Unlocking the Secrets of Accounting's Golden Rules: Discover the principles devised by Luca Pacioli and Leonardo da Vinci. Explore types of accounts, benefits, and guidelines for precise financial recording and reporting.
Overview
All of the stakeholders in an economic entity must be given access to its financial details. The financials must contain truthful material that accurately depicts the entity. It must answer for all of its transactions for this presentation. There must be consistency in accounting because it is necessary to compare economic entities in order to understand their financial state. Learn the three golden rules of accounting that make the challenging process of recording financial activities simpler.
Why is Accounting Important & Vital?
The process of accounting is really vital in order to run a business. It makes it easier to keep track of income and expenses, ensures legal compliance, and gives investors, management, and the government access to quantitative financial data that can be used to make decisions.
What are the Golden Rules of Accounting?
In simple terms, the golden rules of accounts provide guidelines for accountants to systematically record financial transactions. These rules are based on the principle of dual entry, involving debit and credit. They help determine which accounts should be credited and which should be debited.
These rules aid in identifying the appropriate accounts for crediting and debiting. The golden rules of accounting consist of three principles that simplify the complexities of bookkeeping. According to these rules, it is necessary to determine the account type for each transaction, and each account type has its own set of principles that should be applied to every transaction.
Golden Rules of Accounting in Business & its Importance
Accounting in a company provides transparency that aids in relying on costs, tax liabilities, and cash flow. Through ‘accounting’, three important financial statements are produced. The income and expenses are made clear by a profit and loss statement. Understanding the financial status of the company is made easier by a balance sheet. Investors use the cash flow statement to evaluate the financial health of a company and to keep track of the cash that is generated. Your records produce three important financial statements.
- Using the financial income statements, you can learn much more about revenue and expenses
- The balance sheet provides you with a clear view of your company’s financial situation as of a specific date
- The funds generated and spent over a certain time period are reported on the cash flow statement, which serves as a link between the income statement and balance sheet.
If you want to keep your firm afloat, it is imperative that you maintain accurate and current financial records. Here are a few of the factors supporting its significance for your company, no matter how big or small.
Who is in Need of Accounting?
Any firm that had gross sales of more than ₹1.5 lakhs over the previous three years of an active profession was required to keep financial records under the basic principles of accounting. The following professions are required by Income Tax Act Rule 6F to keep a record of financial transactions:
- Health and Legal Services
- Architecture
- Engineering
- Accounting
- Interior Design
- Technical Advice.
- Company Secretary
- Film Artists
Now let’s dive deeper into the Golden Rules!
3 Golden Rules of Accounting
Following are the 3 golden rules of accounts –
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Rule One
‘Debit what comes in – credit what goes out.’
This rule pertains to real accounts, which include assets like furniture, land, buildings, machinery, etc. These accounts typically carry a negative balance. By debiting what is received, the balance of the real account is increased.
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Rule Two
‘Credit the giver and debit the receiver.’
This rule applies to personal accounts. When an individual or entity contributes to the business, it is considered an inflow, and the giver’s details should be recorded. Conversely, the receiver’s information needs to be noted. For instance, when purchasing a gift from a shop, the transaction is reflected in your account accordingly.
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Rule Three
‘Credit all income and debit all expenses.’
This rule relates to nominal accounts. Capital represents a company’s obligations and carries a credit balance. By crediting all income and profits, the capital increases. On the other hand, deducting losses and expenses reduces the capital.
Types of Golden Rules of Accounting
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Nominal Account
A nominal account is used to record all accounting transactions for a specific fiscal year, and at the end of the year, the balances are transferred to permanent accounts. This allows the balances to be reset to zero, restarting the process. Revenues, expenses, gains, and losses are the most common types of nominal accounts. According to Golden Rule 3, expenses and losses are debited, while profits and gains are credited.
