Key Takeaways
- Closing entries are journal entries that close all temporary accounts and transfer their balances to the permanent accounts.
- The closing process ensures that the transactions affecting the income statement are separated between accounting periods to determine the financial performance of a company within a given period.
Overview of the Accounting Cycle
Closing the books is one of the last steps in the accounting cycle that is done after the financial statements are prepared. The accounting cycle refers to the steps that a company takes to prepare their financial statements.
Below are the steps in the accounting cycle, done in the following order:
- Gathering of business source documents
- Analyzing and journalizing business transactions
- Posting journalized transactions to the ledger
- Preparing an unadjusted trial balance
- Journalizing and posting adjusting entries
- Preparing an adjusted trial balance
- Preparing the financial statements
- Journalizing and posting closing entries
- Preparing a post-closing trial balance
- Journalizing and posting reversing entries
Introduction to Closing Entries
Closing Entries are journal entries that are recorded for the purpose of closing all temporary accounts and transferring their balances to permanent accounts.
Closing the books is the process of bringing the balance of all temporary accounts to zero by posting closing entries. This process is done at the end of the accounting period after adjusting entries and financial statements have been prepared.
What are temporary and permanent accounts?
Temporary Accounts, also called Nominal Accounts, are those accounts in the ledger where the balances are closed at the end of the accounting period and transferred to a permanent account. All income and expense accounts, such as revenues, cost of sales, depreciation, gains, and losses, that you’ll find in the income statement are temporary accounts.
Temporary accounts are used to measure income and determine the results of operations during a given period. They would have already served their purpose at the end of that period which is the reason why they are closed and their balances are reduced to zero. At the start of a new accounting period, new temporary accounts will be used to measure the company’s financial performance for the period.
On the other hand, Permanent Accounts, also called Real Accounts, are ledger accounts whose balances are not closed and are always carried over to the next accounting period. All accounts in the statement of financial position or balance sheet, such as cash, receivables, fixed assets, payables, and equity are permanent accounts.
Permanent accounts are not used to measure income and financial performance that’s why their balances are not closed at the end of the period. When a new accounting period begins, these accounts will retain their balances from the previous period.
In summary, the closing process only applies to temporary accounts found in the income statement. Accounts in the statement of financial position are permanent and their balances will not be closed at the end of an accounting period, unless the company stops using the account or ceases its operations.
Purpose of Closing Entries
The purpose of closing the books is to prepare the ledger accounts for recording the transactions of the next period. Reducing the balance of the temporary accounts to zero will allow a fresh start for those accounts whenever a new period begins. This way, there will be a separation of income and expense accounts between the current period and the previous ones.
It’s easier to measure and track revenues and expenses during the period when the accounts start with a clean slate. This ensures that the income earned and expenses incurred so far pertains only to that period and does not include cumulative data from previous periods.
In contrast, the balance of permanent accounts are cumulative since they are always brought forward across several accounting periods. Since the statement of financial position only shows data at a point in time, rather than within a period covered, permanent accounts don’t need to be closed for reasons of measuring performance over a selected period.
Preparing the Closing Entries
Closing entries transfer the balances of temporary accounts to an equity account. For corporations, it is the retained earnings account, while for sole proprietors and partnerships, it is the individual’s capital account.
However, transferring individual income and expense accounts directly to retained earnings or capital accounts may clutter these equity accounts especially if there are a lot of temporary accounts to be closed. For this reason, accountants use an income and expense summary account when preparing closing entries.
An Income and Expense Summary account serves as a temporary holding account for the balances of temporary accounts that are being closed. The purpose of this account is as follows:
- To keep equity accounts from getting cluttered with numerous closing journal entries.
- To serve as a central location that summarizes income and expenses during a period. The resulting balance of the income and expense summary account determines whether the financial performance for that period resulted in net income or net loss.
- To serve as an audit trail for accountants and auditors.
Once all temporary accounts are closed to the income and expense summary account, the balance of the latter will ultimately be closed to the relevant equity accounts.
When preparing closing entries, you may use the adjusted trial balance or income statement as a guide and starting point. Let’s go through each of the following closing entries:
- Closing income accounts
- Closing expense accounts
- Closing the income and expense summary account to equity
- Closing drawing accounts to capital accounts
Closing income accounts
All temporary accounts with a credit balance, particularly the income accounts, are debited while the income and expense summary account is credited.
For example, let’s assume that your company has the following income account balances:
The entry to close the above accounts is:
Closing expense accounts
All temporary accounts with a debit balance, particularly the expense accounts, are credited while the income and expense summary account is debited.
For example, let’s assume that your company has the following expense account balances:
The entry to close the above accounts is:
Closing the income and expense summary account
After all income statement accounts are closed to the income and expense summary account, the latter’s balance will determine whether there is net income or net loss.
If the income and summary account results in a credit balance, then the result is a net income. The entry to close this account to equity will be:
The equity account on which the income and expense summary will be closed may depend on the legal structure of your business. If it is a corporation, then it should be closed to the retained earnings account. However, for a sole proprietorship and partnership, the income and expense summary account is closed to the owner’s or partner’s capital accounts.
Continuing with the example above, the balance of the income and expense summary account is a credit of $29,800. The entry to close this, assuming that your company is a sole proprietorship, would be:
However, if the income and summary account shows a debit balance, then a net loss occurred. The closing entry would then be:
For example, let’s assume that the partnership of Mr. A and Ms. B suffered a net loss of $10,000 during a period. Both partners agreed to share any income or losses equally. The entry to close the income and expense summary account would be:
Closing drawing accounts
In a sole proprietorship or partnership, a drawing account is used to record any personal withdrawal of company assets by the owner or a partner. However, a drawing account is not considered an expense and is never reflected in the income statement.
The balance of the drawing account should be closed to the capital account to reduce the latter’s balance. The closing entry for this would be:
To illustrate, let’s assume that you withdrew $1,000 cash during the period for your personal use, the entry to close the drawing account will be:
The above closing entries are recorded in both the general journal and the general ledger. If you’re using a computerized accounting system, the software may automatically perform the closing process.
When you’re using a manual accounting system, an additional step after posting the closing entries is to double-rule all general ledger accounts. Double-ruling signifies that the current accounting period has ended.
For permanent accounts with debit balance, place the balance on the credit side before ruling. For those with credit balance, place the balance on the debit side before ruling.
As the next accounting period starts, reopen the permanent accounts by placing their balance to their normal sides. The transactions for the new period can now be recorded as usual.
Post-closing Trial Balance
The Post-closing Trial Balance is a trial balance that only lists all permanent accounts in the general ledger after the closing process is performed. Since all balances of the temporary accounts are zero at this point, no income, expense or drawing account should show in this trial balance.
Below is an example of a post-closing trial balance.
The goals of the post-closing trial balance are:
- Proves the equality of the ledger accounts as a new accounting period begins.
- Ensures that only permanent accounts that have balances are listed and carried forward.
Review Questions
- What does “closing the books” mean?
- What is the difference between temporary and permanent accounts?
- What is the reason why only the temporary accounts are closed and not the permanent accounts?
- What is the purpose of a post-closing trial balance?
- What is a drawing account and why is it closed to the capital account?
