Closing Entries as Part of the Accounting Cycle

Find Out How to Get Ready for the Next Account Period

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Closing entries are journal entries made at the end of an accounting cycle to set the balance of temporary accounts to zero and to begin the next accounting period. The process transfers these temporary accounts entries to the company's balance sheet. Temporary accounts that are closed include revenue, expense and drawing accounts.

The assets, liabilities and owner's equity accounts, however, are not closed.

They are permanent accounts and their ending balances are the beginning balances for the next accounting period. 

Why Do Closing Entries?

When the revenue, expense and drawing accounts--the temporary accounts--are closed, their balances return to zero in preparation for the new accounting period. That is one reason closing entries are prepared. The other reason closing entries are prepared is so the company's retained earnings account will show any actual increase in revenues from the prior year and any decreases from dividends 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 underlying purpose of closing entries is to zero out those temporary accounts that have changed during the account period being closed in order to begin entries in the next accounting cycle.

A term often used for closing entries is "reconciling" the company's accounts.  

The Income Summary Account

The income summary account is 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 -- the earnings figure that remains after subtracting all business expenses, depreciation, debt service expense and taxes.

 The income summary account is never used when preparing the financial statement because its only purpose is to be used during the closing process.

Four Steps to Complete Closing Entries

There are four steps to complete the closing entries:

  1. Look for the revenue accounts in the trial balance, which is the list of all the revenue and capital accounts in the company's ledger. You will see that they have a credit balance. In order to return them to zero, you must debit each revenue account to the income summary. 
  2. Look for the expense accounts in the trial balance. You will see that they have a debit balance. You must credit each expense account to the income summary in order to return the expense account total to zero. 
  3. If the income summary has a credit balance, that is the company's net income. Now, the income summary must be closed to retained earnings. Debit income summary and credit retained earnings.
  4. The last step is to close the dividend account to retained earnings. The dividend account has a debit account. Credit the dividend account and debit the retained earnings account. Retained earnings now has the appropriate amount of the net income that was allocated to it in it.

For most companies, this is the end of the accounting cycle.

 

An Acceptable Shortcut

The four step method described above is often the best choice because it provides a clear audit trail. For smaller businesses, however, it is often quicker and equally accurate to bypass the income summary and instead to close temporary entries directly to the retained earnings account. The end result is the same in both instances: temporary accounts are closed to the retained earnings account for presentation in the company's balance sheet.