Resources - Applied Finance / Chapter 3
Decoding Types of Accounts in Accounting & Their Golden Rules
Overview
An accountant’s job is to record any business transactions that involve money coming into or going out of the business. To keep a track of these inflows and outflows, all business transactions are classified into accounts.
Scope: To understand the various types of accounts along with their debit and credit rules
- Real Accounts
- Nominal Accounts
- Personal Accounts
An Account is a record or statement of financial expenditure and receipts relating to a particular period or purpose.At the end of the period, one can easily check the balance in each account pertaining to different purposes.
These different accounts are often collated into a COA or Chart of Accounts, to navigate multiple transactions quickly & easily. This Sorting and tracking of transactions using a chart of accounts lays the groundwork for formulating financial accounts that aid business decisions.
Types of Accounts in Accounting
Real Accounts
A Real Account deals with the material assets of a business, such as property.
These accounts consist of:
- Assets
- Liabilities
- Equity
Real Accounts reflect your company’s financial status and can change from time to time because they’re active throughout the entire year.
Golden Rule: ‘Debit what comes in, Credit what goes out.’
Debit what comes in
Add to the existing balance
Credit what goes out
Deduct from the existing balance.
ASSETS: Resources that are owned or controlled by the business which help in generating revenue in the form of cash, inventories, machinery, etc
Company XYZ bought machinery worth Rs. 50,000 in cash Machinery and cash both are assets. In this transaction, there was an increase in machinery whereas cash was reduced by Rs.50,000. Thus, the Machinery account should be debited while the cash account should be credited for recording this transaction.
LIABILITIES: Represent the business obligations to outsiders. They are claims against the assets /resources by the outsiders such as loans payable, creditors, etc.
XYZ takes a loan of Rs.100,000 from a bank for the purpose of expansion. The loan is an obligation for the business which is to be paid back in future. Hence, it is a liability. Something that the business owes to outsiders. In this case, the bank account of XYZ co. increases and it is debited being an asset of the business. On the other hand, the loan is credited as it causes an increase in the liabilities of the business.
Equity: Represents the owners’ claim on the assets.
X, the owner of the business, adds Rs. 200,000 in cash in the business in the form of capital. In this case, the business receives more equity and hence X capital account is credited. Also, cash is added and therefore, it is debited by Rs. 200,000 being the asset of the business.
Note: Real accounts do not close at the end of the accounting period. Their opening balances are brought forward from the previous accounting period.
Nominal Accounts
A nominal account includes all expenses, incomes, and any loss or gain arising out of a sale.
These accounts consist of:
- Expenses
- Revenues
A nominal account, or temporary account, is essentially the opposite of a real account. Nominal account balances close at the end of the financial year & are recorded on the Income Statement. You record these accounts on your business’s income statement. Temporary accounts include revenue, expense, and gain and loss accounts.
Golden Rule: ‘Debit what comes in, Credit what goes out.’
Debit the receiver
Any person receiving any amount is debited in the books of accounts.
Credit the giver
Any person giving any amount is credited in the books of accounts.
Expenses: The costs incurred for operating the business such as rent of the factory premises, wages paid to factory staff, salaries to office staff, etc
XYZ company pays wages to the factory workers of Rs.100000 in cash. The wages are expenses incurred. They reduce the owners’ equity by Rs.100000 hence, it must be treated as the opposite of Equity. Equity increases are credited. Therefore, wages paid will be debited by Rs. 100,000. Cash as an asset is reduced and hence, credited by the same amount.
REVENUE: The income earned business operations such as the sale of goods, revenue from services delivered, etc.
XYZ company makes sales in cash worth Rs. 200,000. Sales revenue increases the owners’ equity by this amount; Hence, it must be treated the same way as Equity. Equity increases are credited. Therefore, sales revenue received will also be credited by Rs.200,000. Cash being an asset is increased due to this transaction and hence, debited by the same amount.
Personal Accounts
Personal accounts are accounts owned by individuals, firms, companies & institutions. In other words, these accounts imply a person in the eyes of law or in existence.
Following are the sub-accounts under this category:
- Natural Personal Accounts: Comprise of real persons or individuals. Ex- Raman A/c, Seema A/c, Rajan A/c, etc.
- Artificial Personal Accounts: Comprise of firms, companies, and institutions as these are treated as artificial persons in the eyes of law. Ex- Raman A/c, Seema A/c, Rajan A/c, etc.
- Representative Personal Accounts: Linked to persons or group of persons. Ex- salaries outstanding, Prepaid rent, Income received in advance, etc.
Golden RULE: ‘Debit the receiver, Credit the giver.’
Debit the receiver
Any person receiving any amount is debited in the books of accounts.
Credit the giver
Any person giving any amount is credited in the books of accounts.
XYZ company pays their suppliers Ram & Sons through cheque. Here, Ram & Sons is the receiver and giver is the bank through which payment is made. Thus, Ram & Sons is debited, and Bank A/c is credited.
Closing summary
The entire accounting system revolves around these accounts. It is important to have a good grasp of these with their golden rules of recording.
The subsequent chapter will enhance your knowledge of the double-entry system of accounting for treating business transactions by using accounting equations.