Closing entries take place at the end of an accounting cycle as a set of journal entries. The closing entries serve to transfer the balances out of certain temporary accounts and into permanent ones. This resets the balance of the temporary accounts to zero, ready to begin the next accounting period.
The process transfers these temporary account balances to permanent entries on the company's balance sheet. Temporary accounts that close each cycle include revenue, expense and dividends paid accounts.
The balance sheet's assets, liabilities and owner's equity accounts, however, are not closed. These permanent accounts and their ending balances act as the beginning balances for the next accounting period.
The Purpose of Closing Entries
A term often used for closing entries is "reconciling" the company's accounts. Accountants perform closing entries to return the revenue, expense, and drawing temporary account balances to zero in preparation for the new accounting period.
The closing entries are also recorded so that the company's retained earnings account shows any actual increase in revenues from the prior year and also shows any decreases from dividend payments and expenses.
Retained earnings are those earnings not distributed to shareholders as dividends, but retained for further investment, often in advertising, sales, production, and equipment.
The Income Summary Account
The income summary account serves as a temporary account used only during the closing process. It contains all the company's revenues and expenses for the current accounting time period. In other words, it contains net income or the earnings figure that remains after subtracting all business expenses, depreciation, debt service expense, and taxes. The income summary account doesn't factor in when preparing financial statements because its only purpose is to be used during the closing process.
Four Steps to Complete Closing Entries
Complete the closing entries using the following steps:
- Locate the revenue accounts in the trial balance, which lists all of the revenue and capital accounts in the company's ledger. You will see that they have a credit balance. To return them to zero, you must perform a debit entry for each revenue account to move the balance to the income summary account.
- Locate the expense accounts in the trial balance. You will see that they have a debit balance. Perform a credit entry for each expense account to the income summary account, to return the expense account totals to zero.
- If the income summary account has a credit balance after completing the entries, or the credit entry amounts exceeded the debits, the company has a net income. If the debit balance exceeds the credits the company has a net loss. Now, the income summary must be closed to the retained earnings account. Perform a journal entry to debit the income summary account and credit the retained earnings account.
- The last step involves closing the dividend account to retained earnings. The dividend account has a normal debit balance. Credit the dividend account and debit the retained earnings account. Retained earnings now reflect the appropriate amount of net income that was allocated to it.
For most companies, this completes the accounting cycle for the current time period.
A Shortcut and Software Handling
The four-step method described above works well because it provides a clear audit trail. For smaller businesses, it might make sense to bypass the income summary account and instead close temporary entries directly to the retained earnings account.
The end result is equally accurate, with temporary accounts closed to the retained earnings account for presentation in the company's balance sheet.
In some cases, accounting software might automatically handle the transfer of balances to an income summary account, once the user closes the accounting period. The entries take place "behind the scenes," often with no income summary account showing in the chart of accounts or other transaction records.