Golden Rules of Accounting: Meaning & Types

Any entity, regardless of type or size, must provide its financial information to its stakeholders. This financial information should be accurate and paint a correct picture of its operations. Hence, it must account for its income, expenditures, assets, and liabilities.

To ensure this happens consistently and uniformly, every business must adhere to a few golden rules of accounting. These ‘golden rules’ considerably simplify the convoluted task of recording financial transactions.

In this article, we will learn about these golden rules, the different types of accounts, and why we need these accounting rules.

What Are the Golden Rules of Accounting?

The rules of accounting act as fundamental principles that help businesses efficiently record their financial transactions. Thus, they serve as the foundation for all accounting transactions. These rules also follow the double-entry system of accounting.

This system records each transaction in two accounts: debit and credit. It is important to know which accounts to debit and which to credit. Thus, the three rules of accounting, which we will shortly discuss, simplify the complicated rules of bookkeeping for businesses.

They ensure that the accounting records are accurate and reliable, allowing businesses to make informed decisions. These rules also ensure that the organisations comply with the respective laws put forward by the government. Following these rules, you must identify the type of account for each transaction.

Let us now look at the different types of accounts to understand them better.

Types of Accounts in Accounting

To better understand the accounting rules, you must be familiar with the different types of account entities used in the double-entry system. These are as follows:

• Nominal Account

Essentially, a nominal account is a general ledger used to record any entity’s transactions temporarily. These can be profits, expenditures, incomes, and losses for a certain period.

This account records all transactions for one financial year. Afterwards, it resets to zero and starts recording again at the beginning of the new fiscal year.

It is important to note that the golden rules of accounting must be applied to all types of accounts. Thus, the golden rule for a nominal account is to debit expenses and losses and credit all incomes and profits.

A few examples of nominal accounts are interest accounts and salary accounts.

• Personal Account

A personal account is a general ledger that records financial transactions concerning individuals, associations, and companies. It also works with the credit and debit principle. This account is further divided into:

i) Artificial Personal Account

This account captures transactions of entities that are not human beings but behave as separate legal entities per the law. Entities that use artificial personal accounts include banks and hospitals.

ii) Natural Personal Account

As the name suggests, these personal accounts record financial transactions of individuals or entities that are natural persons, such as suppliers or customers. A natural person, by definition, is someone who has a legal identity and the right to enter into agreements or contracts.

iii) Representative Personal Account

A representative personal account captures the transactions of an entity or individual representing another entity or individual. Thus, these accounts track and record the transactions of the representatives.

Similar to the nominal account, the golden rules of accounting apply to the personal account. The golden rule for personal accounts is, ‘debit the receiver, and credit the giver’.

• Real Account

A real account is also a general ledger. However, unlike nominal or personal accounts, this account comprises all the transactions related to a company’s assets and liabilities.

Additionally, these accounts are called ‘permanent accounts’ because they are not closed after the accounting period but are carried over to the next period.

The assets can be subdivided further into intangible and tangible assets. Examples of tangible assets include machinery, land, buildings, etc. On the other hand, a few examples of intangible assets include copyrights and patents.

The golden rule of accounting for a real account is, ‘debit what comes in and credit what goes out’.

The Three Golden Rules of Accounting

Understanding the golden rules of accounting is the first step to understanding business finance. Let’s look at each one.

Rule 1: Debit What Comes In, Credit What Goes Out

This rule is primarily for Real Accounts, which deal with a business’s assets and properties. Think of assets as resources like goods, machinery, or cash.

When an asset enters the business or its value increases within the business, the account representing that asset is debited. Conversely, when an asset leaves the business or its value decreases, its account is credited.

For instance, imagine a small catering business buys new cooking utensils using its bank account:

• Cooking utensils (an asset) are coming into the business.
• Money from the bank (also an asset) is going out.

This transaction would be recorded as:

Rule 2: Debit the Receiver, Credit the Giver

This principle applies to Personal Accounts. These accounts relate to individuals, businesses, or any other entities with whom the business operates.

If a person or entity receives a benefit or value from the business, their account is debited. If a person or entity provides a benefit or value to the business, their account is credited. This rule helps track who owes the business and whom the business owes.

