Mastering the golden rules of accounting: A fundamental guide

How do you measure the true value of a company or an individual? At a basic level, sales/income should be more than the costs for a business/person to remain financially stable. Accountants prepare financial statements or statements of accounts that are accessible to various stakeholders such as investors, tax authorities, debt holders, and banks. Accuracy and uniformity of presentation matter the most as they help assess the financial health of a firm or an individual vis-a-vis another entity or person. Accountants generally follow three established rules of accounting to prepare balance sheets. These golden rules of accounting form the very basis of passing journal entries, which in turn, form the basis of accounting and bookkeeping.

Understanding accounting and its role

Accounting is the process of recording, classifying, and summarizing financial transactions. The golden rules of accounting are a set of guidelines that accountants follow for the systematic recording of financial transactions. 

The golden rules of accounting revolve around the double entry system of accounting; i.e., debit and credit. These rules help accountants know which accounts have to be charged and which need to be credited.

Types of accounts in accounting

In accounting, every financial transaction that a business or an individual undertakes is classified into three categories: 

1. Nominal account 

The nominal account tracks all records related to revenue, expenses, profits, and losses for a particular accounting period. That is why it is often called a temporary account, as its balance is reset to zero at the beginning of every financial year. 

Some examples of nominal accounts include rent accounts, interest accounts, salary accounts, and commission-received accounts.

2. Personal account

While recording monetary transactions, a personal account relates to people, associations, and companies. 

Personal accounts can be further divided into three subcategories:

• Artificial personal account 

An artificial personal account represents bodies that are not human beings but act as separate legal entities according to the law. For example, government bodies, hospitals, banks, companies, cooperatives, and partnerships. 

• Natural personal account 

A natural personal account represents human beings—for example, a capital account, a drawings account, creditors, debtors, etc. 

• Representative personal account

This type of personal account represents the accounts of natural or artificial entities. However, the transactions are either from the previous or the following year. 

3.  Real account

Real account deals with transactions related to a firm’s liabilities and assets. The assets, in this case, can be further subdivided into tangible and intangible assets. Tangible assets include land, buildings, machinery, and furniture. Alternatively, intangible assets include goodwill, patents, and copyrights. 

A real account does not close when a financial year is completed. Rather, it is carried forward to the following year. A real account also appears in the company’s balance sheet.  

The significance of debits and credits

Money coming in and going out of your business is recorded as debits and credits. 

The modern-day accounting system is known as the double-entry accounting system. The double-entry accounting system is a good option for reducing accounting errors. This is because it records two book entries to balance a business’s books to zero. 

The double-entry accounting system debits incoming money and credits outgoing money.

Debits and credits are like the yin and yang of accounting, interconnected and responsible for keeping a business’s bookkeeping entries in balance and harmony. There is no debit without a credit.

The three golden rules of accounting

At the heart of accounting are the golden rules, a set of fundamental principles that underpin the accounting process. The three golden rules of accounting represent three different types of accounts. Let’s understand the rules of accounting and how they can help businesses classify and record transactions in an accurate and streamlined manner. 

Type of Account	Accounting Rule
Personal Account	Debit the receiver, credit the giver
Real Account	Debit what comes in, credit what goes out
Nominal Account	Debit all expenses and losses, credit all incomes and gains

Rule 1: Debit the receiver, credit the giver

The “Debit the receiver, Credit the giver” rule is applicable for personal accounts. When a business receives money or consideration in any form for someone, you “debit” or record the increase in your assets on the debit side. When you give something to someone, you “credit” or record the decrease in your assets on the credit side.

Let’s say your business, Y Renewables, receives a Rs. 11,000 loan from your cousin named Shasha. In this case, the journal entry will be:

Date	Account	Debit	Credit
01/01/20XX	Shasha’s Loan A/c	11,000
01/01/20XX	To Shasha’s A/c		11,000

Debit the Receiver: Debit Shasha’s Loan Account on the debit side, as it represents an increase in your business’s assets. This reflects that your business has received Rs. 11,000. 

Credit the Giver: Credit Shasha’s Personal Account on the credit side, indicating that she has given a loan to your business. This shows a decrease in her assets.

Rule 2: Debit what comes in, credit what goes out

This rule is applicable for real accounts where tangible assets like machinery, buildings, land, and furniture are taken into account. They have a debiting balance by default and debit everything that comes in, adding them to the existing account balance. 

Let’s say your business, Y Renewables, buys machinery worth Rs. 25,000 using cash from their account. In this case, the journal entry will be:

Date	Account	Debit	Credit
01/01/20XX	Machinery A/c	25,000
01/01/20XX	To Cash A/c		25,000

Debit what comes in: Debit the Machinery Account on the debit side, signifying an increase in the value of this asset. This shows that the machinery has been acquired. 

Credit what goes out: Credit the Cash Account on the credit side, as money has gone out of your business to purchase the machinery. This shows a decrease in your cash balance.

Rule 3: Debit all expenses and losses, credit all incomes and gains

When your business incurs an expense or suffers a loss, you “debit” or record the increase in the respective expense or loss account on the debit side. When your business generates income or experiences gains, you “credit” or record the increase in the respective income or gain account on the credit side.

