Golden Rules of Accounting
To explain it simply, accounting is the process of tracking your finances. Although you don’t have to be an expert in accounting to manage your finances, it is imperative to understand the basic aspects of accounting to monitor transactions and ensure a secured financial plan. In this regard, the golden rules of accounting act as the fundamental guide to record accurate and balanced financial transactions.
Let’s explore the traditional and modern rules of accounting in detail.
What is Accounting?
Accounting, also referred to as accountancy, is the systematic process of tracking, recording, analyzing, and processing financial information of a business or individual entity.
The primary goal behind this process is to identify the events of financial nature during a specific time period and report them in an organized manner to make informed decisions.
Many individuals and businesses hire professional accountants for accounting and bookkeeping. Some may also hire certified Chartered Accountants to manage a company’s or individual’s financial information. Effective accounting helps companies and individuals ensure compliance with taxation requirements and manage financial activities.
Some accountants take the traditional approach, but many prefer the modern rules of accounting as well. In both cases, the end-goal is to ensure seamless reporting of financial records and ensure uniformity in accounting.
What are the Different Types of Accounting?
Some of the primary types of accounting are:
Managerial Accounting: It involves recording and presenting financial data simply for the internal needs of a company. This type of accounting helps managers and stakeholders set their budgets, assess the situation of the company, and evaluate the overall performance of the business.
Tax Accounting: This type of accounting primarily focuses on managing financial information only for tax purposes. In addition to reporting the records as per tax regulations, tax accountants also help with timely filing of tax returns.
Financial Accounting: This type of accounting deals with assessing the financial health of a business and providing an overview of the company’s financial transactions. This type of accounting is the opposite of managerial accounting; while managerial accounting helps to create internal financial reports, financial accounting creates reports for external parties.
Cost Accounting: Cost accountants focus on calculating the exact cost of doing business. This type of accounting is usually employed by businesses that want to find out the costs associated with raw materials, labor and overhead in order to enhance financial management.
Forensic Accounting: This type of accounting involves auditing and investigative practices to uncover financial irregularities. Forensic accountants play a key role during legal cases where they are entrusted with examination of financial data, internal transaction records, trace transactions, and provide evidence of fraud.
Importance of Accounting for Businesses
Keeping the books of accounts updated and proper is essential to ensure growth and success of a business. Maintaining the records accurately helps to promote financial transparency among the owners, managers, investors and other stakeholders. By being aware of the overall financial performance of a business, the management can make informed decisions - be it for sustainable operations or future growth.
In essence, financial reports help to quantify the growth potential of a company. Studying the accounting books can help investors and stakeholders know about the liquidity situation of the business as well as determine whether a working capital loan is just around the corner.
Lastly, proper analysis of the financial details of a business is also required for tax reporting and other legal requirements of the government authorities.
Who Needs to Follow the Books of Accounts?
The Income Tax Act specifies who is required to maintain the books of accountants for the purpose of income tax scrutiny if required. As per Section 44AA of the Income Tax Act, assessees involved in the following professions need to maintain books of account:
Engineering
Accountancy
Medical
Legal
Architectural
Film industry
Interior decoration
Technical consultancy
Additionally, as per Rule 6F of the IT Act, the books of accounts of the professionals/companies belonging to the categories mentioned above should properly record all financial transactions related to:
Journals: To maintain all accounts as per the Mercantile Accounting system. Should contain details of all transactions as per the double-booking accounting rule.
Ledgers: Contains details of all accounts as per the corresponding journal.
Bills or receipts of transactions: Signed bills (both original and copies) for transactions exceeding Rs. 25,000.
Cash books: Record of cash receipts and payments generated on a daily basis.
Types of Accounts Under Accounting System
The golden rules of accounting categorize transactions into three types of accounts. Every financial transaction recorded has to fall into one of the three accounts that have been explained below:
1. Nominal Account
The nominal account is used to track all records related to revenue, expenses, profits, and losses for a particular accounting period. This 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 include rent accounts, interest accounts, etc.
