The golden rules of accounting are based on the traditional classification of accounts i.e personal, real and nominal accounts. It simplifies the rules of debit and credit of the double-entry system.
Golden rules of accountingTo understand the golden rules of accounting clearly, we must know first, “What is Account and its type?”
Account Definition:Accounts are the basic storage units for accounting data. We use them to accumulate amounts from similar transactions. An accounting system has a separate account for each asset, each liability, and each component of owner’s equity, including revenues and expenses. In manual accounting, An account is created in the general ledger in a T shape which has a left‐hand side, called the debit side, and a right‐hand side called the credit side. An account is debited when an amount is entered on the left‐hand side and credited when an amount is entered on the right‐hand side. In accounting, we use accounts to record all the financial transactions and events. The transactions and events are recorded in the accounts on the basis of the rules of debit and credit only. Debit and Credit are important concepts of the double-entry system of accounting. The double-entry system of accounting follows two rules:
- Every transaction affects at least two accounts.
- Total debits must equal total credits.
Traditional Classification of Accounts:In the traditional approach for recording transactions, there are three types of accounts that have two rules for each type of account, one related to Debit and one related to Credit for recording the transactions which are termed as golden rules of accounting. In the double-entry system, each transaction must be recorded with at least one debit and one credit, and the total amount of the debits must equal the total amount of the credits. All accounting systems, no matter how sophisticated, are based on the principle of duality. The types of accounts for application of golden rules of accounting are :
- Personal Accounts,
- Real Accounts and
- Nominal Accounts.
Personal Accounts:Accounts that deals with persons, i.e. human beings and artificial judicial persons such as companies, government organizations, HUF, etc. Personal Accounts are classified into: (a) Natural Personal Accounts:- All personal accounts that are concerned with natural human beings are called natural personal accounts. It includes Accounts of individuals, debtors, creditors, proprietor, etc. (b) Artificial Personal Accounts:- All the entities which have a separate legal identity in the eye of the law are covered under this category. Therefore, the accounts of clubs, charitable trust, company, bank, etc are artificial personal accounts. (c) Representative Personal Accounts:- These are not in the name of any person or entity but they represent a person or group of persons. Examples of these accounts are :
- Capital Account
- Drawing Account
- Accounts payable
- Accounts receivable
- Tax payable
- Tax receivable
- Outstanding expenses
Golden Rules for Personal Accounts:
- Debit the Receiver. Write on the left side of an Account which represents a person, if that person receives money from the business.
- Credit the Giver. Write on the Right side of an Account which represents a person, if that person gives money to the business.
Real Accounts:Assets are the resources that a business owns and that can be usefully expressed in monetary terms. Assets are items of value used by the business in its operations. For example; Machinery, Vehicles, Land & building, Equipment, etc are assets that are used by the business in its operations. Hence, assets provide economic benefits to the business. All assets except personal accounts, which are tangible or intangible, fall under the category “Real Accounts“. Tangible real accounts are related to things that can be touched and felt physically. Few examples of tangible real accounts are
- office equipment
Golden Rules for Real Accounts:
- Debit what comes in. Write on the left side of a Real A/c, if an asset comes into the business.
- Credit what goes out. Write on the right side of a Real A/c, if an asset goes out of business.
Nominal Account:Those accounts which are associated with income, gains, losses or expenses are known as Nominal Account. The net result of all nominal accounts is reflected as a profit or loss which is transferred to capital account. Here are some examples of nominal accounts: Income & Gains Accounts:
- Sales account
- Interest earned
- Commission earned
- Profit on sale of investment
- Purchase account
- Rent account
- Wages & salary
- Office expense
- Printing and stationary
- Loss on sale of fixed asset
Golden Rules for Nominal Accounts:
- Debit all expenses & losses. Write on the left side of an account, which represents an expense/loss.
- Credit all incomes & gains. Write on the right side of an account, which represents an income/gain.
Modern Classification of Accounts:Under the traditional classifications, accounts are divided into three categories i.e. Real, nominal and personal accounts. But in the modern classification of accounts, all accounts are divided into five categories for the purposes of recording the transactions:
Modern Rules of Debit & CreditOn the above modern classification of accounts, We apply the following golden rules of accounting as mentioned below:
Asset Account:Assets are the economic resources that a company owns. Assets are used by the company in its operations to generate sales and profits. An account receivable is an example of an asset account. Accounts receivable are amounts owed to an entity by customers to whom the entity has provided goods or services on credit. The Accounts Receivable account is often called the Trade Debtors account or simply Debtors. Other examples of asset accounts;
- Cash at bank
- land & buildings
- Increase in asset is debited. All the transactions which increase the balance of Assets i.e. Purchase of Fixed Assets, Investments, etc. are entered on the left side of the respective asset account.
- Decrease in asset is credited. All the transactions which decrease the balance of Assets i.e. Sale of Fixed Assets, Investments, etc. are entered on the right side of the respective asset account.
Expense/Loss Account:For recording changes in Expense/Losses, the following rules are applied:
- Increase in expenses/losses is debited. All the transactions which increase the expenses i.e. incurring Salary, Rent, Interest, and Other Expenses are entered on the left side of the respective expense or loss account.
- Decrease in expenses/losses is credited. The transactions which decrease the expenses i.e. reimbursement of expenditure by way of grants, etc are entered on the right side of the respective expense or loss account.
Liability Account:Liabilities are obligations or debts that an enterprise has to pay at some time in the future. an account payable is an example of a liability account. An account payable is an obligation to pay an amount to an outside party (a creditor) for the purchase of goods, supplies or services on credit. The account payable is also commonly called Trade Creditors or simply Creditors. Other examples of liability accounts;
- Account receivable
- Interest Payable
- Income Taxes Payable
- Advances from Customers
- Increase in liabilities is credited. The transactions which increase liabilities i.e. Purchase of goods on credit, taking fresh loans, etc are entered on the right side of the respective liability account.
- Decrease in liabilities is debited. The transactions which decrease liabilities i.e. Payment to Creditors, repayment of Loans taken, etc are entered on the left side of the respective liability account.
Capital Account:Amount invested by the owner in the business is known as capital. It may be brought in the form of cash or assets by the owner for the business entity. Capital is an obligation and a claim on the assets of the business because the owner of the business is considered a separate entity for accounting purposes. It is, therefore, shown as capital on the liabilities side of the balance sheet. For recording changes in Capital, the following rules are applied:
- Increase in capital is credited. The transactions which increase capital or equity i.e. Introduction of fresh Capital etc are entered on the right side of the respective capital or equity account.
- Decrease in capital is debited. The transactions which decrease capital or equity i.e. withdrawal of Capital by Proprietor, Partners, etc are entered on the left side of the respective capital or equity account.
Revenue/Gain Account:For recording changes in Revenue/Gains, the following rules are applied:
- Increase in revenue/gain is credited. The transactions which increase revenue or gain i.e. Sale of goods, Interest, Rent, Dividends, Discount earned, etc are entered on the right side of the respective revenue or gain account.
- Decrease in revenue/gain is debited. The transactions which decrease revenue or gain i.e. Sales Returns, etc are entered on the left side of the respective revenue or gain account.