In the world of accounting there are a few basic fundamental rules that should be remembered. A quick internet search on the most important accounting rules will yield many results with the exact same 3 rules, usually worded the exact same way. These rules are known as the Golden Rules of Accounting. They are:
- In real accounts:Debit is what comes in and credit what goes out.
- In nominal accounts:Expenses and Losses will be debited & All Incomes and Gains will be credited
- In personal accounts: debit the receiver, credit the giver.
But what does all of this mean?
It means that debits and credits do not always mean what the word says. And in accounting, we need to through away the meaning of the word and accept that debits are on the left and credits are on the right.
For Rule 1: In real accounts, debit is what comes in and credit what goes out.
Let’s determine what real accounts are first. Real accounts are ALL asset accounts of a firm, which include anything tangible and intangible. Think of it this way. When you provide a service, usually you spend time and/or money doing that job. When you debit the account, the hole you got yourself into became a credit to someone else. In order to balance that credit, you now have to debit the whole.
Examples of real accounts include machinery, land, and buildings, among other things. By default, they have a negative balance. As a result, debiting what comes in adds to the existing account balance. When a tangible item leaves the firm, you reduce the account balance because the value of that item is gone. Accounts receivables are considered asset accounts, which means that to increase the amount in receivables, the account must be debited.
Other examples of asset accounts include the following:
Cash (Bank Accounts)
Long and Short-Term Investments
Allowance for Doubtful Accounts (Allowance for Bad Debt)
Land, Buildings, Machinery, and Equipment
Furniture and Fixtures
Rule 2: Expenses and Losses will be debited & All Incomes and Gains will be credited in nominal accounts
Income Statement Items are primarily associated with Nominal Accounts. These accounts typically deal with salary and wages, commission, utility bills, carriage, losses, income, and profit. Nominal accounts have an impact on a company for less than a year. Nominal accounts are closed at the end of each accounting year and restarted anew during the following account period. When the nominal accounts are closed, their balances will be transferred to the balance sheet.
When the account in question is a nominal account, this rule applies. The company’s capital is a liability. As a result, it has a default credit balance. When all income and profits are credited, the capital is increased; when costs and losses are debited, the capital is decreased. You have to keep everything in balance.
Examples of nominal accounts include:
Operating Revenues (Sales, Sales Revenue, etc.)
Operating Expenses (Wages, Rent, Utilities, Cost of Goods Sold, etc.)
Non-operating Revenues and Gains (Interest income)
Non-operating Expenses and Losses (Interest expense)
Rule 3 – Debit the receiver, credit the giver when dealing with personal accounts
When it comes to personal accounts, the rule of debiting the recipient and crediting the giver applies. It is possible to have a personal account for both persons and organizations in a general ledger system.
Whenever receiving something, make a debit to the account you’re holding it in. Credit the account when making a donation.
Take, for example, a purchase from a business worth $1,000 in products. Using your accounting software, you must debit your purchase account and credit the business you got the products from, in order to reconcile your books. You, credit provider of the products and you, debit the recipient’s account.
Another example that anyone with a bank account can relate to is your own personal bank account. When you put money in the bank, your balance gives you a credit. The bank, after receiving your money, debits their accounts to show that their cash actually went up. Even though their cash went up, they still have a liability to pay you, the credit holder.