The golden rule of accounting related to nominal accounts is Credit All Gains and Debit All Losses.
Under this rule, an increase in income or gains should be credited, while a decrease needs to be debited. In contrast, an increase in expenses or losses has to be debited, while a decrease needs to be credited.
2. Personal Account
This general ledger account records financial transactions associated with individuals or entities. This account can be further divided into three types:
Artificial Personal Account - This account is for recording financial transactions for entities or things that are not human. They are primarily legal entities such as hospitals, banks, etc.
Natural Personal Account - This account records transactions related to real persons, i.e., humans, such as a customer or wholesale supplier. The individual is deemed to be a legal entity who can enter into agreements with the company.
Representative Personal Account - As the name suggests, this account records financial details for an entity that is representing another entity or individual. This account is considered to be a blend of artificial and natural personal accounts.
The golden rule of accounting related to personal accounts is Credit the Giver, Debit the Receiver.
As per personal account rule, the ‘Receiver’ would be the company who is supposed to get the money credited from another entity or individual. The other party who contributes is deemed to be the ‘Giver’.
This means that any type of financial contribution or cash inflow by the other party has to be credited in the receiver’s account and the contributor has to be acknowledged as the ‘Giver’ in the records.
3. Real Account
This is a general ledger account that records all transactions related to assets and liabilities. The assets recorded in this account include both tangible (land, building, furniture, etc.) and intangible assets (copyright, goodwill, etc.).
Real accounts are also known as permanent accounts as they are not closed and the balances are carried forward to the next fiscal year.
The golden rule of accounting related to real accounts is Debit What Comes In, Credit What Goes Out.
This means that an increase in assets should be debited while a decrease in assets has to be credited. In contrast, an increase in liabilities has to be credited, while a decrease in liabilities should be debited. In the end, the balance in a real account will reflect the net value of the assets or liabilities.
Understanding Golden Rules of Accounting with Examples
Traditionally, the three golden rules of accounting are the basis of accounting and bookkeeping. These rules ensure uniformity in the field of accounting and help to simplify the process of bookkeeping.
Now, here’s a tabular representation of the three golden rules of accounting:
Account Type | Golden Rule |
|---|---|
Real Account |
|
Personal Account |
|
Nominal Account |
|
Based on these three golden rules, let’s understand the dual entry system with an example.
Suppose Mr. X has started his business with a capital of Rs.1,00,000.
He has bought inventory worth Rs.50,000
He has paid a salary of Rs.30,000 to his employees
He has received interest worth Rs.5000.
He has invested in machinery worth rupees Rs.1,50,000
Let’s identify the specific accounts associated with each transaction.
Transaction | Recording Accounts | Account Types |
|---|---|---|
Initial capital of Rs.1,00,000 | Cash account Capital account | Real account Personal account |
Goods purchase worth Rs.50,000 | Purchases account Cash account | Nominal account Real account |
Salary payment to employees of Rs.30,000 | Salary account Cash account | Nominal account Cash account |
Interest received from bank of Rs.5000 | Interest received account Bank account | Nominal account Real account |
Cost of investment in machinery is Rs.1,50,000 | Machinery account Bank account | Real account Real account |
Now, let’s see how you should record these transactions in the different accounts as per the golden rules of accounting:
Initial capital of Rs.1,00,000
After applying the golden rule for the real account and personal account, the journal entry will look something like this:
Particular | Amount (Dr) | Amount (Cr) |
|---|---|---|
Cash A/c……………………Dr | 1,00,000 | |
To Capital A/c | | 1,00,000 |
Goods purchase worth Rs.50,000
After applying the golden rule for nominal and real accounts, the journal entry will be:
Particular | Amount (Dr) | Amount (Cr) |
|---|---|---|
Purchase A/c……………………Dr | 50,000 | |
To Cash A/c | | 50,000 |
Salary payment to employees of Rs.30,000
After applying the golden rule for nominal account and cash account, the journal entry will be:
Particular | Amount (Dr) | Amount (Cr) |
|---|---|---|
Salary A/c……………………Dr | 30,000 | |
To Cash A/c | | 30,000 |
Interest received from bank of Rs.5000
After applying the golden rule for nominal and real account, the journal entry will be:
Particular | Amount (Dr) | Amount (Cr) |
|---|---|---|
Bank A/c……………………Dr | 5,000 | |
To Interest received A/c | | 5,000 |
Cost of investment in machinery is Rs.1,50,000
After applying the golden rule for real account, here’s how the journal entry will look:
Particular | Amount (Dr) | Amount (Cr) |
|---|---|---|
Machinery A/c……………………Dr | 1,50,000 | |
To Bank A/c | | 1,50,000 |
You can see that for each journal entry, the transactions have been balanced by recording them both on the credit and debit side.
