Every process is followed by a set of rules that are universally applicable and followed by everyone. These rules define the process of core functions to bring uniformity in the presentation and the overall structure of the concept.
Similarly, in accounting, three golden rules form the basis of accounting.
In this article, we will cover the rules of accounting along with the following:
• What is Accounting?
• Types of Accounts under Accounting System
• Golden rules of accounting
• Example explaining rules of accounting
• FAQ related to Accounting Rules
What is Accounting?
Accounting is a process of recording, classifying, and summarising the financial transactions for a business entity or organization. In simple words, accounting refers to that process where the financial transactions are recorded systematically to keep a chronological record of the event happenings.
The accounting process involves constant updation of the transactions to reflect an accurate and proper picture of the institution's financial statements.
Later, with the accounting process's help, results are interpreted and communicated to the users of financial information.
Types of Accounts under Accounting System
Under the rule of accounting, one of the essential aspects to know is the types of accounts coming under the system rule of accounting. With the help of account classification, you will be in a better position to understand the rules effectively.
The three types of accounts coming under the accounting system are as follows:
- Personal Account
- Real Account
- Nominal Account
1. Personal account
A personal account is a general ledger account related to the person, firms, and associations.
Under personal account, there are three subcategories:
- Natural Personal Account connected to human beings. For example, Debtors Capital account, Creditors, Drawings account.
- Artificial Personal Account who are not human beings but act as a separate legal entity in the eyes of the law. They can enter into agreements and operate the functions in the name itself—for example, companies, cooperatives, partnerships, hospitals, banks, and government bodies.
- Representative Personal Account represents the accounts of natural or artificial people. In this account, the transactions either belong to the previous year or the following year. Hence, they are in a position to represent something.
For example, an outstanding salary represents the salary due from last year. In the same way, prepaid rent represents the rent paid in advance for the following year.
2. Real Account
A real account is a ledger account that represents accounts of all assets possessed by the organization. The real account appears in the balance sheet and assesses the financial position of the business.
Further, the assets can be divided into two parts,
Tangible Assets
Tangible assets consist of those assets and properties that can be touched, seen, and measured. These assets have their physical appearance and existence—land, building furniture, fixtures, machinery, and a cash account.
Intangible Assets
Intangible assets consist of those assets and properties that can't be touched but can be felt. These assets don't have a physical experience but possess a monetary value.
For example, Goodwill, Patents Copyrights, Trademarks.
3. Nominal Account
A nominal account is a ledger account that relates to expenses, losses, incomes, and gains. All of the nominal account adjustments are made through the Trading and Profit and Loss Account at the end of the accounting year.
For example, Interest A/c, Rent A/c, Salary A/c, Commission Received
Golden rules of accounting
The golden rules of accounting apply to the types of accounts related to a financial transaction.
The rules of accounting are set differently for the different types of accounts discussed above.
Let's take a look at the three golden rules of accounting:
All of the three golden rules are devised based on the nature of accounts. All of these rules are applicable for organizations and businesses that operate the business's financial activities, defining the treatment of transactions.
Example explaining rules of accounting
After getting through with the types of accounts and the golden rules of accounting, let's understand the concept practically with the help of the following illustration:
Illustration:
Following is the list of transactions recorded by the proprietor Mr. A.
- Mr. A commenced the business in Cash 1,00,000
- He buys goods worth rupees 60,000 in Cash
- He pays a salary of rupees 20,000 to his employees
- He received interest in his bank account worth rupees 3000.
- He purchased machinery worth rupees 200000
Solution:
The first step is to identify the accounts involved in the above transactions and classify them accordingly.
This can be clear with the help of the following table:
After classifying the types of accounts involved in the above transactions, the next thing is to record these transactions in Journal by applying the golden rules to each transaction.
This can be explained from the following:
1. Commenced business with Cash ₹1 lakh
Here, the cash account is a real account, and the capital account is by default treated as a liability to 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
2. Purchase goods in cash for ₹60,000
Here, the 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
3. Pays salary of ₹20,000 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
4. Received interest from Bank ₹3000
Here, the interest Account is the nominal account under Income, and 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
5. Purchased machinery for ₹2,00,000
Here the Machinery A/c is a Real Account, and 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
And this is how you treat the transactions of an entity by first, classifying the types of accounts, second identifying its nature, and third passing in the journal entries.
FAQ related to Golden Accounting Rules
Following are a few Frequently Asked Questions related to accounting rules:
Q1. Who invented the golden rules of accounting?
Answer: The golden rules of accounting come under the double-entry accounting system written by Italian mathematician Fra Luca Pacioli and Leonardo da Vinci.
Q2. What are the benefits of accounting rules?
Answer: With the help of accounting rules, businesses can use them uniformly to interpret the results consistently. It also facilitates the comparison of financial reports and provides information for the users of accounting.
Q3. Can two rules under accounting be the same?
Answer: No two rules are the same under Accounting. There are separate rules for a different set of accounts.
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Key Takeaways
The three golden rules of accounting lay the foundation of the accounting system standardized across the industry. With the help of these rules, you can keep your accounts up to date and function properly.
Let's take a look at the key takeaways of the article:
- Accounting is a process of recording, classifying, and summarising the financial transactions
- There are three types of accounts coming under their accounting system-Personal, Real and Nominal
- There are three sets of golden rules of accounting applicable to the types of accounts
For Personal Account- Debit the Receiver, credit the giver
For Real Account- Debit what comes in, Credit what goes out
For Nominal Account- Debit all expenses and losses, Credit all incomes and gains
- While practically applying the rules of accounting, there are a couple of guidelines that one should keep in mind:
> Ascertain the type of account in the transaction
> Classify and record in Journal
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