Financial accounting is more than just book-keeping. In accounting, every transaction has a dual entry – debit and credit. It is important to identify which account has to be credited and which one debited. This is the dual entry system of accounting. Financial accounting revolves around three rules, known as the golden rules of accounting. These golden rules ensure systematic recording of financial transactions. The golden rules simplify the complex book-keeping rules into a set of principles that are easily understood, studied, and applied.
Types of Accounts
The golden rules of accounting help in documenting the financial transactions in ledgers. These golden rules are based on the type of account. Each transaction will have a debit and credit entry and belong to one of the following three types of accounts.
- Real Account
- Personal Account
- Nominal Account
Real Account
A real account is a general ledger account that reflects all the transactions relating to assets and liabilities. It comprises tangible and intangible assets. Tangible assets such as furniture, land, building, machinery, etc. On the other hand, intangible assets such as goodwill, copyright, patents, etc.
Real accounts are carried forward to the following year, therefore, are not closed at the end of the financial year. Furthermore, a real account appears in the balance sheet. A furniture account is a type of real account.
Personal Account
A personal account is a general ledger account relating to persons. It can be natural persons like individuals or artificial persons like companies, firms, associations, etc. When company A receives money or credit from another business or individual, company A becomes the receiver. And, the other business or individual who gives it becomes the giver, in the case of a personal account. A creditor account is a type of personal account.
Nominal Account
A nominal account is a general ledger account relating to all business income, expenses, profit and losses. It accounts for all transactions pertaining to one fiscal year. As a result, the balances are reset to zero and can start afresh. An interest account is a type of nominal account.
3 Golden Rules of Accounting
Golden rules of account form the basis for bookkeeping. As per the golden rules of accounting, you must ascertain the type of account for each transaction. Each type of account has its own set of rules that needs to be applied for each transaction. Following are the three golden rules of accounting:
Rule 1: Debit What Comes In, Credit What Goes Out.
This rule applies to real accounts. Furniture, land, buildings, machinery, etc., are included in real accounts. By default, they have a debit balance. As a result, debiting what is coming in adds to the existing account balance. Similarly, when a tangible asset leaves the firm, crediting what goes out reduces the account balance.
Rule 2: Debit the Receiver, Credit the Giver.
This rule applies to personal accounts. When a real or artificial person donates something to the organisation, it becomes an inflow, and the person must be credited in the books. Conversely, the receiver must be debited.
Rule 3: Debit All Expenses and Losses, Credit all Incomes and Gains.
This rule applies to nominal accounts. A company’s capital is its liability. As a result, it has a credit balance. Crediting all the income and gains will increase the capital. On the other hand, the capital reduces when expenses and losses are debited.
| Golden Rules of Accounting | Real Account | Personal Account | Nominal Account |
|---|---|---|---|
| Debit | What comes in | The receiver | All expenses and losses |
| Credit | What goes out | The giver | All incomes and gains |
Example
Let’s understand the nature of the golden rules and the accounts with the help of an example. Following are the list of transactions:
- Company ABC starts its business with a capital of AED 1,00,000.
- Rents a property worth AED 25,000.
- Purchases goods worth AED 50,000 on credit from Company XYZ.
- Sells goods worth AED 75,000.
- Pays cash for goods purchased from Company XYZ.
- Pays salary worth AED 50,000 to employees.
Firstly, let us identify the different accounts involved and the types of accounts for each of the transactions:
| Transactions | Accounts Involved | Type of Accounts |
|---|---|---|
| Capital of AED 1,00,000 | Cash A/c; Capital A/c | Real Account; Personal Account |
| Rent worth AED 25,000 | Rent A/c; Cash A/c | Nominal Account; Real Account |
| Purchases goods worth AED 50,000 on credit from Company Y | Purchases A/c; Company Y A/c | Nominal Account; Personal Account |
| Sells goods worth AED 75,000 | Cash A/c; Sales A/c | Real Account; Nominal Account |
| Pays cash for goods purchased from Company Y | Company Y A/c; Cash A/c | Personal Account; Real Account |
| Pays salary worth AED 50,000 to employees | Salary A/c; Cash A/c | Nominal Account; Real Account |
Conclusion
Golden rules of accounting lay the foundation for preparing financial accounts. The company must record every transaction. Each transaction is recorded as a journal entry and then as a ledger. You should ascertain the account each transaction belongs to and then do journal entries based on the three golden rules. Therefore, it is a must to know the golden rules of accounting for the purpose of bookkeeping.