Fundamentals of the Golden Rules of Accounting
The essential principles of this accounting approach have been discussed below:
Futuristic Approach
This principle suggests that a company will exist indefinitely. A business will continue to operate indefinitely until and unless it is dissolved. This is why accountants employ the idea of going concern where they continue to prepare the financial statements while keeping the future accounting periods in mind.
This principle aims to provide a clear picture of a company’s long-term financial health. Businesses can operate on credit, consider transactions that are expected to be fulfilled in the future, and report continued liabilities across different accounting periods.
Monetary Approach
Under this approach, transactions are recorded in terms of their monetary value instead of their nominal value. Even if money is not involved, then also it records it in terms of a single monetary unit. This helps to keep the financial statements clear and consistent.
Pricing Approach
This principle requires businesses to record their transactions as per the cost principle. As per the cost principle, businesses should report all costs on their financial accounts. However, the transactions should be recorded based on the original cost of assets, regardless of their current market value. This ensures honest and objective financial reports.
Conservatism Approach
This principle requires the accountant to be a little cautious when it comes to guessing values, especially for assets and income. The recording of transactions should be objective in nature and if there’s any uncertainty regarding the cash flow, the accountant must go for the lowest possible revenue value. There should be no room for any biases or guesswork.
Benefits of Golden Rules of Accounting
Here’s how the three golden rules of accounting benefit entities and accountants:
Accurate Maintenance of Transactions:
It is important to maintain financial records properly. If the transactions are balanced in the accounts and the financial statements are continuously updated in a systematic manner, the risk of errors gets reduced.
Comparison of Financial Records:
Following the three golden rules of accounting ensures accurate and reliable financial statements year after year. Companies can also use this feature to compare their year-on-year growth in an efficient way.
Calculating Business Valuation:
Properly recorded financial statements also help in the calculation of a company’s valuation. This aids investors and shareholders to analyze the current financial state of a business and make informed decisions related to investments, mergers, acquisitions, loans, and other activities.
Compliance with Regulatory Laws:
As mentioned above, the golden rules are based on Generally Accepted Accounting Principles (GAAP). This means that the accounting books that are managed by employing these rules will comply with accounting standards and principles. It is crucial to ensure compliance as it helps to avoid unnecessary penalties, confirm timely tax payments and gain investors’ trust.
Assists in Budgeting and Future Projections:
If a business is able to maintain accurate financial records, this can aid in establishing a strong foundation for growth. Proper records help accountants and stakeholders create a budget for different business activities as well as estimate possible projections.
What are the Modern Rules of Accounting?
Instead of the three types of accounts in the traditional principles of accounting, modern rules of accounting take a total of six accounts into consideration. Although the core concepts remain the same, the terminology and presentation of data vary. While the traditional route is more of a British approach, modern rules of accounting are considered to be an American concept.
As per the modern rules, the six accounts are assets, capital, expenses, liabilities, drawings and revenue. Here’s a brief overview of the rules:
Account Type | Increase | Decrease |
|---|---|---|
Assets | Debit | Credit |
Capital | Credit | Debit |
Expenses | Debit | Credit |
Drawings | Debit | Credit |
Revenue | Credit | Debit |
Liabilities | Credit | Debit |
Entity Principle: The business should always be treated as a separate entity that is not related to its owners or other related businesses. As per GAAP regulations, a business and its owner are two different things.
