The accounting cycle is all about recording, categorizing, summarizing, and reporting a company’s financial transactions. A crucial step in this cycle happens at the end of each accounting period: closing entries.
Closing entries are journal entries made at the end of an accounting period to transfer the balances from temporary accounts (like revenue and expense accounts) to permanent accounts (like retained earnings). This process effectively resets the temporary accounts to zero, setting the stage for a clean start in the next accounting period.
This article provides a comprehensive guide to understanding and applying closing entries with examples. Let’s dive in and explore some practical examples of closing entries.
Understanding Temporary and Permanent Accounts
Before we get into closing entries, it’s important to understand the difference between temporary and permanent accounts. It all comes down to whether the account resets at the end of the year or keeps running.
Temporary Accounts
Temporary accounts only collect data for a single accounting period. Examples of temporary accounts include:
- Revenue accounts
- Expense accounts
- Dividend accounts
These accounts need to be closed at the end of the accounting period to prepare them for the next period and to give an accurate picture of the company’s financial performance during that specific period.
Permanent Accounts
Permanent accounts, on the other hand, carry their balances forward to future accounting periods. Examples of permanent accounts include:
- Asset accounts
- Liability accounts
- Owner’s equity accounts
Permanent accounts aren’t closed because they represent the cumulative financial position of the business over its entire lifespan, not just a single year.
The Income Summary Account
The income summary account is a temporary holding place that accountants use during the closing process. It’s where all revenue and expense accounts go to get zeroed out before the final numbers get transferred to retained earnings.
Think of it like this: all the money coming in and all the money going out get tallied up in one central spot. Then, the difference is moved over to show how much the company actually earned or lost during that period.
It’s not required to use this account, but a lot of businesses find it helpful.
Step-by-Step Guide to Recording Closing Entries
Closing entries are a standard part of the accounting cycle. Here’s how to do them:
Step 1: Close revenue accounts
To close revenue accounts, you’ll debit each revenue account and credit the income summary account. This process shifts the credit balance from each revenue account into the income summary.
For example, let’s say a company has $40,200 in repair service revenue and $30,200 in rent revenue. The closing entry is to debit Repair Service Revenue for $40,200 and Rent Revenue for $30,200. Then, you’ll credit Income Summary for the total, which is $70,400.
Step 2: Close expense accounts
To close expense accounts, you’ll credit each expense account and debit the income summary account. This moves the debit balance from each expense account into the income summary.
For instance, imagine a company has $31,350 in Wages Expense, $300 in Depreciation Expense, $6,000 in Interest Expense, $3,000 in Insurance Expense, and $15,000 in Supplies Expense. The closing entry will credit each of these expense accounts and debit Income Summary for the sum of all the expenses.
Step 3: Close the income summary account
First, you’ll determine the balance of the income summary account. It will show either a net income or a net loss.
If the income summary has a credit balance, it indicates a net income. In this case, you’ll debit the income summary and credit retained earnings.
If the income summary has a debit balance, it indicates a net loss. So, you’ll credit the income summary and debit retained earnings.
For example, if the Income Summary has a credit balance of $1,000, you would debit Income Summary $1,000 and credit Retained Earnings $1,000.
Step 4: Close dividend accounts
To close dividend accounts, you’ll debit retained earnings and credit the dividend account. This moves the debit balance from the dividend account to retained earnings.
For example, if a company paid $10,000 in dividends, the closing entry would debit Retained Earnings for $10,000 and credit Dividends for $10,000.
Examples of closing entries
Let’s say ABC Company had a full fiscal year and needs to make closing entries. Here’s how they might do it:
First, they need to close out their revenue accounts. If ABC Company had $500,000 in revenue, the journal entry would look like this:
Debit: Revenue – $500,000
Credit: Income Summary – $500,000
Next, they close out their expense accounts. If ABC Company had $300,000 in expenses, the journal entry would be:
Debit: Income Summary – $300,000
Credit: Expenses – $300,000
Now, they close the income summary to retained earnings. The income summary balance is $200,000 ($500,000 – $300,000). The journal entry is:
Debit: Income Summary – $200,000
Credit: Retained Earnings – $200,000
Finally, they close out the dividends. If ABC Company paid $50,000 in dividends, the journal entry is:
Debit: Retained Earnings – $50,000
Credit: Dividends – $50,000
These closing entries update retained earnings on the balance sheet and zero out the income statement accounts, getting them ready for the next period.
Why are closing entries and post-closing trial balances important?
Closing entries are a necessary step in the accounting process because they keep your financial reporting accurate. They ensure that all your temporary accounts start fresh with a zero balance at the beginning of each new accounting period. They also guarantee that the retained earnings figure on your balance sheet is correct.
If you don’t perform closing entries properly, you could misreport your retained earnings, leading to errors in your future financial statements.
The post-closing trial balance is a trial balance you prepare after you’ve posted your closing entries. The purpose is to double-check that your debit and credit balances are equal after you’ve made all your closing entries. It also makes sure that only your permanent accounts show a balance.
Closing entries and accounting software
Accounting software can automate the closing entry process, saving you time and effort. For example, Deskera accounting software has features that streamline and speed up the closing process.
Using accounting software for closing entries can:
- Reduce the risk of errors
- Increase efficiency
- Save time
If you’re not already using accounting software, it’s worth considering to simplify your closing process.
Conclusion
Closing entries are a critical step in the accounting cycle, allowing you to prepare reliable and accurate financial statements.
Understanding how to make closing entries is essential for sound financial management. By properly closing your temporary accounts, you’ll be ready to start a new accounting period with a clean slate.