Rules are basic guides that are universally applicable and followed by all for the smooth execution of business activities. Every rule is important as it forms the strength of a business or an event, dictating how things should be done. Just as there are rules for every process, there are golden rules of accounting too.
Note that every economic entity must make its financial information available to all of its stakeholders, and this information must be accurate and present the true picture of the business. Also, the presentation of the financial information must account for all transactions carried out, and there has to be uniformity in accounting.
The “three golden rules of accounting,” which are the most famous and commonly used terms in the field of accounting and finance, are used. These accounting rules are useful in the preparation of journal entries, which then form the basis of accounting and bookkeeping. The three accounting golden rules are also known as the traditional rules of accounting or the rules of debit and credit.
Understanding Debits And Credits
It is a popular saying that the world of accounting is ruled by debits and credits, and so, before delving into the accounting three golden rules, it is important you understand the attachments to debits and credits.
The debit and credit sides in an accounting book are equal but opposite entries and they affect the five core entries in an accounting book, which are:
- Assets: Resources owned by a company that can be converted into cash due to their economic value, such as land, equipment, cash, and vehicles.
- Expenses: The costs incurred during the course of business operations, such as wages and supplies.
- Liabilities: The total amount owed to another person or business, such as accounts payable.
- Equity: The assets minus the liabilities.
- Income and Revenue: The money made from sales.
Recall that debits are entries made on the left side of an account and increase an asset or expense account and decrease equity, liability, or revenue accounts. Meanwhile, credits are entries made on the right side of an account. The credits increase equity, liability, and revenue accounts and decrease asset and expense accounts. The debit and credit of all transactions must be recorded.
In addition, the 3 golden accounting rules revolve around debits and credits, and they are the backbones of the three types of accounts.
Types Of Accounts
To get a clearer understanding of the golden rules of accounting, the types of accounts in finance must first be well digested. These accounts apply to all the types of general ledgers; that is, every account is classified under one of the accounts. There are three types of accounts, and they are:
- Personal Account
- Real Account
- Nominal Account
This is a general ledger account associated with individuals, whether they are natural persons, such as beings, or artificial persons, such as firms, companies, or associations. In this case, when there is a transaction between two businesses, the business that receives something becomes the receiver, while the one that sends something becomes the giver. An example of a personal account is a creditor account.
A real account is a general ledger account that is not related to a person’s account but to assets and liabilities. This type of account does not close for the year; instead, the closing balance is retained and carried forward to the next year, and the amounts carried forward become the opening balance for the new year. An example of a real account is a bank account.
A nominal account is a general ledger account that is associated with revenues, expenses, gains, and losses. In a nominal account, the accounting transactions are stored for a fiscal year, and then the balances are transferred to a permanent account at the end of the fiscal year. This type of account allows balances to be set back to zero and will be restarted. An example of a nominal account is an interest account.
The 3 Golden Rules of Accounting
The three golden rules of accounting are:
- Debit the receiver and credit the giver
- Debit what comes in and credit what goes out
- Debit expenses and losses, credit all incomes and gains
Explained below are 3 golden rules of accounting examples:
Debit the receiver and Credit the giver
This rule comes into play with personal accounts. When you receive something, you debit the account, and when you give something out, it goes to the credit account.
Example: If you purchased equipment worth $500 from Company XYZ, in your account book, you would debit your purchase account while crediting Company XYZ. That is, Company XYZ is providing the goods, and you are receiving them.
Example 2: You paid $1000 cash to Company A for factory supplies. You will debit the receiver and credit your cash account (giver).
Debit what comes in and Credit what goes out:
This rule is applicable to a real account, which can be an asset, liability, or equity account. When something comes into your business, you debit the account, and when it goes out of your business, you credit the account.
Example: You purchased furniture worth $1,500 in cash. You will debit your furniture account (coming in), and credit your cash account (going out).
Debit expenses and losses; Credit all incomes and gains:
The last of the three golden rules in accounting deals with the nominal account, which is also called a temporary account because it is closed at the end of each accounting period. In a nominal account, you debit the account if the business has an expense or loss, and you credit the account if the business needs to record income or gain.
Example 1 (Expense or Loss): If you purchased goods from Company ABC for $2000, you will debit the expense ($2000) and credit the income.
Example 2 (Income or Gain): You sold goods worth $850 to Company Z. You will credit the income in your sales account and debit the expense.
In conclusion, it is these three accounting golden rules that lay the foundation on which the accounting system is built. These rules set the accounting standard for financial transactions across the industry, but before any of the rules can be applied, you need to do these two things:
- Confirm the type of account in the transaction.
- Determine whether the transaction increases or decreases the account’s value.
With the three golden rules of accounting in mind, your account books will be up-to-date and accurate.