A business is an entity whose goal is to generate profits from its operations; however, an owner is someone who wants to generate returns on his or her investment in the business.
Money Measurement Principle: Only those transactions should be recorded that can be expressed in monetary terms. By only recording transactions that can be expressed as monetary value, businesses are less likely to introduce their personal biases and judgments while creating their financial statements.
Materiality Principle: Only important or huge transactions that may have an influence on the decision-making process of the stakeholders need to be disclosed. Any immaterial, insignificant or irrelevant information that will have small or no impact on the finances of a company should be omitted.
Conservatism Principle: As per this principle, if an accountant has two possible outcomes in any scenario, he/she must choose that outcome which is conservative in nature. When in doubt, the accountant should go for the option that is less likely to exaggerate assets and income.
In India, most professional accountants and CAs follow the traditional rules of accounting; however, there are many who find the modern standards much more flexible and self-explanatory.
Final Thoughts
By being aware of the golden rules of accounting, you can make informed decisions to ensure financial growth and stability for your business or for your individual needs. The golden rules lay out a common ground for accountants in order to help them maintain the books in a proper and consistent manner.
In addition to keeping the accounts records straight, it helps to adhere to regulatory compliances and tax obligations. By keeping track of your financial records, you can ensure seamless filing of your ITR.
For expert assistance related to ITR filing, download the TaxBuddy app today! Ensure seamless tax filing by connecting with our tax expert. Contact us now!
Frequently Asked Questions
Q1. What are ledgers?
Ledgers are record-keeping books that serve as a repository for all financial transactions. It helps businesses to track and manage their finances and make informed decisions to ensure the financial health of the company.
Ledgers usually include a collection of different accounts to record values associated with different aspects of the company, such as liabilities, expenses, assets, income, etc.
Q2. What is the meaning of an accounting cycle?
The accounting cycle is a standard process that is followed to track, record, and analyze all financial activities of a company for a specific period of time. This systematic process gets initiated when the first transaction takes place and ends when the books are closed for that specific cycle.
Q3. Who is a Chartered Accountant?
A Chartered Accountant is an expert financial professional who holds an internationally acclaimed degree and has been certified by the Institute of Chartered Accountants of India (ICAI), India's largest professional accounting body. He/she specializes in offering financial advice to businesses, governments, and entities.
Q4. Who invented the golden rules of accounting?
Italian mathematician Fra Luca Pacioli is considered to be the father of modern accounting. In 1494, he was the first to explain the double-entry accounting system that has now become the standard for recording financial transactions.
Q5. What do you mean by GAAP?
Generally Accepted Accounting Principles (GAAP) is a recognized collection of commonly followed accounting principles that are deemed to be the standards for financial reporting of transactions. These principles have been adopted and issued by the Financial Accounting Standards Board of the USA.
Q6. What is the accounting rule for journal entries?
Under the double-entry bookkeeping system, each journal entry should have a debit and credit side. Even if the debited and credit amounts are associated with multiple different accounts, the amounts in both columns of the journal entry have to be equal.
Q7. What is a cash book in accounting?
A cash book is a special type of financial journal that records all cash transactions of the organization. The receipts and payments of money that has been received or paid out are recorded in detail and the transactions are documented in chronological order.
Q8. What is debit and credit?
In double-entry bookkeeping, credit is any type of outgoing money from the business and debit refers to incoming money. To balance the books, it is essential to have a record of credit in the account for every debit, and both should be of equal value.
Q9. What is normal balance in accounting?
The normal balance refers to the debited or credited balance of a particular account. It signifies whether the transaction was a debit or credit, i.e., whether it has increased the income or expenses of the business.
Q10. What are the 5 principles of accounting?
The five basic principles of accounting include:
Cost Principle
Matching Principle
Revenue Recognition Principle
Objectivity Principle
Full Disclosure Principle
