Understanding Closing Entries in Accounting: Purpose and Process
This gives you the balance to compare to the income statement, and allows you to double check that all income statement accounts are closed and have correct amounts. If you put the revenues and expenses directly into retained earnings, you will not see that check figure. No matter which way you choose to close, the same final balance is in retained earnings. Closing journal entries are used at the end of the accounting cycle to close the temporary accounts for the accounting period, and transfer the balances to the retained earnings account. The nominal account or revenue accounts, i.e. income and expenses, are closed by providing closing entries after the financial statements are prepared.
We see from the adjusted trial balance that our revenue accounts have a credit balance. To make them zero we want to decrease the balance or do the opposite. We will debit the revenue accounts and credit the Income Summary account. The credit to income summary should equal the total revenue from the income statement. The income summary account balance depends on whether or not the business in question earns or loses money during the accounting period being closed. If the company earns money, the account balance will be a credit.
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An accounting year-end which is not the calendar year end is sometimes referred to as a fiscal year end. The third entry requires Income Summary to close to the RetainedEarnings account. To get a zero balance in the Income Summaryaccount, there are guidelines to consider. When preparing closing entries, there are a few things to bear in mind. However, doing so would result in an excessive amount of detail in the capital account of the permanent owner.
Temporary vs. Permanent Accounts
Distinguishing between temporary and permanent accounts is fundamental to understanding the closing process. Temporary accounts, or nominal accounts, include revenues, expenses, and dividends. These accounts capture financial activity within a specific period and are closed at the end of each cycle to evaluate performance independently.
Cash
The trial balance is like a snapshot of your business’s financial health at a specific moment. It lists the current balances in all your general ledger accounts. In this case, we can see the snapshot of the opening trial balance below. Clear the balance of the revenue account by debiting revenue and crediting income summary. The income summary is a temporary account how when and why do you prepare closing entries used to make closing entries. Income and expenses are closed to a temporary clearing account, usually Income Summary.
Close and
- We have completed the first two columns and now we have the final column which represents the closing (or archive) process.
- The process transfers these temporary account balances to permanent entries on the company’s balance sheet.
- After transferring all revenues and expenses to the Income Summary account, the remaining balance shows the company’s net income or net loss for the period.
- Of course, this process assumes that closing journal entries are made manually.
- In a partnership, a drawing account is maintained for each partner.
This follows the rule that credits are used to record increases in owners’ equity and debits are used to record decreases. Several internet sites can provide additional information for you on adjusting entries. One very good site where you can find many tools to help you study this topic is Accounting Coach which provides a tool that is available to you free of charge. Visit the website and take a quiz on accounting basics to test your knowledge.
In this chapter, we complete the final steps (steps 8 and 9) ofthe accounting cycle, the closing process. This is an optional stepin the accounting cycle that you will learn about in futurecourses. Steps 1 through 4 were covered in Analyzing and Recording Transactions and Steps 5 through 7were covered in The Adjustment Process. After posting the above entries, all the nominal accounts would zero-out, hence the term “closing entries”. Events are analyzed to find the impact on the financial position or to be more specific the impacts on the accounting equation.
In a computerized accounting system, the closing entries are likely done electronically by simply selecting “Closing Entries” or by specifying the beginning and ending dates of the financial statements. As a result, the temporary accounts will begin the following accounting year with zero balances. Regardless of size or structure, closing entries are essential for accurate period-to-period financial reporting. While understanding the manual process provides essential accounting knowledge, modern businesses benefit significantly from automating these procedures.
To further clarify this concept, balances are closed to assure all revenues and expenses are recorded in the proper period and then start over the following period. The revenue and expense accounts should start at zero each period, because we are measuring how much revenue is earned and expenses incurred during the period. However, the cash balances, as well as the other balance sheet accounts, are carried over from the end of a current period to the beginning of the next period. The closing entry entails debiting income summary and crediting retained earnings when a company’s revenues are greater than its expenses. The income summary account must be credited and retained earnings reduced through a debit in the event of a loss for the period. The retained earnings account balance has now increased to 8,000, and forms part of the trial balance after the closing journal entries have been made.
- Closing entries take place at the end of an accounting cycle as a set of journal entries.
- This entry is made at the end of an accounting period by moving information from the income statement to the balance sheet.
- All temporary accounts must be reset to zero at the end of the accounting period.
- It can be a calendar year for one business while another business might use a fiscal quarter.
- The balance in the Income Summary account equals the net income or loss for the period.
If dividends were not declared, closing entries would cease atthis point. If dividends are declared, to get a zero balance in theDividends account, the entry will show a credit to Dividends and adebit to Retained Earnings. As you will learn in Corporation Accounting, there are three components to thedeclaration and payment of dividends. The first part is the date ofdeclaration, which creates the obligation or liability to pay thedividend. The second part is the date of record that determines whoreceives the dividends, and the third part is the date of payment,which is the date that payments are made. Printing Plus has $100 ofdividends with a debit balance on the adjusted trial balance.