When a company incurs an expense or experiences a loss, it is recorded as a debit in the books. Conversely, if the business generates a profit or earns income through its services, it is recorded as a credit entry. For instance, when a company pays rent for its premises, which is considered an expense, it is debited in the accounting records.
| Date | Account | Debit | Credit |
| XXXX | Rent Account | ₹ 12000 | |
| Cash Account | ₹ 12000 |
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Personal Account
A general ledger account is categorised as a personal account, which includes accounts related to both individuals (natural persons) and entities (artificial persons) such as companies. When a business receives something from another business or individual, the first business becomes the receiver while the second business or individual becomes the giver in the context of a personal account. According to Golden Rule 1, the receiver is debited, and the giver is credited.
Applying this rule, in our case of purchasing a present from a gift shop, the books should reflect a debit entry in the personal account and a credit entry in the business account.
| Date | Account | Debit | Credit |
| XXXX | Purchase account | ₹ 5000 | |
| Gift shop | ₹ 5000 |
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Real Account
The closing balance of a real account is retained and carried over to the next year as the opening balance. These accounts commonly pertain to assets, liabilities, and equity. According to Golden Rule 2, what comes in is debited, and what goes out is credited. In the case of a firm acquiring valuable property or goods, it is debited in the books as a real account. Conversely, when something valuable is disposed of by the company, it is recorded as a credit entry in the books.
Here’s an example of a cash purchase of furniture worth ₹ 10,000.
| Date | Account | Debit | Credit |
| XXXX | Furniture account | ₹ 10000 | |
| Cash account | ₹ 10000 |
Benefits of the Golden Rules of Accounting
Adhering to the principles of golden rules of accounts offers the following advantages:
- Proper Maintenance of Business Records
The proper upkeep of a company’s records is vital for its success, ensuring the secure and organised storage of its information.
- Comparing Financial Results
By adhering to the golden rules, businesses can ensure accurate recording of financial records, facilitating easier and more efficient comparison of their year-over-year financial results.
- Calculating the Valuation of a Business
Accurately calculating financial statements enables a firm to determine its business valuation accurately. Additionally, it enhances the chances of attracting investments and promoting business expansion.
- Helps in Budgeting as well as Future Projections
A well-established budget, grounded in proper accounting practices, lays a solid groundwork for business growth. Moreover, it facilitates more precise future projections.
- Evidence During Legal Cases
Maintaining systematic financial records is crucial for companies when it comes to swift referencing during legal proceedings. In this regard, employing accounting golden rules proves to be extremely useful.
- Assists in Tax-related Matters
Accurately managing a company’s financial statements helps prevent tax deficiencies, as improper accounting practices can result in substantial penalties. Furthermore, such practices can have a negative impact on the company’s brand value and reputation.
- Helps Comply with Regulatory Authorities
Maintaining proper accounting practices is crucial for ensuring compliance with regulatory authorities. Without a strong foundation in the accounting discipline, businesses will face challenges in achieving regulatory compliance.
With a solid understanding of the golden rules of accounting, you can identify the appropriate account for each type of transaction. As a result, the journal entries for financial transactions will be precise and suitable.
Who is Mandated to Follow the Books of Accounts?
A company engaged in a recognised profession, which has generated revenue exceeding ₹ 1.5 lakhs in the past three years, is required to maintain financial records in accordance with the golden rules of accounting.
As per Rule 6F of the Income Tax Act, the following professions are obligated to maintain financial records-
- Legal
- Technical Consultation
- Architectural
- Engineering
- Accountancy
- Authorised Representative
- Film Artists
- Medical
- Interior Decoration
- Company Secretary
Under section 44AA of the Income Tax Act, a professional is exempted from maintaining books of accounts if their professional receipts do not surpass ₹ 1,50,000 in any of the preceding three years. However, in such instances, the professional must maintain books of accounts that can be utilised by an Accounts Officer to determine the taxable income.
Fundamental of the Golden Rules of Accounting
The essential accounting principles are as follows-
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Futuristic Approach
A firm is deemed to have an indefinite existence. The only way to terminate it once it has been established is through division or separation. Hence, accountants rely on the concept of a going concern.
This principle assumes that the company will continue its regular operations until the conclusion of the next accounting period, assuming no contradictory information arises. By applying the going concern principle, businesses can engage in credit transactions, account for future receivables and payables, and allocate depreciation when a long-term asset is expected to be utilised.