Consider a scenario where a local designer, “Designs by Diya,” provides services to a client, “Happy Events,” and allows them to pay later:

• Happy Events is the receiver of the design services.

Later, Designs by Diya pays its supplier, “Paper Products Co.”:

• Paper Products Co. is the receiver of the payment.
• Designs by Diya (represented by Bank/Cash) is the giver.

Focusing on the personal accounts involved:

Note: When Designs by Diya receives services/goods or cash, the giver’s personal account will be credited. For instance, if Designs by Diya took a loan from “Best Finance Ltd.”, Best Finance Ltd. would be the giver and its account would be credited.

Rule 3: Debit all Expenses and Losses, Credit all Incomes and Gains

This rule governs Nominal Accounts. These accounts cover all the financial elements that contribute to the profit or loss of a business over a period. All expenditures and financial setbacks incurred by the business are debited.

On the other hand, all earnings, revenues, and financial advantages are credited. For example, if a tailoring shop pays its monthly rent:

• Rent payment is an expense for the shop.

If the same tailoring shop earns a fee for an urgent alteration service:

• The fee earned is an income for the shop.

Here’s how this is applied:

Reasons Why We Need Accounting Rules

Now that we have defined the golden rules of accounting, let us look at the key advantages of these rules:

• Easy Maintenance of Business Records: Accounting rules provide a fixed framework for recording every financial transaction. This systematic approach means that business records are kept organised and uniform. Whether it’s tracking daily sales or yearly expenses, these rules make it simpler for businesses in India to manage their financial data, retrieve information when needed, and ensure clarity, even if different individuals handle the accounts over time.

• Effective Budgeting and Projections: When financial information is recorded based on consistent rules, it provides a reliable company performance history. Indian businesses can effectively use this accurate historical data to plan for the future. This includes creating realistic budgets by anticipating future income and expenses, and making informed financial projections to guide growth strategies and prepare for potential challenges.

• Seamless Comparison of Financial Data: Standardised accounting rules mean that financial statements are prepared using the same principles. This uniformity allows for easy comparison of a company’s financial performance over different periods, helping to identify trends. Furthermore, businesses can compare their figures with those of other companies in the same industry in India, providing valuable insights into their competitive standing.

• Improved Regulatory Compliance: Governments and regulatory bodies in India, such as the Income Tax Department and those overseeing GST, require businesses to submit financial reports. Accounting rules help ensure that these reports are prepared accurately and in the prescribed format. Adhering to these standards helps businesses meet their legal obligations, avoid penalties, and maintain a good standing with the authorities.

• Accurate Business Valuation: When a business owner in India looks to sell their business, seek investment, or merge with another company, determining their business’s correct financial worth is crucial. Accounting rules ensure that the financial statements present a true and fair view of the business’s financial position and performance. This transparency and reliability are vital for arriving at an accurate business valuation, ensuring fair deals for all parties involved.

Bookkeeping vs. Accounting: Key Differences

Sometimes, we get confused between the terms ‘bookkeeping’ and ‘accounting’. While they follow similar processes, both are quite different. Let us quickly see the key differences between the two:

Bookkeeping: Booking primarily focuses on recording and organising the business’s financial transactions. It follows a more repetitive, routine process and involves systematic recording of transactions. The bookkeeper records these transactions in journals and ledgers, offering accurate and comprehensive records of financial transactions.

Accounting: Accounting primarily focuses on analysing, interpreting, and reporting financial transactions. Unlike bookkeeping, it is more analytical and requires preparing financial statements and making important business decisions.

Furthermore, you can create business strategies, finalise budgets, and make investment decisions by analysing the financial data. Thus, accounting is vital for making strategic business decisions based on financial statements.

Conclusion

All businesses and entities must record their financial transactions, which is done by passing journal entries and, subsequently, summarised into ledgers. These journal entries are passed by adhering to the golden rules of accounting. Before applying the rules, you must identify the account type.

These processes form the building blocks of accounting and bookkeeping for all entities and are hence called the ‘Golden Rules of Accounting’. Individuals and businesses rely on these rules to accurately record their incomes, expenditures, assets, and liabilities. Understanding and following these rules ensures efficient recordkeeping for companies and entrepreneurs.

Disclaimer: This content is only for educational/ informational purposes. It does not make any recommendations to act or invest.