Let’s say your business, Y Renewables, pays rent of Rs. 15,000 in cash. In this case, the journal entry will be:

Date	Account	Debit	Credit
01/01/20XX	Rent A/c	15,000
01/01/20XX	To Cash A/c		15,000

The above examples explain how the golden rules of accounting govern the recording of financial transactions, ensuring accuracy and consistency in accounting records. 

Applying the golden rules with examples

Let’s understand the double-entry accounting system with an example using the three golden rules of accounting: 

• Suppose Mr. A has started his business with a capital of Rs. 2,00,000.
• He has bought inventory worth Rs.75,000
• He has paid a salary of Rs. 40,000 to his employees
• He has received interest worth Rs.10,000 from the bank. 
• He has invested in machinery worth Rs.1,60,000

Let’s identify the specific accounts associated with each transaction.

Transaction	Recording Accounts	Account Types
Initial capital of Rs.2,00,000	Cash account Capital account	Real account Personal account
Goods purchase worth Rs.75,000	Purchases account Cash account	Nominal account Real account
Salary payment to employees of Rs.40,000	​Salary account Cash account	Nominal account Cash account
Interest received from bank of Rs.10,000	​Interest received account Bank account	​Nominal account Real account
Cost of investment in machinery is Rs.1,60,000	Machinery account Bank account	Real account Real account

Now, let’s see how you should record these transactions under different accounts as per the golden rules of accounting:

1. Started his business with a capital of Rs. 2,00,000.

Here, the cash account is a real account, and the capital account is by default treated as a liability to the business under a Personal Account.

After applying the golden rule for the real account and Personal Account,

• Debit what comes in
• Credit the giver

The journal entry will be thus: 

Date	Account	Debit	Credit
01/01/20XX	Cash A/c	2,00,000
01/01/20XX	To Capital A/c		2,00,000

2. Bought inventory worth Rs.75,000

Here, the Purchase (inventory purchase) is a Nominal A/c, and Cash is a Real Account.

After applying the golden rule for a nominal and real account,

• Debit all expenses and loss
• Credit what goes out

The journal entry will be

Date	Account	Debit	Credit
01/01/20XX	Purchase A/c	75,000
01/01/20XX	To Cash A/c		75,000

3. Paid a salary of Rs.40,000 to his employees

Here the salary account is a Nominal Account, and Cash is a Real Account.

After applying the golden rule for a nominal and real account,

• Debit all expenses and loss
• Credit what goes out

The journal entry will be

Date	Account	Debit	Credit
01/01/20XX	Salary A/c	40,000
01/01/20XX	To Cash A/c		40,000

4. Received interest of Rs. 10,000 from the bank

Here, the interest Account is the nominal account under Income, and the Bank is a real Account.

After applying the golden rule of Nominal and Real Account,

• Credit all Incomes and Gains
• Debit what comes in

The journal entry will be

Date	Account	Debit	Credit
01/01/20XX	Bank A/c	10,000
01/01/20XX	To Interest Received A/c		10,000

5. Purchased machinery worth Rs. 1,60,000

Here the Machinery A/c is a Real Account, and the Bank A/c is also a Real A/c

After applying the golden rule of Real Account

• Debit what comes in
• Credit what goes out

The journal entry will be

Date	Account	Debit	Credit
01/01/20XX	Machinery A/c	1,60,000
01/01/20XX	To Bank A/c		1,60,000

Here is how you apply the three golden rules of accounting to classify different types of transactions that a business undertakes. This is how you treat the transactions of an entity by classifying the types of accounts, identifying their nature, and passing in the journal entries.

Benefits of following the golden rules of accounting

Internal and external stakeholders use books of accounts to evaluate the financial health of a business. The books of accounts need to follow uniform rules while recording the transactions for them to be comparable. Following the three rules of accounts ensures that the books of accounts are comparable while being accurate and precise. 

We have listed some of the benefits of following the golden rules of accounting:  

1. Consistency

Financial transactions of the same nature should be recorded using a standardized approach across businesses. Following the rules of accounting ensures consistency. This ensures that accountants will record the same kind of transaction in the same manner irrespective of the nature of the business. 

2. Ease of understanding

Following a standard helps bring clarity to the bookkeeping process. The golden rules form the base for all accounting, bringing standardization to the accounting process and making the books of accounts easy to understand and compare. This makes it easier for anyone, from business owners to investors, to understand the financial health of a business.

3. Efficient financial analysis

We need accurate, comparable financial data to make business decisions. The rules of accounting provide a common ground for recording transactions. We can easily compare a company’s finances from year to year or even against another firm’s accounts.

4. Error detection 

Accounting mistakes can prove costly for firms. The golden rules act as a baseline to spot and fix errors. A common standard followed by all businesses makes it easy to identify errors. 

5. Robust financial management 

Accurate and well-maintained books of accounts form the foundation of a sound business. The double-entry bookkeeping system ensures that every financial transaction is recorded and the golden rules of accounting govern the classification and recording of these transactions. 

Ensuring uniformity and accuracy

In the section above, we have discussed how the golden rules of accounting contribute to maintaining uniformity in financial reporting across businesses. Needless to say, these 

rules help avoid errors, discrepancies, and inconsistencies in financial records.

Conclusion

Maintaining accurate books of accounts helps businesses keep track of their income and expenses. Certain accounting standards are followed across the world to maintain uniformity across verticals. As a general rule, businesses follow the three golden rules of accounting to classify and record transactions to make comparisons easier.

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