3 Golden Rules of Accounting Every Business Owner Should Know

In today’s business world, everyone who owns a business must thoroughly understand accounting. Having a solid knowledge of accounting makes the individual realize the company’s performance.

Accounting is a process of identifying, analyzing, recording, and communicating the required information about the company’s financial situation. And, in return, helping the company’s decision-makers to make wise decisions.

Before we talk about the Golden Rules of Accounting, let’s walk you through some basic terms. They are as follows:

Entity is defined as an economic unit that differentiates the accounting of certain transactions from other entities. The main types of entities are – partnership, corporation, and sole proprietorship.

Transaction: A transaction is an occasion when some value is exchanged between two or more entities. It could involve purchasing, receiving money, paying a creditor, etc. It could be a credit or cash transaction. 

Credit: Abbreviated as Cr, credits are accounting entries that lower assets or raise liabilities. A credit is the granting of an advance or the advance of goods, services, or money.

Debit: Abbreviated as Dr., debit is an accounting entry that serves to raise an asset’s value or lower a liability. A debit is the removal of goods, services, or money from the account of the business entity that is a debtor.

Expenses: A business’s expenditures are the cost of the assets or services used during an accounting period. Depreciation, salary, rent, light & water, telephone, and other regular expenses are a few examples. 

Loss is the difference between a period’s expenses and associated revenues. Or, in other terms, as the sum of money lost or costs incurred without any profit in exchange. For instance, money or items stolen and lost or a fire accident. 

Gain: A gain is defined as an increase in the value of an asset. Profit or Gain occurs when the current price of an asset owned is higher than the original purchase price.

Other standard terms in accounting are assets, audit, balance sheet, budgeting, cash flow, dividends, equity, and more.

As we now have a basic idea of it, let’s now introduce you to the three golden rules of accounting, its importance, classification, and more. 

Why do we need rules in accounting?

Without specific rules, journal entries cannot be recorded. The “Golden Rules of Accounting” are the guidelines for recording journal entries or transactions systematically or chronologically. To pass the journal entries necessary for accurate accounting, one must follow the 3 Golden Rules of Accounting.

Before diving into these golden principles, let’s brush up on the basic terminologies under the accounting rules.

Journal: It is a book of original entries where every transactional information is recorded as it occurs. It draws attention to the accounts that need to be credited and those that need to be debited. Journalizing is the process of entering the transactions in a journal.

Accounts: In the journal, there are broadly three major classifications of accounts – Personal Account, Real Account, and Nominal Account.

• Personal Account: A General Purpose Ledger connected to individuals, firms, and associations. It can also be an artificial person and a representative personal account. There are three types of it viz. 
  • Natural Personal Account: Account related to human beings. Example: Richi, George, Bill, Amanda, etc.
  • Artificial Personal Account: Accounts of business entities. Example: Companies, government entities, societies, and clubs.
  • Representative Personal Account: Accounts that reflect joint accounts. Example: Drawings account of a proprietor, capital account of a proprietor, outstanding liability account, etc.   

• Real Account: Accounts related to a firm’s assets, possessions, liability, equity, and properties. Example: Machinery account, Investments accounts, Asset account, Liability account, Cash in hand, Fixed Deposits, etc. 
• Nominal Account: This account, also known as a temporary account, belongs to income, gains, losses, and expenses. It is an account that you close at the end of each accounting period. Example: Accounts for salary, rent, interest paid, discounts received, etc.

Let’s now move on to the Golden Rules of Accounting.

Rule 1: Debit the Receiver, Credit the Giver

Personal accounts are subject to the principle of debiting the recipient and crediting the giver. Debit the account if you receive something. Credit the account if you donate. 

Scenario 1: You buy items from Company XYZ worth USD 2000. You must credit Company XYZ and debit your Purchase Account in your records. You must credit Company XYZ because they are the giver supplying the goods. The receiver’s Purchase Account must then be debited.

Scenario 2: Say you paid Company XYZ for office supplies in Cash for USD 1500 in this example. You must credit your (the giver’s) Cash Account and debit the recipient.

Rule 2: Debit what Comes In and Credit what goes out

Use the second golden rule when dealing with real accounts, also called permanent accounts. These accounts do not end their fiscal year. Their remaining balances are instead carried over to the upcoming accounting quarter. 

This rule makes it very straightforward: Debit the account whenever an item enters your company (such as an asset). Credit the account when the amount leaves your company. For example, a payment made.

Let’s use the example of buying a vehicle for USD 5000. Credit your Cash Account (what goes out) and debit your vehicle Account (what comes in)

Rule 3: Debit all expenses & losses and credit all income & gains

Nominal accounts are covered by the accounting profession’s final golden rule. If your company incurs expenses or suffers losses, debit the account using nominal accounts. If your company has to record revenue or profit, credit the account.

For example, for income or gain, let’s say you sell Company XYZ goods valued at USD 17000. Your Sales Account must debit the expense and credit the income.

For example, for expense or loss, let’s say you spend USD 13000 to buy anything from Company XYZ. You must debit the payment (the USD 13000 purchase) and credit the income to register the transaction.

Credits and debits are documented for each transaction in accounting. The foundational ideas of accounting depend on debits and credits. Here are some of the examples-

Example 1: Business commenced with Capital of USD 10000

Two accounts—the Cash and Capital accounts—are engaged in this transaction. Here, the Cash Account is the real account, so you should debit it with any money that comes into the firm (in this case, Cash), and since the Capital Account is the owner of the business’s account, you should credit it. And then, the general entry would be Cash A/C to Capital A/C. 

Example 2: Purchased machinery worth cash USD 3000

Here, there will be two accounts that will be affected – Machinery A/C and Cash A/C. You will debit what comes in and credit what goes out because both are real accounts. In this instance, Cash is going out of the business, so cash A/C will be credited, and machinery is entering the industry, so its A/C will be debited. Therefore, Machinery to Cash A/C would be the overall entry.

Example 3: Purchased Goods on Credit from Smith worth USD 2000

The accounts in question are Smith, the creditor, and the Purchases A/C. You will have to debit the expense because Purchases A/C is a nominal account, and Smith, the giver, will be credited with the money. As a result, Smith’s account would be credited, and the Purchases account will be debited. 

Example 4: Salaries paid USD 5000

Two accounts—Salaries A/C and Bank A/C—are involved in this case. Since a salary account is only a nominal account, the amount will be debited because salaries are an expense for the company. However, since the bank account belongs to the firm personally, the money will be credited to the account. Salary A/C to the Bank would be the standard entry in this case.

Summing Up

To record financial transactions in ledgers, all three golden rules are used. And doing so enables the company to comprehend where they stand in terms of economic assessments today. Decision-makers may make sensible choices, get assistance with tax and legal issues, and more with these accurate documents.