Golden Rules of Accounting: Every economic entity is required to provide financial information to all of its stakeholders. The financial information provided must be accurate and present a true picture of the entity. And it must account for all of its transactions for this presentation.
Financial accounting encompasses more than just bookkeeping. Every transaction in accounting involves two entries – debit and credit – and it’s crucial to determine which accounts should be credited and debited. This dual entry accounting system is fundamental to accurate financial reporting.
So, learn the three accounting golden rules that will help you simplify the difficult task of recording financial transactions. Let’s go deeper.
Types of Account
- Nominal Account: A nominal account is a ledger that records a business’s income, expenses, profits, and also losses over a fiscal year. At the start of each new fiscal year, the account balance resets to zero. So the Nominal accounts include Commission Received, Salary Account, Rent Account, and Interest Account.
- Personal Account: A personal account is a ledger account that pertains to individuals, whether they are natural persons (humans) or artificial persons such as corporations, firms, and associations. For example, if Company A receives funds or credit from another firm or individual, it becomes the receiver, and the other party becomes the giver in the personal account ledger. In this case, the personal account is considered a creditor account.
- Artificial Personal Account
- Natural Personal Account
- Representative Personal Account
- Real Account: A real account is a ledger that records a company’s assets and liabilities. Assets can be tangible, which includes land, buildings, machinery, and also furniture, or intangible things, such as goodwill, patents, and copyrights. Unlike a nominal account, a real account does not close at the end of the fiscal year but is it gets carried forward to the next year. Additionally, a real account appears on a company’s balance sheet.
3 Golden Rules of Accounting
- Rule One: Debit what comes in –
- Credit what goes out. This rule applies to assets like furniture, land, buildings, and machinery that have a negative balance by default. When you receive something valuable, like money or a new piece of equipment, debit it in your account to increase your balance. When you pay for something, like a bill or a purchase, credit it in your account to decrease your balance.
- Rule Two: Credit the giver and Debit the receiver.
- This rule applies to personal accounts, such as accounts for customers, suppliers, or employees. When someone gives you something, like a payment or a gift, credit their account to show an increase in their balance. When you receive something, like a payment or a refund, debit your account to show an increase in your balance.
- Rule Three: Credit all income and Debit all expenses.
- This rule applies to nominal accounts, which include all income and expense accounts. When you earn money, credit it to increase your capital, which represents the total value of your business. When you spend money, debit it to decrease your capital, as expenses decrease your overall value.
Debits and credits are two types of entries in your accounting records that must always be equal in value but opposite in direction. They affect five key types of accounts that every business should keep track of:
- Assets: These are things your business owns that have economic value, like land, equipment, cash, or vehicles. Debits increase the value of your assets, while credits decrease it.
- Expenses: These are the costs you incur while running your business, like wages, supplies, or rent. Debits increase your expenses, while credits decrease them.
- Liabilities: These are the amounts of money you owe to other people or businesses, like accounts payable or loans. Debits decrease your liabilities, while credits increase them.
- Equity: This is the value of your assets minus your liabilities. Debits decrease your equity, while credits increase it.
- Income and Revenue: These are the cash inflows your business earns from sales or services provided. Debits decrease your income and revenue, while credits increase them.
Golden Rules of Accounting Benefits
- Proper record-keeping Maintaining accurate and organized records is crucial for the success of any company. Adhering to the golden rules ensures that financial records are properly recorded, stored, and easily accessible when needed.
- Comparing financial results By following the golden rules, businesses can compare their financial results from one year to another in a more efficient and accurate manner.
- Valuation of the business Proper calculation of financial statements can aid in the correct valuation of a business. This can help attract more investments and support the company’s expansion.
- Budgeting and future projections Sound budgeting practices based on proper accounting can provide a strong foundation for growth and assist in making more accurate future projections.
- Legal evidence When it comes to legal cases, businesses need to present their financial data systematically. The use of accounting golden rules can be beneficial in this regard.
- Tax compliance Following proper accounting practices can help businesses avoid shortfalls in taxes and prevent penalties. Failure to comply with tax regulations can also negatively impact a company’s reputation.
- Regulatory compliance Adhering to the golden rules of accounting is essential for complying with regulatory authorities. Without proper accounting discipline, it can be difficult for businesses to meet regulatory standards.