However, if management anticipates the imminent suspension of activities, standard accounting practices will no longer be applicable. In such cases, a specialised form of accounting is employed for dissolution purposes.
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Monetary Approach
Accounting distinguishes itself from trading by requiring the documentation of values in a single monetary unit. Unlike trading, where items can be evaluated differently, accounting faces challenges in assigning objective valuations to products and items due to their subjective nature. However, accounting has established regulations to tackle this issue and ensure consistent and standardised valuation practices.
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Pricing Approach
The concept of cost is closely associated with the conservative philosophy in accounting. According to the cost principle, businesses are required to report all costs on their financial statements. While assets like land, houses, and gold tend to appreciate in value, accountants do not recognise this appreciation until it is realised.
Accountants hold the belief that the market value of assets is subjective and influenced by various perspectives, making it impractical to account for all potential valuations. Instead, accounting relies on the cost principle and factual information, considering the actual purchase price and verified selling price. This approach ensures a conservative and objective representation of financial records.
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Conservatism Approach
Accountants are inherently cautious and strive to balance optimism with preparedness for adverse circumstances. This cautious mindset is clearly reflected in the professional standards they have established. Conservatism plays a crucial role in accounting.
In situations where the expected inflow of cash is uncertain, organisations employing the conservative approach must identify the lowest potential revenue and the most significant potential expenses. By doing so, they adopt a prudent stance, acknowledging the possibility of unfavourable outcomes and ensuring a realistic assessment of financial results.
Guidelines to Keep in Mind While Applying the Golden Rules of Accounting
When applying these principles, it is important to keep the following guidelines in mind:
- Determine the type of account involved in the transaction.
- Determine whether the transaction increases or decreases the value of the account.
- By adhering to these three accounting golden rules, you can ensure that your accounts are up-to-date and accurate.
Conclusion
The basis for the accounting system, as it exists now, is laid out by these three fundamental accounting principles. These regulations harmonise how financial transactions are represented throughout the sector. There are a few principles you must bear in mind when applying these regulations, and they are.
- Determine the type of account being used in the transaction by checking.
- Verify whether the transaction results in an increase or decrease in the account’s value.
These 3 golden rules of accounting will assist you in keeping accurate and current accounts. If you need to clarify any legal procedures, you can easily contact Vakilsearch, India’s leading legal service provider. Through the experts at Vakilsearch, you can easily complete the paperwork and filings in a hassle-free manner!
FAQs
What are Ledger Books?
Ledger books serve as repositories of essential information required for the preparation of financial statements.
Who created the Golden Rules of Accounting?
The golden rules of accounting were formulated by Fra Luca Pacioli, an Italian mathematician, in collaboration with Leonardo da Vinci.
What is Accounting?
Accounting involves the systematic recording of financial transactions in a business and encompasses the tasks of summarising, analysing, and reporting these transactions to regulatory authorities or tax collection agencies.
What is an Accounting Cycle?
The accounting cycle is a systematic process in which a business acknowledges, records, organises, and applies credits to payments made and received during a specific accounting period.
Which professions require accounting?
Professions that exceed ₹ 1.5 lakh in gross receipts during the past 3 years are required to maintain records of their financial transactions. According to Rule 6F of the Income Tax Act, the following professions fall under this requirement:
✷ Legal
✷ Medical
✷ Architectural
✷ Technical Consultation
✷ Film Artists
✷ Authorised Representatives
✷ Engineering
✷ Accountancy
✷ Company Secretary
✷ Interior Decoration
What are Debit and Credit?
In double-entry accounting, debits and credits are used to record changes in value resulting from business transactions in the accounting ledger. A debit entry signifies an increase in value within the account, while a credit entry indicates a decrease in value from the account.
What is an Accounting cycle?
The accounting cycle encompasses the series of steps that a business undertakes to receive, record, organise, and allocate payments made and received within a designated accounting period.
Who invented the golden rules of accounting?
Luca Pacioli, an Italian mathematician, is widely recognised as the pioneer of modern accounting. He collaborated with Leonardo da Vinci and together they formulated the foundational principles known as the golden rules of accounting.
