In the vast world of accounting, there are three key principles that every business owner should be well-versed in. Just like the Golden Rule of ‘treat others as you would like to be treated’ guides our interactions with others, these golden rules of accounting are essential for maintaining accurate and up-to-date financial records. Let’s uncover these principles and explore how they impact your business.
Basic Concepts of Debits and Credits
Before we dive into the details, let’s quickly revisit the basic concepts of debits and credits. In the realm of accounting, debits and credits are the yin and yang, influencing five core types of accounts:
Assets – The valuable resources owned by your business, such as cash, property, and equipment.
Expenses – The costs incurred during your business operations, including salaries and supplies.
Liabilities – The amounts your business owes to others, such as loans and accounts payable.
Equity – The value of your asset minus your liabilities, representing the owner’s stake in the business.
Income and Revenue – The cash earned from sales and other business activities.
A debit is like a positive movement, recorded on the left side of an account, while a credit is akin to a negative movement, recorded on the right side of an account. They work together to keep your financial records in balance.
The Three Golden Rules
Now let’s unveil the three golden rules of accounting:
1. Debit the Receiver, Credit the Giver
This rule applies to personal accounts, which involve individuals or organisations. To simplify it, when your business receives something from someone, you debit the account, and when your business gives something to someone, you credit the account.
Suppose your business purchases goods worth £1,000 from Company X. In your accounting books, you need to debit your Purchase account and credit Company X. As Company X is the giver, providing the goods, you credit their account. Simultaneously, you debit the receiver, which is your Purchase account.
Imagine your business pays £500 in cash to Company X for office supplies. You need to debit the receiver (Supplies) and credit your (the giver’s) Cash account.
2. Debit What Comes In, Credit What Goes Out
This rule is pertinent to real accounts, also known as permanent accounts. Unlike other accounts, real accounts do not close at the end of an accounting period; their balances carry forward.
With real accounts, you debit the account when something comes into your business (e.g., an asset), and you credit the account when something goes out of your business.
Suppose you purchase furniture for £2,500 in cash. You need to debit your Furniture account (what comes in) and credit your Cash account (what goes out).
3. Debit Expenses and Losses, Credit Income and Gains
The final golden rule deals with nominal accounts, which are temporary accounts closed at the end of each accounting period.
With nominal accounts, you debit the account for business expenses or losses, and you credit the account for recorded income or gains.
Example 1: Expense or Loss
Suppose your business purchases goods worth £3,000 from Company Y. To record the transaction, you must debit the expense (£3,000 purchase) and credit the income.
Example 2: Income or Gain
Imagine you sell goods worth £1,700 to Company Z. You must credit the income in your Sales account and debit the expense.
By mastering these three golden rules of accounting, you’ll gain a deeper understanding of your business’s financial health. Accurate, well-organised and audited financial records will empower you to make informed decisions and drive your business towards success. Remember, solid accounting practices are the foundation of a thriving enterprise.