Golden Rules of Accounting: Meaning, Types & Examples | 5paisa (2024)

Introduction

The Indian government requires every entity to record financial information to present to all stakeholders. The most important aspect of recording financials, also called financial accounting, is bookkeeping. It has two entries; debit and credit. Golden rules of accounting are rules that ensure that bookkeeping is executed systematically.

What Are the Golden Rules of Accounting?

Golden rules of accounting are a defined set of rules that govern how entities record their financial transactions through bookkeeping within financial accounting. The golden rules of accounting are basic principles that serve as the foundation for all accounting transactions.

They help ensure that accounting records are consistent and reliable and help in making informed business decisions. One of the most important features of the modern rules of accounting is that they allow entities to identify which transaction to credit and which to debit in the accounting books.

Since entities record their financial transactions through a dual-entry accounting system, the three golden rules of accounting assist in effectively recording the transactions to depict the financials transparently. In general, there are 3 golden rules of accounting which allow entities to record their financials and comply with the respective laws set by the Indian government.

Types of Accounts

The golden rules of accounting that govern financial accounting and recording transactions have categorised three accounts. Every financial transaction recorded by an entity will belong to one of the three accounts mentioned below.

● Nominal Account
A Nominal account is a general ledger that records a business’s financial transactions, such as revenue, expenses, gains, and losses. A nominal account works on the principle of income and expenses. Under this rule, an increase in revenue or gains is credited, while a decrease is debited. On the other hand, an increase in expenses or losses is debited, while a decrease is credited.

The nominal account contains all the financial transactions for a business in a fiscal year and resets to zero at the start of the next fiscal year. Examples of nominal accounts include sales accounts, rent accounts, wages expenses, and interest accounts.

● Personal Account

A personal account is a general ledger that captures the financial transactions related to individuals, companies and associations and works on the debit and credit principle. Personal accounts are of three types.

1. Artificial Personal Account: This personal account records the financial transactions for entities that are not human beings but are separate legal entities per law. Some examples of entities that use an artificial personal account are banks, companies, hospitals, partnerships etc.

2. Natural Personal Account: A natural personal account records all the financial transactions for individuals or entities that are natural persons, such as a customer or a supplier. A natural person is an individual who has a legal identity and can enter into contracts or agreements.

3. Representative Personal Account: A representative personal account records financial transactions for an individual or entity representing another person or entity. The representative personal account tracks all transactions related to the representative's activities.

● Real Account

A real account is also a general ledger but differs as it records the financial transactions related to the assets and liabilities of a company. Real accounts are also known as permanent accounts because they are not closed at the end of an accounting period, and their balances are carried forward to the next accounting period.

The real accounts' assets section is further divided into tangible and intangible assets. Tangibles assets are the ones that have a physical existence, such as land, machinery, buildings etc., while intangible assets are virtual such as goodwill, copyrights, patents etc.

Real accounts are governed by the golden rules of real account, which states that an increase in assets is debited while a decrease in assets is credited. On the other hand, an increase in liabilities is credited, while a decrease in liabilities is debited. The balance in a real account represents the net value of the asset, liability, or equity account.

Golden Rules Of Accounting

Here is a tabular format to describe the journal entry golden rules of accounting:

The Three Golden Rules Of Accounting

Here are the three golden rules of accounting with examples.

Rule 1: Debit all expenses and losses, credit all income and gain

Example: Suppose you have purchased goods of Rs 5,000 from company XYZ. Since you have to make an expense of Rs 5,000, as per the golden rule, you will have to debit the expenditure and credit the income in the company accounts.

Rule 2: Debit the receiver, credit the giver

Example: A company, PQR buys Rs 10,000 worth of goods from company ABC. In the financial books of company PQR, the accountant will debit the company’s purchase account and credit company ABC. It is because company PQR will have to incur an expenditure of Rs 10,000 to buy the goods, which under the rule must be debited.

Rule 3: Debit what comes in, credit what goes out

Example: Suppose you have machinery for your business from a supplier to increase your production for Rs 1,00,000. Since the machinery will be coming in, the machinery account will be debited. While cash will go out for the purchase, the cash account will be credited.

Let’s consider another example.

Consider the following financial transactions:

● Suppose a company XYZ starts its business with a capital of Rs 5,00,000.
● It rents office space for Rs 30,000.
● The company buys office stationery and other goods worth Rs 2,00,000 on credit from firm PQR.
● It sells goods worth Rs 2,50,000.
● It repays firm PQR for the stationary and other goods.
● The company pays Rs 1,00,000 worth of salaries to the employees.

Take a look at how the golden rules of accounting will record the above transactions:

Benefits Of The Golden Rule Of Accounting

Following the Golden Rules of Accounting offers several benefits for individuals and organisations.

● Accurate Recording Of Transactions: Accuracy ensures that all transactions are recorded accurately. The accounts are balanced in the company accounts, reducing the risk of errors and ensuring the integrity of financial statements.

● Effective Compliance With Applicable Laws: The golden rules are based on generally accepted accounting principles (GAAP), which ensures that the financial statements comply with accounting standards and regulations. Compliance is essential for avoiding penalties and legal disputes and building stakeholder trust.

● Calculating The Valuation Of The Business: One benefit of the three rules of accounting is to analyse a business to determine its valuation. Companies can effectively determine the current business valuation when they maintain accounting books by recording every financial transaction correctly.

● Better Decision Making: Accurate and reliable financial statements help stakeholders make informed decisions about the financial health of an organisation. The decisions may include investment decisions, loans, mergers and acquisitions, and other business activities.

Fundamentals Of The Golden Rules of Accounting

The fundamentals of the golden rules of accounting are as follows:

● Futuristic Approach: The going approach principle suggests that the business will continue to operate indefinitely unless there is evidence to the contrary. The futuristic approach means that the accountant prepares the financial statements. Based on that, the business will continue to operate and meet its obligations in the foreseeable future.

● Monetary Approach: The monetary approach in accounting is a method of accounting for transactions that recognise the impact of inflation on financial reporting. Under this approach, transactions are recorded in terms of their purchasing power rather than their nominal value. The amount recorded for a transaction reflects the currency's value at the time of the transaction, adjusted for inflation.

● Pricing Approach: The approach requires businesses to record all the financial transactions in their accounting books based on the cost principle. This principle requires that assets are recorded at their original cost, regardless of their current market value. The cost principle means that the historical cost of an asset is used to determine its value in the financial statements.

● Conservatism Approach: The conservatism principle requires the accountant recording the financing transactions to be as cautious as possible. The financial transactions should be recorded based on objective evidence and not on the personal opinions or biases of the individuals involved.