What Are the Three Golden Rules of Accounting? Explained with examples

Financial accounting includes more than just bookkeeping. In accounting, every transaction consists of two entries: debit and credit. Knowing which accounts should be credited and which should be charged is vital. The double entry accounting system is used here. The three golden rules of accounts are the rules that regulate accounting information. These rules of accounting allow for the systematic documenting of financial transactions. They simplify sophisticated bookkeeping operations into a set of ideas that may be commonly comprehended, studied, and applied.

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.

What Are the 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: Four Objectives of Accounting with Significant Examples

Bookkeeping is founded on journal entry golden rules of accounting. These golden rules require you to determine the kind of account for each transaction. Each account type has its regulations that must be followed for each transaction. The three golden accounting rules are as follows:

Real Account

A real account is a general ledger account that records all asset and liability transactions. It consists of both actual and intangible assets. Tangible assets include furniture, land, buildings, machinery, etc. On the other hand, intangible assets include goodwill, copyright, patents, etc.

Because in a real account, the governing rule is carried over to the next fiscal year, they are not closed after the fiscal year. In addition, an accurate report shows on the balance sheet. A form of real account rule is furniture accounts.

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

For existing accounts, this regulation is applicable. Accurate versions contain furniture, land, buildings, machines, etc. They have a debit balance by default. They are debiting what is coming to increase the current account's balance. The following is an example of a cash purchase of ₹20,000 for furniture.

Personal Account

A general ledger account for people is referred to as a personal account. It can be natural persons such as humans or artificial persons such as corporations, enterprises, associations, etc. Company “A” becomes the receiver when it gets money or credit from another firm or individual. In the event of a personal account rule, the other business or individual who contributes it becomes the giver. A personal account is a creditor account.

Rule 2: Credit the Giver and Debit the Receiver

It is a personal account rule. When someone, genuine or made up, provides something to the organisation, it counts as an inflow, and the donor needs to be acknowledged in the records. The receiver must, however, be credited. Consider the purchase of a present from a gift shop. The transaction will be shown in your account.

Also Read: Inflation Accounting: Definition, Methods, Features, Pros & Cons

Nominal Account

A nominal account is a general ledger account used to track the revenue, expenses, profits, and losses. It keeps track of every transaction for a specific fiscal year. The balances are thus reset to zero, and the procedure may start over. Interest accrues on nominal accounts.

Rule 3: Credit All Income and Gains; Debit All Expenses and Losses

Nominal accounts are covered under this rule. Capital is a company's responsibility. It consequently has a credit balance. The capital will rise if all earnings and gains are credited. Conversely, when losses and costs are debited, the capital decreases. This is demonstrated in the example below. A business pays rent for the premises it occupies, which is an expenditure for the company.

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.

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.

Also Read: Amazing Guide to Branches of Accounting: Functions and Usage

Golden Rules of Recognising Accounting Principles

These centre around two accounting principles, debit and credit, and are sometimes called "golden rules of accounting." Both sides in a double-entry accounting system are impacted equally and differently.

A credit entry is made on the right side of an account, whereas a debit entry is made on the left. In the former, funds for assets or expenses rise while revenues, liabilities, and equity fall. Contrarily, credits represent the exact opposite: a drop in an asset or cost account and a gain in the payment, weakness, and equity accounts.

Exploring the many sorts of accounts that serve as the cornerstone of these guiding principles is essential before discussing accounting regulations in more detail. Real accounts, personal accounts, and nominal accounts fall under this category. A general ledger account called a "real account" contains information on assets and liabilities. These accounts are carried forward and do not finish out the year. A type of real account is a bank account.

The personal account, which serves as a private repository for people, businesses, and other associations, comes next. An illustration of this kind of account is a creditor account. On the other hand, the historical form of performance is a nominal account, and it involves keeping track of all earnings, profits, losses, and outlays.

Fundamental Accounting Principles' Golden Rules

The following are the essential accounting principles:

• The Monetary Unit

Accounting cannot account for things in the same way as bartering can since all values must be recorded in terms of a single monetary unit. It becomes difficult to assign values to goods and items since they are inherently subjective. Conversely, accounting has rules in place to address the scenario.

• Concerning The Future

A company is thought to exist indefinitely. Because it does not die naturally, the only way to end it after it has been established is to split it. As a result, accountants employ the idea of a going concern. This idea implies that the firm will continue as usual until the end of the next accounting period and that no contrary information exists. Because of the going concern concept, businesses can operate on credit, account for receivables and payables that they expect to receive or pay in the future, and charge depreciation if the machine will be utilised for many years.

Standard accounting is discontinued if management learns that activities will be suspended shortly. A unique sort of accounting is employed for dissolution purposes.

• Conservatism Principle

Accountants are supposed to be naturally cautious. They want to hope for the best while bracing themselves for the worst. This is reflected in the norms they have established for their profession. The notion of conservatism is a critical element of accounting. When there is uncertainty regarding the number of planned inflow number flows, the organisation must specify the lowest possible revenue and the most significant potential expenses according to this concept.

This is demonstrated by accountants valuing inventory at a lesser cost or market price. However, such prudence aids the company's readiness for future financial difficulties.

• Pricing Principle

The cost concept is closely tied to the conservative principle. According to the cost principle, businesses should report all costs on their financial accounts. In general, things like land, buildings, gold, etc., increase in value. The accountants, however, won't permit this appreciation to appear on the company's financial records until it has been realised.

Accountants believe that anything's market value is only a subjective judgement. There are so many distinct views that it is impossible for accountants to account for them all. It is a truth since something has been purchased, and the selling price can be verified. As a result, the cost principle and facts are the foundation of accounting.

Also Read: Understanding Important Concepts Of Computerized Accounting

Conclusion

All transactions of an entity must be recorded and reported. The entity must submit journal entries to account for these transactions, which will be summarised in ledgers. The golden rules of accounting are employed to pass the journal entries. To apply these rules, one must first identify the type of account.

These are the foundation of accounting and have earned the title "Golden Rules of Accounting." They resemble the letters of the English alphabet. Without knowing the letters, one cannot construct words and, as a result, cannot use the language. In the same way, failing to follow the golden accounting golden rules might hinder one from passing journal entries and, as a result, appropriately documenting transactions.

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