Sharekhan Blog

Rules of Accounting Explained

  • Apr 18, 2024

Every transaction in accounting has two entries: debit and credit. This dual-entry accounting system is critical when one attempts to determine which accounts are to be credited and which are to be debited.

The 3 golden rules of accounts govern financial accounting, ensuring the organisation of financial transactions and bringing uniformity to the process. These rules simplify complex bookkeeping, making accounting concepts easier to study and apply.

The accounting golden rules are a set of three principles that allow one to simplify the complex rules of bookkeeping.

Types of Accounts

Accounting's golden rules aid in documenting the transactions in ledgers. These golden guidelines differ depending on the type of account. Every transaction comprising a debit and a credit entry will belong to one of the three types of accounts illustrated below.

1.Nominal Account

A nominal account is a general ledger account consisting of the transactions of a business like expenses, incomes, profits and losses. It contains all the transactions that occur in one financial year. Furthermore, it resets to zero and restarts when the next financial year begins.

Examples of nominal accounts are Commission Received, Salary Account, Rent Account and Interest Account.

2.Real Account

A real account is a general ledger account that does not close at the end of the accounting year. In other words, the balances in the real accounts are carried over to become the beginning balances of the next accounting period. In addition, a real account is shown on the balance sheet. Real accounts are also referred to as permanent accounts. It contains the record of all the assets and liabilities.

Examples of real accounts are tangible assets that include furniture, land, buildings, machinery, etc. and intangible assets such as goodwill, copyrights, patents, etc.

3.Personal Account

A personal account is a ledger account that pertains to individuals. Corporations, firms, associations, etc, can own these. Company A is the receiver when it gets funds or credit from another firm or individual. In the event of a personal account, the contributor becomes the giver. A personal account is a creditor account.

Example: Payment of salary to employees.

What are the Golden Rules of Accounting?

There are 3 rules for accounting known as The Golden Rules of Accounting. Understanding what is golden rules of accounting is essential for any individual studying or working in the field of accounting.

1.Rule One- "Debit what comes in - credit what goes out."

This rule is applied to real accounts where we consider tangible assets like machinery, buildings, land, furniture, etc. They debit everything that comes in (by default), adding them to the existing account balance. Similarly, the account balance needs to be credited when a tangible asset leaves the company.   

2. Rule Two- "Credit the giver and Debit the Receiver."

It is a rule for personal accounts. When someone contributes to a business, it counts as an inflow, and the giver must be noted in the records. However, the receiver must be acknowledged. For example, your account will be updated to reflect the transaction when you purchase something from a shop.

3. Rule Three- "Credit all income and debit all expenses."

This rule is applicable to nominal accounts. Here, the capital of a company is an obligation and has a credit balance. This capital rises on adding all the income and profits. On the contrary, it decreases on debiting all the losses and expenditures.

Benefits of Accounting Procedures

The Golden Rules of Accounting provides numerous benefits. Several of them are as under:

1.Financial Position

Accounting represents the financial position of a particular or group of businesses. The financial performance of the company in the last year is often useful to compare the performance of the other firms.

2. Assistance to Manager

An account renders the essential data to the managers in the form of a balance sheet and profit & loss account that benefits decision-making.

3.Replaces Memory

Accounting in a systematic and timely manner records all the transactions of an individual/firm. If one requires the information in the future, they can easily obtain the information in books of accounting.

4.Benefits in Comparison

The format of accounting for different businesses is the same, so one can efficiently compare their business performance with the performance of other organisations. One can also compare their performance with the performance rendered last year.

5.Benefits in Calculation of Tax Liabilities

The profit & loss account presents the current year's profit so that the individual/firm can effortlessly calculate the tax liability.

The Bottom Line

The 3 Golden Rules of Accounts, comprising debit and credit principles, streamline financial transactions and categorise accounts into nominal, real, and personal types. These rules guide the recording process, facilitating accurate financial reporting. Accounting procedures benefit businesses by providing insights into financial positions, aiding decision-making, preserving transaction records, facilitating comparison, and simplifying tax calculations.

Team Sharekhan
by Team Sharekhan

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