss account, gain account or income accounts come under the category of nominal account.
Role of Accounting in Business and its importance
Accounting provides clarity in business that helps make the right 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 the financial position of the business.
- 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
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:
An increase in assets is termed as a debit in the account, and a decrease in assets is termed as credit.
A decrease in liabilities translates as a debit in the account and vice versa.
Similarly, a decrease in the company’s capital is recorded as a debit, and an increase in the same is a credit.
A decrease in the revenue is a debit in the account, and an increase is a credit.
An increase in expenditure results in debt and a decrease in expenditure is credit.
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 critical to the success of a business. The practice of accounting will make sure that all your business transactions are recorded in a safe place in the correct order and, more importantly, in a systematic way.
- Preparation of financial statements – If the golden rules of accounting are applied, then the financial transactions will be recorded appropriately. Financial statements like profit and loss account, trading account, balance sheets, can all be prepared quickly if the accounting is correctly done.
- Comparison of financial results – Accounting done by following the golden rules will make it easy to compare one year’s financial results against another year. Analysis of year-on-year financial results becomes easier and trustworthy.
- Corporate Decision making – An accounting process based on the three golden accounting rules makes the 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 helping compliance with regulatory authorities. Without the basic foundation laid down by the three golden accounting rules, it would be difficult to achieve regulatory compliance.
- Helps in Taxation matters – Due to incorrect accounting practices, the shortfall in taxes could attract heavy penalties from government authorities, negatively impacting image and brand value.