What are the three Golden Rules of Accounting?

The Golden Rules Of Accounting

Accounting, often referred to as the "language of business" measures, processes and communicates the results of an organization's economic activities to its users, which include investors, creditors, management and other stakeholders. Accounting today is much more than book-keeping as it is responsible for the overall analyzing, summarizing and reporting of financial data.

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In order to understand how transactions are recorded in a business, we must first understand some important terms:

Debit and Credit: Debit and credit are considered the two main pillars and alphabets of accounting. While recording transactions in a T-Shaped account, all debits are listed on the left-hand side and all credits, on the right-hand side.

Double Entry System: Each transaction in accountancy affects a minimum of two accounts, out of which, one will be debited and the other will be credited. The total of debit and credit amounts will be the same. This standard accounting method involving each transaction in a minimum of two accounts is called double entry system.

Approaches to Accounting

There are two approaches through which a business can record its transactions. These are:

A. TRADITIONAL APPROACH

Also known as the Universal or British Approach, this approach follows the concept of debit and credit in order to classify its accounts. Herein, there are 3 golden rules to record transactions. These 3 rules are for 3 respective types of accounts. These accounts are broadly classified into personal and impersonal accounts.

What are the three types of Accounts?

1. Personal Accounts

Personal accounts are the accounts which are related to the person. These accounts are individual accounts, firm's accounts and company's accounts. Personal accounts are classified into:

a. Natural Personal Accounts - E.g. Ram A/c, Shyam A/c etc.

b. Artificial Personal Accounts - E.g. Ram Ltd., M/S Shyam and Sons etc.

c. Representative Personal Accounts - Wages Outstanding A/c, Prepaid Rent A/c etc.

2. Impersonal Accounts

a. Real Accounts

Real accounts include the assets, liabilities, and equity accounts of the organization. They are referred to as "permanent accounts" since their opening balance is brought forward from the previous year. These accounts are further classified into:

i. Tangible Real Accounts - E.g. Plant A/c, Machinery A/c
ii. Intangible Real Accounts - E.g. Goodwill A/c, Patent A/c

b. Nominal Accounts

Nominal accounts are the accounts relating to the income, losses, expenses and gains of the business. These are often referred to as the "non-permanent accounts" since they have zero balance at the end of the accounting year. Their balance is settled off and transferred to Trading and Profit & Loss A/c. These accounts are further classified into:

i. Incomes - E.g. Sale of goods
ii. Expenses - E.g. Payment of salary
iii. Gains - E.g. Gain from sale of machinery
iv. Losses - E.g. Loss from sale of furniture

The first and foremost task to record a transaction is to identify the type of accounts involved in that particular transaction. As discussed, each transaction will affect a minimum of two accounts.

Examples of transactions and the types of accounts affected

3 Golden Rules for accounting of transactions under the Traditional Approach

The next step is to record the aforementioned transactions in the books of accounts. For this purpose, we follow the 3 golden rules of accounting in the traditional approach:

Rule 1 - For Real Accounts

Debit what comes into the business
Credit what goes out from the business

Rule 2 - For Personal Accounts

Debit the Receiver
Credit the Giver

Rule 3 - For Nominal Accounts

Debit the expenses and losses of business
Credit the incomes and gains of business

Applying the golden rules of accounting to the aforementioned transactions:

Golden Rules of Accounting with Examples

Transaction 1: Paid Rs. 5000 cash as salary to employee

Types of accounts identified: Real and Nominal

Rule for Real Account: Debit what comes into the business

Credit what goes out from the business

Rule for Nominal Account: Debit the expenses and losses of business

Credit the incomes and gains of business

Since cash is going out of the business, Cash A/c will be credited
Since Salary is the expense of a business, Salary A/c will be debited

So, the entry will be:

Transaction 3: Purchased goods worth Rs. 50,000 from ABC Ltd. on credit

Types of accounts identified: Personal and Nominal

Rule for Personal Account: Debit the Receiver
Credit the Giver

Rule for Nominal Account: Debit the expenses and losses of business

Credit the incomes and gains of business

Since ABC Ltd. is the giver, ABC Ltd. A/c will be credited
Since Purchases are the expenses of a business, Purchases A/c will be debited

So, the entry will be:

B. MODERN APPROACH

The modern approach to record transactions uses the Accounting Equation to classify different transactions. Under this approach, the accounts are classified into Assets, Liabilities, Capital, Revenue and Expenses. The rules followed under this approach are:

Conclusion

The resultant transaction under both the approaches will be the same. Let us take a transaction to check this point:

Transaction 2: Deposited Rs. 2000 in HDFC Bank A/c

Under Traditional Approach:

Rule 1 - For Real Accounts

Debit what comes into the business
Credit what goes out from the business

Thus, Bank A/c will be debited, and Cash A/c will be credited.

Under Modern Approach

Type of Account - Assets Accounts
Amount of account increasing will be debited
Amount of account decreasing will be credited

Since, Bank A/c is increasing, it will be debited
Cash A/c is decreasing, it will be credited.

Resultant entry in both cases: