Accounting today is much more than bookkeeping. Two important aspects of accounting are debit and credit. We must only enter a transaction after understanding the detailed meaning of which account should be debited or credited.
When a financial transaction takes place, it affects two accounts, and in the dual entry system of accounting, we have two columns for entering our transactions. As we all know, one is the debit side, and the other is the credit side. To understand an accounting entry, first, we need to understand the account types and their corresponding debit credit rule
Types of Accounts
Personal Account:
- Debit the Receiver, Credit the Giver: When dealing with personal accounts like individuals or organizations, debit what comes in and credit what goes out.
- Types of Personal Account –
- Artificial Personal Account: Non-human bodies that act as separate legal entities as per the law. These include hospitals, banks, companies, government bodies, partnerships, and cooperatives.
- Natural Personal Account: This type of account represents human beings. It includes individual capital accounts, debtors account, creditors account, drawings account.
- Representative Personal Account: This account represents the accounts of natural or artificial entities.
Real Account
Real Accounts are a set of tangible aspects of business like furniture, cash, etc. It contains transactions related to the assets and liabilities of the company. The asset category can be further subdivided into tangible and intangible assets. Real accounts deal with material assets of the business.
- If the item that belongs to the real account is coming into the business, it should be written on the Debit side while making the accounting entries.
- If the item of the real account is going out of business, it should be written on the Credit side while making the accounting entries.
Personal Accounts
- Personal accounts can be considered general ledgers related to people, associations, and companies.
- If the person/ group of persons/ legal body is receiving something from the business, then – Debit the receiver.
- If the person/ group of persons/ legal body is paying something to the business – Credit the payer or giver
Nominal Accounts
Nominal Accounts represent all the transactions of business like Expenses, Losses, Income, and gains incurred while doing business. Some common, e.g., are
- Electricity Expenses,
- Telephone Expenses,
- Interest Received,
- Profit on the Sale of Machines, etc.
If it’s an expense or loss for the business – Debit
If it’s an income or gain for the business – credit
| Type Of Account | Golden Rules of Accounting |
|---|---|
| Nominal Account |
|
| Personal Account |
|
| Real Account |
|
Benefits of Accounting Procedures
Maintaining financial transaction accounts in accordance with accounting’s golden standards provides some benefits.
- Maintenance of Business Records – Maintaining business records is crucial to a company’s success. Accounting makes sure that all of the business transactions are documented in a secure location in the correct order and, more significantly, in a methodical manner.
- Business Valuation – A solid accounting procedure aids in correct business valuation, allowing for more investment and expansion.
- Budgeting and Future Projections – A healthy budget based on proper accounting processes may provide a solid foundation for any organization to grow. With a solid accounting process in place, future estimates are more accurate.
- Financial Statement Preparation – If the golden rules of accounting are followed, financial transactions will be recorded correctly. If the accounting is done correctly – financial statements like profit and loss statements, trading accounts, and balance sheets could all be created rapidly.
- Comparison of Financial Results – Accounting done according to the golden principles makes it easy to compare one year’s financial outcomes to another. Analysis of year-on-year financial performance becomes simpler and more reliable.
- Regulatory Compliance – Accounting is critical for organizations in order to comply with regulatory bodies. It would be hard to accomplish regulatory compliance without the basic basis laid down by the accounting rules.
- Aids in Taxation Matters – Tax shortfalls caused by faulty accounting methods may result in substantial penalties from government agencies, negatively harming image and brand value.
- Corporate Decision-Making – The accounting procedure based on the accounting rules ensures that financial data are trustworthy and valuable in the decision-making procedure of senior management.
Golden Rules of Accounting
Rule 1
“Debit what comes in – credit what goes out.”
This rule pertains to personal accounts and ensures accurate recording of transactions where value is exchanged between parties. It mandates that every financial transaction is properly documented by tracking both the giver (payer) and the receiver (payee).
To maintain accurate records:
- When a business receives value: Debit the corresponding account.
- When a business gives value: Credit the corresponding account.
This approach guarantees clear and reliable financial records, enhancing the accuracy of financial statements.
Example: If your business pays 500 in rent to your landlord:
- Landlord: Giver (providing rental space)
- Your Business: Receiver (benefiting from rental space)
You need to:
- Debit the Rent Expense account by 500
- Credit the Cash/Bank account by 500
Rule 2
“Credit the giver and Debit the Receiver.”
The principle for real accounts is “Debit what comes in, and credit what goes out.” This rule ensures that all inflows and outflows of resources are accurately recorded, providing a systematic approach for tracking assets and liabilities.
Key Points:
- Debit what comes in: When a business acquires an asset, the asset account is debited to reflect the increase in value.
- Credit what goes out: When a business disposes of an asset, the asset account is credited to reflect the decrease in value.
Importance:
Effective management of assets and liabilities is crucial for maintaining sound financial health. This rule provides transparency in showing both the acquisition and disposal of assets. By adhering to this rule, businesses ensure that their accounting records accurately reflect changes in their assets and liabilities, aiding in clear and organized financial reporting.
Example:
If a business acquires equipment worth 1,000:
- Equipment Account: Debit 1,000 (to record the increase in asset value)
If the business later disposes of the same equipment:
- Equipment Account: Credit 1,000 (to record the decrease in asset value)
Rule 3
“Credit all income and debit all expenses.”
“Debit expenses and losses, credit income and gains” applies to all nominal accounts. This rule is essential for accurately recording financial performance, which is crucial for assessing a business’s profitability and sustainability.
Key Points:
- Debit Expenses and Losses: Expenses and losses are recorded as debits. This reflects the outflow of resources and costs incurred by the business.
- Credit Income and Gains: Income and gains are recorded as credits. This reflects the inflow of resources and profits earned by the business.
Importance:
By following this rule, businesses can systematically record all receipts and payments, providing a clear view of financial performance. This helps stakeholders make informed decisions and supports strategic planning. It serves as a fundamental principle in accounting, ensuring a true and accurate depiction of a business’s financial health.
Example:
- If a business incurs an expense of 200 for utilities:
- Utilities Expense Account: Debit 200
- If the business earns 500 in revenue from sales:
- Sales Revenue Account: Credit 500
FAQs
Do the Golden Rules apply to all types of businesses?
Yes, the Golden Rules of Accounting apply to all types of businesses, regardless of their size or nature. They provide a consistent framework for recording financial transactions across different sectors.
How do the Golden Rules aid in preparing financial statements?
By adhering to the Golden Rules, accountants can ensure that all transactions are accurately recorded, which is crucial for preparing reliable financial statements. This consistency allows stakeholders to make informed decisions based on the financial health of the business.