The Golden Rules of Accounting
You may have probably heard of the “Golden Rule” in life, which suggests that you ought to treat other people the same way that you would like to be treated. However, were you aware that there is a golden rule that can also be applied to accounting? In fact, there are three primary principles that serve as the foundation for accounting.
Every economic entity is required to make its financial information available to all its stakeholders. It is essential that the information in the financial statements be correct and give a true representation of the firm. It is required to account for all its transactions considering this presentation. To enable meaningful comparisons between various economic units and their individual financial situations, accounting needs to be standardized.
To ensure consistency and offer accurate accounting for all transactions, it is necessary to adhere to the three golden rules of accounting. These rules serve as the essential tenets for writing journal entries, which in turn serve as the fundamental tenets for accounting and bookkeeping.
Knowing the golden rules of accounting can help you to record financial transactions more easily, which is a difficult procedure. Let us explore further.
“The golden rules of accounting are comparable to the letters in the English alphabet. If someone does not know the alphabet, then it is impossible for them to form words and communicate in that language. In the same way, in accounting, if one is not familiar with the golden rules, then that individual is unable to pass journal entries and, as a result, cannot accurately account for the transactions.”
What are the Golden Rules of Accounting?
Fra Luca Pacioli, an Italian mathematician, and Leonardo da Vinci were responsible for developing the golden rules of accounting. The golden rules of accounting are comparable to the letters in the English alphabet. If someone does not know the alphabet, then it is impossible for them to form words and communicate in that language. In the same way, in accounting, if one is not familiar with the golden rules, then that individual is unable to pass journal entries and, as a result, cannot accurately account for the transactions.
The golden rules of accounting are a set of standards that accountants can adhere to in order to methodically record financial transactions. There is much more to financial accounting than simple bookkeeping. In accounting, each transaction requires two separate entries. They are based on a system known as dual entry, which involves both debit and credit transactions.
The three standards that make up the golden rules of accounting are the foundation upon which financial accounting is built. These golden principles guarantee the accurate and orderly recording of financial transactions. The golden rules condense the intricate laws of bookkeeping into a collection of concepts that can be studied, comprehended, and put into practice with relative ease. It will be simpler to choose which account should be credited and which one should be debited when these rules are applied.
In accordance with these requirements, you are required to specify the type of account linked to each transaction. Every type of account now has a specific set of rules that must be followed for every transaction that occurs.
For you to get a clearer view, let us first look at the many types of accounts that are available.
Types of Accounts
In the context of financial accounting, each debit and credit transaction entry will be assigned to one of the three types of accounts:
A general ledger is an example of a nominal account. A general ledger records the transactions of an organization, such as its income, expenses, profits, and losses. It details every transaction that took place during a particular accounting year. In addition, when the new fiscal year begins, it is reset to zero, and the process begins again from the beginning.
Accounts such as Salary Account, Commission Received, Rent Account, and Interest Account are all examples of nominal accounts.
A personal account is similar to a general ledger because it keeps track of transactions relating to individuals, organizations, and businesses. It can be broken down into the following three categories:
Artificial Personal Account
This type of account is used to represent legal entities that, according to the law, are not recognized to be human beings. Hospitals, partnerships, banks, government agencies, and other types of organizations are some of the examples of artificial personal accounts.
Natural Personal Account
This represents people or human beings. Some of the examples include a Drawings account, a Capital account, Debtors, Creditors, etc.
Representative Personal Account
This account contains the financial details of both natural and artificial entities. All the transactions in this account either pertain to the previous year or to the year that is to follow. Take, for instance, income that has been drawn in advance, or compensation that is owed from the previous years.
Like the other two types of accounts, a real account is also a general ledger, but it concentrates on transactions that have to do with a company’s liabilities and assets rather than its equity. The assets in this situation can be further divided into two groups: tangible assets and intangible assets.
Tangible assets include things like land, machines, structures, and even furniture. In contrast, intangible assets include items like patents, goodwill, copyrights, and other comparable things.
A real account does not close at the conclusion of an accounting year, in contrast to a nominal account. Instead, the remaining amount is carried over to the succeeding year. The corporation’s balance statement also has a real account that can be viewed.
Now that you have a solid understanding of the various types of accounts, it’s time to look at how those accounts relate to the golden rules of accounting.
The Golden Rules of Accounting
The golden rules of accounting serve as the essential building blocks for accurate bookkeeping. In order to maintain compliance with the most fundamental principles of accounting, you are obligated to select the proper kind of account to correspond with each transaction. Every single transaction has to comply to its own specific set of criteria, which are determined by the kind of account that is being used. These guidelines are different for every account. The following are the three accounting guidelines that are the most important
Rule 1: Debit all expenses and losses, credit all incomes and gains
Nominal accounts are covered under this golden rule of accounting. A company’s capital is a liability. Thus, it has a credit balance. The capital will increase if all the gains and earnings are credited. On the other side, when losses and expenses are debited, the capital decreases.
Rule 2: Debit the receiver, credit the giver
Personal accounts fall under the purview of this golden rule. When a person donates or gives something to the company, it counts as an inflow, so the donor must be credited in the books of accounts. Since the opposite is also true, the receiver needs to be debited.
Rule 3: Debit what comes in, credit what goes out
This golden rule is utilized when dealing with real accounts. By default, they have a debit balance. As a result, debiting what is coming increases the amount of the account. When a tangible asset leaves an organization, the account balance will decrease if you credit what goes out.
What are the benefits of the golden rules of accounting?
Business records are properly maintained
Maintaining correct records for a business is essential to ensuring its long-term success. The company’s records will then be preserved in a systematic and safe manner.
Comparing financial results
The golden rules guarantee that the financial records are recorded in the appropriate manner. Therefore, firms are able to compare the financial performance of previous years in a manner that is not only simpler but also more productive.
Calculating the valuation of a business
The accurate calculation of a company’s financial statements is a factor that contributes to an accurate appraisal of the company. In addition to this, it is useful for attracting additional investments and growing the company as a result
Assists in budgeting and making estimates
If a company has a realistic budget that was created using accurate accounting procedures, this can serve as a solid basis for the company’s expansion. In addition to that, it helps make more accurate estimates for the future.
Evidence during legal cases
Companies need to record their financial data in a methodical manner so that it can be easily accessed in the event of a legal dispute. In this context, making use of accounting’s golden rules is extremely helpful.
Tax deficiencies are less likely to occur when a company’s financial statements are accurately recorded for. Use of unethical accounting practices could incur heavy fines. Additionally, it might have an impact on the company’s reputation and brand value.
Helps with regulatory compliance
Accurate accounting is crucial when it comes to complying with the regulatory authorities’ standards. Without the proper accounting methods, it will be difficult for any organization to comply with rules and regulations.
The preparation of financial accounts relies heavily on adhering to the golden rules of accounting. Each and every transaction needs to be recorded by the organization. Each transaction is initially entered into a journal, and then it is entered into a ledger. Find out which account each transaction belongs to, and only after that should you make journal entries using the three golden rules. This is the primary reason why it is essential to have a solid understanding of the golden rules of accounting.
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