The three golden rules of accounting are the basis of accounting and bookkeeping. Accounting rules simplify the complex rules of bookkeeping. These rules are crucial in bringing uniformity in the field of accounting.
In this article, we will be learning the 3 golden rules of accounting. We will discuss the definition as well as the purpose of these accounting rules.
Table of Contents
- Requirement for 3 Golden Rules of Accounting
- Types of accounts
- Three Golden Rules of Accounting
- Accounting Rules with Examples
Need for 3 Golden Rules of Accounting
The three golden rules of accounting are the basis of accounting and bookkeeping. These are the set of guidelines followed by accountants for systematically recording financial transactions. Accounting rules simplify the complex rules of bookkeeping. These rules bring uniformity to the field of accounting.
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Types of Accounts
There are three different accounts for which there are 3 golden accounting rules. Let us first understand these accounts to interpret how these rules are related to these accounts.
1. Nominal account
It is a general ledger that records accounting transactions for a period of one fiscal year. Salary account, rent account and interest account are the different types of nominal accounts. Once this year ends, the balance in the nominal account is transferred to a permanent account. The outcome of a nominal account is profit or loss which gets transferred to a capital account.
These balances may be transferred into the income summary amount or directly into a retained earnings account. This resets the balance to zero in the nominal account so that they can accept new transactions for the new fiscal year. Cost of goods sold, loss on asset sale, and sale of services are examples of transactions stored in nominal accounts.
2. Real account
A real account is also known as the general ledger that appears on the balance sheet of the company. A real account is a type of account that contains transactions associated with the assets and liabilities of the company. This account does not close on the completion of a financial year and is carried forward to the next fiscal year.
This rolled-over amount becomes the opening balance in the next period. These accounts are not listed in the income statement and are instead moved to retained earnings at the end of a fiscal year.
As we know that retained earnings is a real account, and balances in nominal accounts are shifted into real accounts. Cash, fixed assets, accounts payable and receivable, and retained earnings are the type of real accounts. A real account is of the following two types:
- Tangible real accounts: These accounts record those assets that have a physical presence such as cash accounts, inventory accounts, and stationary accounts.
- Intangible real accounts: These accounts record those assets that do not have any physical existence but can be measured monetarily. Trademarks, copyright, goodwill, and patent are types of intangible real accounts.
3. Personal account
It is a general ledger that is used by individuals, associations of firms, and companies. This account is further divided into three subcategories, including artificial personal account, natural personal account, and representative personal account.
- Natural personal account: These are human beings, and any account belonging to them comes under this head. It may be a creditor, debtor, capital, or drawings account.
- Artificial personal account: These accounts belong to those entities that act as separate legal bodies as per the law. These can enter into legal agreements as well. Government bodies, cooperatives, partnerships, and companies are examples of such personal accounts.
- Representative personal account: These accounts represent both actual and artificial persons. This happens in the case of expenses that are pre-paid or outstanding or when income becomes accrued. Prepaid rent accounts or unearned brokerage accounts are examples of such personal accounts.
What are the 3 Golden Rules of Accounting?
Let us now learn about these 3 golden accounting rules with examples. We will also discuss how these rules are related to the above-discussed accounts.
1. ‘Debit all expenses and losses; Credit all incomes and gains’
This golden accounting rule is applicable to nominal accounts. It considers the company’s capital as a liability and, as a result, has a credit balance. Whenever the entire income and gains are credited, it will increase the capital of the company. When losses and expenses are debited, the capital reduces.
2. ‘Debit the receiver, Credit the Giver’
This is the second golden rule in accounting that is applicable to personal accounts. Whenever a natural or artificial entity makes a donation to the company, it turns into an inflow. In such a case, the receiver must be debited, whereas the entity that receives this donation is credited in the books.
3. ‘Debit what comes in, Credit what goes out’
This accounting rule is applicable to tangible real accounts. By default, these have to debit balance and they debit everything that comes in. This ultimately adds them to the existing account balance. Whenever a tangible asset is disassociated from the company, then the account balance must be credited.
Understanding Rules of Accounting With Example
We have discussed the definition of each account. Now, let us consider an example to identify accounts associated with different types of transactions.
Suppose company A starts operating a business with 5 lakh rupees. To operate this business, they rent a property whose per month rent is 1,00,000 rupees. The inventory is purchased for 2,00,000 rupees on credit from company B. The goods are sold for 2,50,000 rupees. The company A pays cash (50,000 rupees) for goods that are purchased from Company B. Company A also pays salaries amounting to rupees 1,50,000.
Let us go through each transaction in detail:
- Since cash is a tangible asset, it belongs to the tangible real account. However, capital belongs to a personal account. Here, rules of real and personal accounts will be applicable in parts. In this case, we will debit what comes in and credit the giver. Hence, cash account gets debited and capital gets credited with ₹ 5,00,000.
- Since rent is an expense, it belongs to nominal account while cash is tangible real account. Due to these two accounts, two rules of nominal and real accounts will be applicable over here. Here, we will debit all losses and expenses while we will credit what goes out. In this case, rent account will be debited whereas cash account will be credited with ₹ 1,00,000.
- Since the purchase of goods is an expense, it belongs to nominal account. Thus, a part of rule 1 will be applicable (Debit all expenses and losses). Since this purchase is made on credit from company B, it belongs to the personal account of the company. Hence, a part of rule number 2 will be applicable (Credit the Giver). Therefore, in this case, purchase account of company A will be debited, whereas company B’s account will be credited with ₹ 2,00,000.
- When company A sells these goods, it generates income due to which it belongs to a nominal account (sales account). Due to this, a part of golden accounting rule number 1 will be applicable (Credit all income and gains). Since cash belongs to tangible real account, here we will be applying the third accounting rule (debit what comes in). In this case, the cash account will be debited, whereas the sales account will be credited with ₹ 2,50,000.
- When company A purchases goods from Company B for cash, here the personal account of company B is included. Here, golden rule of accounting number 2 will be partially applicable (Debit the receiver). Cash belongs to tangible real assets, hence part of accounting rule number 3 will be applicable (Credit what goes out). Hence, account of company B will be debited and cash account will be credited with ₹ 50,000
|Types of Accounts
|Capital of ₹ 5,00,000
|Cash and Capital account
|Real and Personal Account
|₹ 1,00,000 as rent
|Cash and Rent account
|Nominal and Real Account
|Purchase of goods worth ₹ 2,00,000 on credit
|Purchases account and the account of Company B
|Nominal and Personal Account
|Sold goods for ₹ 2,50,000
|Cash and Sales A/c
|Real and Nominal Account
|Pays cash for goods to Company B
|Company B’s and Cash A/c
|Personal and Real Account
|₹ 1,50,000 as salary
|Salary and Cash A/c
|Nominal and Real Account
Hope that through this article, you have been able to understand the three golden rules of accounting in detail. Do remember that transactions belong to one of these three accounts. Based on accounting rules, you can associate the type of accounts with them and understand which account gets credited or debited.
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