The double-entry system of credit and debt is one of the most important aspects of accounting. Important as it is, people often find it difficult to understand. Typically a certified professional handles this aspect of accounting. However, getting a qualified professional may be difficult and expensive especially if you are just starting your business.
The best way to handle credit and debt is by getting acquainted with the three golden rules of accounting. However, despite being extremely useful, due to their complexity, these rules have become one of accounting’s best-kept secrets.
But don’t worry we are going to demystify these rules for you so that you may also be able to use these like the most highly qualified bookkeepers.
Before you understand the golden rules it is important that you understand the different types of accounts you may have to deal with.
There are three types of accounts:
- Real Account: These are for transactions related to tangible things or assets of a business. Changes in the real account happen in the following cases:
- Sale or purchase of an asset
- Creation or disposal of an asset
The two types of real accounts are tangible and intangible.
- Personal Account: These are for transactions with individuals, firms or groups of associates. The types of transactions that can be done with personal accounts include:
- Natural person accounts: Relate to human beings
- Artificial persons account: Relate to institutions, companies and other such legal entities. Example: Insurance companies, hospitals, Cooperative societies
- Representative accounts: Represent one person or group of people. Example: Commission account, outstanding salary account
- Nominal Account: These are for transactions associated with losses, expenses, income or gains. The final outcome of a nominal account is recorded as profit or loss.
You can find out about your account type from your copy of the verification letter since banks typically ask for this information. However, the format varies as per banks since different banks have different formats of banker’s verification letters.
The golden rule applies to your needs depends on the account you are dealing with:
- If real account then:
- Debit what comes into the business
- Credit what goes out of the business
By default real accounts have a negative balance. Therefore when you debit what comes in you are essentially adding it to the current account balance. Similarly, the reverse is true for credit.
- If personal account then:
- Debit the receiver
- Credit the giver
When your company pays a person or a legal entity a debit is made in that person’s account. However, if the person donates to your company it acts as an inflow hence you need to credit that personal account.
- If nominal account then:
- Debit losses and expenses
- Credit income and gains
In the case of a nominal account, a debit is made if your business makes a loss or incurs an expense or losses are made. On the flip side, credit is made in case your business earns income or gain.
With these accounting secrets in your toolkit, your bookkeeping skills will become as efficient as any certified professional.