The Golden Rule

Fundamental types of accounts:

Accounts are classified into Real, Personal and nominal based on who and what is affected.
If it’s a person- personal account
If it’s a thing- real account
If it’s a business performance- nominal account.

Golden Rules of accounting

There is this concept called "Golden Rules" of accounting, that guides the 'Journal Entries phase' of accounting. They are pre-defined principles for recording the transactions using double entry system of bookkeeping. These rules are based on type of accounts.

Now, Let us dive into the details:

Real Accounts:

Meaning: As per traditional Golden Rules of accounting, Real Accounts are used to track things that are owned and controlled by business. ie tangible and intangible assets. Examples of real accounts are: Cash and bank balances, building, plant and machinery, trademark.

The closing balances of real accounts (in the balance sheet) are carried forward to the next period, unlike the balances in nominal account which are closed out each year.

Golden Rule: Debit what comes in, Credit what goes out.

Meaning :

• Debits in real accounts indicate an increase in assets that the company owns from purchase, acquisition or from cash inflow.
• Credits in real a/c: Credit in real accounts indicate decrease in assets owned by company from disposal or sale or from cash outflow.

From business’s perspective, cash and bank balances are real accounts— because they’re assets owned and not entities they are dealing with.

Personal Accounts

As the name suggests, Personal accounts is used to track transactions with persons. It can be natural persons (Individual) artificial persons (Entities such as companies, firms, banks, or government bodies).
Examples of real personal accounts are: Debtors a/c, Creditors a/c, Owners a/c

The closing balances of personal accounts track transactions with individuals or entities like customers, suppliers, shareholders/owners/partners —so the balances (like how much is owed or receivable) are naturally carried forward to the next period, unlike the balances in nominal account which are closed out / reset each year.

Note that Personal accounts don’t appear on the balance sheet in the same way as real accounts (which represent owned assets or owed liabilities). Instead, they form part of subsidiary books or are reflected through controlling accounts.

Golden Rule: Debit the receiver, Credit the giver.

Meaning :

Debits in Personal a/c means, the named person has received something of value from the business ie the person is at receiving end of the transaction .

• In case of Equity: Debits in equity accounts generally reflect a reduction in owner's interest due to losses sustained by business or buy back or withdrawal of contribution. (as is applicable to business form)
• In case of Creditors: Debits in liability accounts reflect a reduction in obligations.
• In case of Debtors: Debit in their accounts represents settlements made to them

Credit in Personal a/c means, business has received something of value from the named person. Hence their account is credited to acknowledge their role as giver. That something can be either stock or money.

• In case of Equity: Credits in equity accounts show an increase in owner's share due to: retained earnings, further issue of share or from fresh contributions (as is applicable to business form.)
• In case of Liability: Credit in liability accounts represent increase in dues that the business owes to third parties.
• In case of Debtors: Credit in debtors accounts represents receipt of payment from them/ settlement of dues by them.

While for the purpose of passing journal entries, traditional Golden Rules of accounting considers Debtors, Creditors and Owner’s capital as Personal accounts because they correspond to persons— but for Reporting phase (Balance Sheet), the balances in these accounts are shown as part of the entity’s financial position, hence treated like Real Accounts. Personal a/c becomes Real a/c, in the context of financial statement.

Nominal Accounts

Nominal accounts is used to track Expenses, losses, incomes, and gains whether it is notional or actual. These accounts helps measure business performance ie ascertain profit or loss during a specific period.

Unlike real and personal accounts, balances in nominal accounts are reset at the end of each accounting period to capture fresh performance data of the subsequent financial year.

Golden Rule: Debit all expenses and losses, Credit all incomes and gains.

Meaning :

Debits in Nominal a/c: means its an expense item or net loss on a transaction.
Credits in Nominal a/c: means its an income item or net gain on a transaction

What is expense ?

Expense refers to cost incurred by the entity to generate revenue or maintain the operations.

What is Loss?

A loss is a reduction in economic benefit that a business is entitled to stemming from transactions outside its regular operations and that results in decline in net resources of the entity or increase in liabilities.The term net resources refers to entity's net assets or equity. Example: Loss on sale of fixed assets, Inventory write off, Loss from calamity, loss from investment etc

What is income?

Income refers to the inflow of economic benefits earned by an entity through its primary business activities or other sources.

What is Gain?

Gain is an increase in economic benefit that a business becomes entitled to, arising are from transactions or events that enhances the net resource of the entity or decrease liabilities and are typically outside the scope of day-to-day business operations/core operating activities.

Example: Gain on sale of fixed assets (yields more than its accounting value) Gain from insurance proceeds, liability waived, favourable currecy fluctuations, appreciation in investment etc

when it comes to recording of transactions via Journal entries, the golden rules uses classification terms such as losses and gains based on their impact to equity, with losses recorded as debits and gains as credits. But for Reporting financial performance, all items whether income, expense, gain or loss — are grouped functionally into 3 categories. They are: a) Operating b) non-operating c) Exceptional or One-Time Items.