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written by Abhishek | August 16, 2020

3 Golden Rules of Accounting Explained with Best Examples

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Every process has a set of rules universally applicable and followed by all. These rules are important as they are central to the core functions. Similarly, there are golden rules of accounting too. There are three golden rules of accounting, which we shall learn about in this blog. But let us first understand more about accounting. 

Accounting has been around since time immemorial and can be traced back to Mesopotamian civilizations. The father of accounting, Luca Pacioli, was the first person to talk about Double-Entry bookkeeping, a practice still in use today. The modern profession of chartered accountancy originated in Scotland in the nineteenth century. Accounting, according to Wikipedia,” is the measurement, processing, and communication of financial and non-financial information about economic entities, such as businesses and corporations”. 

That, in simple terms, translates to the recording of financial transactions systematically to keep a record of the transactions. It also requires keeping the accounts updated with the most current transaction updated, reflecting an accurate picture of an institution's current financial condition.

3 Golden Rules of Accounting

  • Rule 1 - Debit the receiver, credit the giver

  • Rule 2 - Debit what comes in, credit what goes out

  • Rule 3 - Debit all expenses and losses and credit all incomes and gains

To understand these rules, we need to take them individually and in the proper context. Let’s first understand the role of accounting in a business, to whom it applies, and find out the benefits of good accounting practices that follow these three golden accounting rules.

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.

Also Read: What is Inventory Management Software System?

Advantages of Accounting

Maintaining the accounts of financial transactions according to the golden rules of accounting gives certain advantages. 

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Evidence in Legal matters - Business matters need to be recorded systematically and filed away in an organised fashion for quick reference in legal issues.
  6. 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.
  7. 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.
  8. Valuation of business - A robust accounting process helps in proper business valuation, helping to get more investment and expand the business.
  9. Budgeting and Future Projections - A good budget based on proper accounting practices can be a strong foundation for any business to be scaled up. Future projections are more accurate with a robust accounting practice in place.

Who requires accounting?

Any business with gross receipts of more than Rs. 1.5 lakhs in the preceding three years of an existing profession must maintain a record of financial transactions, following the golden rules of accounting. According to Rule 6F of the Income Tax Act, the following professions must maintain an account of financial transactions:

  • Medical
  • Legal
  • Architectural
  • Engineering
  • Accountancy
  • Interior Decoration
  • Technical Consultation
  • Authorised Representative
  • Film Artists
  • Company Secretary

A professional is not required to maintain books of accounts as per section 44AA of the Income Tax Act if the receipts from the profession are not more than Rs. 1,50,000 in any of the preceding three years. In such a situation, the professional will have to maintain books of accounts using which an Accounts Officer can compute the taxable income.

The specified books, as per rule 6F of the Income Tax Act, are

  1. Cash Book - This book keeps a record of day-to-day cash receipts and payments, showing cash balance at the end of the day or month.
  2. Journal - It is a log of day-to-day transactions where total credits equal total debits following the double-entry accounting system and using the golden rules for accounting. Each debit will have a corresponding credit and vice versa.
  3. Ledger - A ledger is a superset of the journal listing details of all accounts and can be used to prepare various financial statements.
  4. Photocopied bills or receipts which are more than Rs.25 value.
  5. Original bills of expenses incurred by the business worth more than Rs.50.

Also Read: What is a Billing Software? - How Does It Help Small Business in Finances?

It is required that all these books should be maintained at the head office of a business. Books of each year should be kept available for scrutiny for at least 6 years. If the books mentioned are not maintained as per the rules, a penalty charge of Rs. 25000 is applicable.

If the transactions are of international nature, for every missing transaction, 2% of the value of each will be applicable. Therefore, it is prudent to follow the prescribed method of maintaining accounting books keeping track of all income and expenses. 

Now let’s get back to our golden rules of accounting as promised at the beginning of this article. When taken individually, each of those rules is simple and easy to understand, but when they are considered together, there is a bit of difficulty that creeps in. The reason is, each one of the rules applies to a different type of account. 

Let’s try to understand them one by one.

There are 3 types of accounts, Personal, Real and Nominal.

Personal Account

A personal account is a general ledger account. All accounts related to persons, whether natural persons like individuals or artificial persons like companies, fall in this category. 

In the case of a personal account, when a business receives something from another business or individual, the first business becomes the receiver, and the second business or individual from which it was received becomes the giver. 

Golden Rule 1 says, Debit the receiver, credit the giver. Applying the rule to our example, the books should reflect a debit on the personal account and a credit on the business account.

Let’s take the example of buying a gift from a gift shop. In your account, the transaction will reflect as such.

Date

Account

Debit

Credit

XXXX

Purchase Account

Rs.5000

 
 

Gift Shop

 

Rs.5000

Real Account

In a real account, the closing balance is retained and carried forward at the end of the year. These carried forward amounts then become the opening balances for the next year. These accounts usually pertain to assets, liabilities and equity.

Golden Rule 2 says, Debit what comes in, Credit what goes out. In a real account, if a business receives something of value (property or goods), it is represented in the books as debited. If something of value goes out from the business it is represented in the books as credited. An example is given below.

The example below is of a furniture purchase worth Rs. 10000 in cash.

Also Read: Digital Khata and How Khatabook Helps Businesses

Date

Account

Debit

Credit

XXXX

Furniture Account

Rs. 10000

 
 

Cash Account

 

Rs. 10000

Nominal Account

A nominal account is the type of account in which all accounting transactions are stored for one fiscal year, transferring balances to permanent accounts at the end of a fiscal year. This allows for resetting the balances to zero and starting afresh. Nominal accounts are usually related to Revenues, Expenses, Gains and Losses.

Golden Rule 3 says,Debit all expenses and losses, credit all incomes and gains.If a business incurs a loss or expense, then the books' respective entry is represented as a debit. If the business earns a profit or gains income by way of rendering services, then the entry in the book is represented as credit. An example below demonstrates this. A business pays rent for the premises it holds and is an expense for the business.

Date

Account

Debit

Credit

XXXX

Rent account

Rs.12000

 
 

Cash Account

 

Rs.12000

Conclusion

These three golden rules of accounting lay the foundation on which the accounting system is standing today. These rules standardise the representation of financial transactions across the industry. Before you apply these rules, there are a couple of guidelines you must keep in mind, which are,

  • Check to ascertain the type of account in the transaction.
  • Check whether the transaction increases or decreases the value of the account.

Keep your accounts up to date and accurate with these three golden rules of accounting.

FAQs

Q: Which rule applies to Nominal accounts?

Ans:

Debit all expenses and losses, credit all incomes and gains. Any expenses in a business are entered as debit and credited to the account which receives the funds.

Q: Which rule applies to Real accounts?

Ans:

Debit what comes in, credit what goes out. Typically, for a business account this rule says debit the account where the goods have come in, and credit the accounts used to purchase those goods and services.

Q: Which rule applies to Personal account?

Ans:

Debit the Receiver, Credit the giver, is the rule that applies to personal accounts, where the receiver is the person who receives the goods or service in return of money and giver is the entity that offers the goods or services.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.