Financial Accounting: Golden Rules of Accounting

The Problem with Debit Credit Rules

The system of debit and credit is right at the foundation of double entry system of book keeping. It is very useful, however at the same time it is very difficult to use in reality. Understanding the system of debits and credits may require a sophisticated employee. However, no company can afford such ruinous waste of cash for record keeping. It is generally done by clerical staff and people who work at the store. Therefore, golden rules of accounting were devised.

Golden rules convert complex bookkeeping rules into a set of principles which can be easily studied and applied. Here is how the system is applied:

Ascertain the Type of Account

The types of accounts viz. real, nominal and personal have been explained in earlier articles. The golden rules of accounting require that you ascertain the type of account in question. Each account type has its rule that needs to be applied to account for the transactions. The golden rules have been listed below:

The Golden Rules of Accounting

1. Debit The Receiver, Credit The Giver
   This principle is used in the case of personal accounts. When a person gives something to the organization, it becomes an inflow and therefore the person must be credit in the books of accounts. The converse of this is also true, which is why the receiver needs to be debited.
2. Debit What Comes In, Credit What Goes Out
   This principle is applied in case of real accounts. Real accounts involve machinery, land and building etc. They have a debit balance by default. Thus when you debit what comes in, you are adding to the existing account balance. This is exactly what needs to be done. Similarly when you credit what goes out, you are reducing the account balance when a tangible asset goes out of the organization.
3. Debit All Expenses And Losses, Credit All Incomes And Gains
   This rule is applied when the account in question is a nominal account. The capital of the company is a liability. Therefore it has a default credit balance. When you credit all incomes and gains, you increase the capital and by debiting expenses and losses, you decrease the capital. This is exactly what needs to be done for the system to stay in balance.

The golden rules of accounting allow anyone to be a bookkeeper. They only need to understand the types of accounts and then diligently apply the rules.

Fundamental Principles of Accounting:

1. Monetary Unit

   Accounting needs all values to be recorded in terms of a single monetary unit. It cannot account for goods like the barter system. Assigning values to goods and items therefore becomes a problem since it is subjective. However, accounting has prescribed rules to deal with the same.

2. Going Concern

   A company is said to have an eternal existence. Once it is formed, the only way to end it is by dissolution. It does not die a natural death like humans do. Hence, accountants assume the going concern principle. This principle implies that the firm will continue to do its business as usual till the end of the next accounting period and that there is no information to the contrary. Because of the going concern principle, organizations can function on credit, account for accounts receivables and payables which intend to receive or pay in the future and charge depreciation assuming that the machine will be used for many years.
   In case, the management has information that the operations will be suspended in the near future, normal accounting ceases. A special type of accounting meant for dissolution purpose is used.

3. Principle Of Conservatism

   Accountants are said to be very conservative by nature. They want to hope for the best and be prepared for the worst. This is displayed in the rules that they have created for their profession. One of the central tenets of accounting is the principle of conservatism. According to this principle, when there is doubt about the amount of expected inflows and outflows, the organization must state the lowest possible revenue and the highest possible costs.
   This can be seen in the fact that accountants value inventory at lower of cost or market price. However, such conservatism helps the company be prepared for any forthcoming financial crises.

4. Cost Principle

   Closely related to the principle of conservatism is the cost principle. The cost principle advocates that companies should list everything on the financial statements at the cost price. Usually assets like land and building, gold, etc appreciate. However, the accountants will not allow this appreciation to be reflected on the financial statements of the company till it is realized.
   Accountants believe that the market value of anything is just an opinion. Accountants cannot account on the basis of opinions because there are many of them. The selling price of something is a fact since someone has paid for it and the same can be verified. Hence accounting works on cost principle and therefore on facts.