The use of closing entries resets the temporary accounts to begin accumulating new transactions in the next period. Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period. These are general account ledgers that record transactions over the period and accounting cycle. These account balances are ultimately used to prepare the income statement at the end of the fiscal year. Examples of temporary accounts include revenue, expense and dividends paid accounts. Below are examples of closing entries that zero the temporary accounts in the income statement and transfer the balances to the permanent retained earnings account.
The trial balance is like a snapshot of your business’s financial health at a specific moment. In this case, since it’s an opening trial balance, we’re just getting started with the accounting cycle (Step 1). This process resets both the income and expense accounts to zero, preparing them for the next accounting period. The retained earnings account is reduced by the amount paid out in dividends through a debit, and the dividends expense is credited.
Introduction: The Accounting Cycle
A closing entry is a journal entry that is made at the end of an accounting period to transfer balances from a temporary account to a permanent account. It can directly be closed in the retained earnings account or it can be done through a longer process. The longer process requires temporary accounts to be closed in an intermediate income summary account first and then that account is zeroed out to the retained earnings. The result in both cases is the same and depends on the bookkeeper’s preference or company’s policy on it. You need to use closing entries to reduce the value of your temporary accounts to zero. That way, your next accounting period does not have a balance in your revenue or expense account from the previous period.
- A temporary account records balances for a single accounting period, whereas a permanent account stores balances over multiple periods.
- Income summary is a holding account used to aggregate all income accounts except for dividend expenses.
- Here we see that total expenses for both were $9,650 for January 2020.
If your business is a corporation, you will not have a drawing account, but if you paid stockholders, you will have a dividends account. If you paid dividends for the month, you will need to close that account as well. While these accounts remain on the books, their balance is reset to zero each month, which is done using closing entries. First, transfer the $5,000 in your revenue account to your income summary account. Clear the balance of the revenue account by debiting revenue and crediting income summary.
Preparing Closing Entries
Corporations will close the income summary account to the retained earnings account. Any account listed on the balance sheet, barring paid dividends, is a permanent account. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent. Whether you credit or debit your income summary account will depend on whether your revenue is more than your expenses. Because expenses are decreased by credits, you must credit the account and debit the income summary account. You must debit your revenue accounts to decrease it, which means you must also credit your income summary account.
In summary, permanent accounts hold balances that persist from one period to another. In contrast, temporary accounts capture transactions and activities for a specific period and require resetting to zero with closing entries. The income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet. Instead, the basic closing step is to access an option in the software to close the reporting period. Doing so automatically populates the retained earnings account for you, and prevents any further transactions from being recorded in the system for the period that has been closed. To close the income summary account to the retained earnings account, Bob needs to debit the retained earnings and credit the income summary.
Lengthy accounting cycles and inaccurate projections can result in revenue leaks costing companies millions. The income statement reflects your net income for the month of December. If your expenses for December had exceeded your revenue, you would have a net loss.
What is a Closing Entry?
Now that the income summary account is closed, you can close your dividend account directly with your retained earnings account. All the temporary accounts, including revenue, expense, and dividends, have been reset to zero. The balances from these temporary accounts have been transferred to the permanent account, retained earnings.
Which account is never closed?
A closing entry is recorded by debiting the relevant temporary account and crediting the relevant permanent account. All of the temporary accounts have now been closed, and at this point the income summary account should have a balance which is equal to the net income shown on Bob’s income statement. No, closing entries are performed after adjusting entries in the accounting cycle. Adjusting entries ensure that revenues and expenses are appropriately recognized in the correct accounting period. Here Bob needs to debit retained earnings account and credit dividends account.
In addition, if the accounting system uses subledgers, it must close out each subledger for the month prior to closing the general ledger for the entire company. If the subsidiaries also use their own subledgers, then their subledgers must be closed out before the results of the subsidiaries can be transferred to the books of the parent company. Whether you’re processing closing entries manually, or letting your accounting software do the work, closing entries are perhaps the most important part of the accounting cycle. The accountant can choose either method as eventually all the accounts will be transferred to the retained earnings account on the balance sheet.
However, you might wonder, “Where are the revenue, expense, and dividend accounts? If we expand the view, we’ll find the usual suspects—the temporary accounts. These accounts were reset to zero at the end of the previous year to start afresh. All of these entries have emptied the revenue, expense, and income summary accounts, and shifted the net profit for the period to the retained earnings account. Once all of the required entries have been made, you can run your post-closing trial balance, as well as other reports such as an income statement or statement of retained earnings. If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account.
Next, transfer the $2,500 in your expense account to your income summary account. If you don’t have accounting software, you must manually create closing entries each accounting period. For example, if your accounting periods last one month, use month-end closing entries. Whatever accounting period you select, make sure to be consistent and not jump between frequencies.
The general journal is used to record various types of accounting entries, including closing entries at the end of an accounting period. These permanent accounts form the foundation of your business’s balance sheet. Close the income summary account by debiting income summary and crediting retained earnings.