When an accounting period comes to an end, there are several steps an accountant needs to take to clean up a company’s books and prepare them for the next accounting period. This cyclical process is referred to as the accounting cycle, and one of the last few steps in the process is the act of making closing entries. Show Before closing entries can be made, all transactions that took place before the end of the accounting period (which can be a month, quarter, or year) must be accounted for and posted to the general ledger. Posting closing entries, then, clears the way for financial statements to be made. So how does one make a closing entry? Before anything is recorded in any ledger, it’s important to understand the difference between temporary and permanent accounts because moving entries from temporary accounts to permanent ones is the basis of closing entries. Temporary AccountsTemporary accounts, also referred to as nominal accounts or income statement accounts, start each accounting period with a balance of zero. These accounts cover categories like revenue and expenses, both of which are numbers found on the income statement. As a reminder, the income statement shows how well a company did over the last period. In other words, it’s a measure of performance over a set period of time. As such, all the numbers on it are temporary, and the next period’s income statement will bear no resemblance to the last. This is reflected in the temporary accounts that feed the income statement. As an accounting period progresses, entries for income and expenses will be recorded in these temporary accounts and, at the end of the period, must be “closed out” and returned to a zero balance so that new transactions will not be confused with those from the last period. During the closing entries process, an accountant would close revenue and close expenses by transferring those balances to permanent accounts.  The hardest part is getting started. We’ll show you the way. Permanent AccountsPermanent accounts are those that are not bound by a set time frame. They include things like retained earnings and equity accounts. They are also commonly referred to as balance sheet accounts. Unlike the income statement, the balance sheet is not a reflection of performance. Instead, it shows a company’s current position as a result of all accounting periods that came before. If a company made $50,000 in profit one month, for example, the income statement would show all the details of how that profit was made—what the company spent money on, how much was brought in, etc. The balance sheet, on the other hand, would simply see the retained earnings line jump up by $50,000. Permanent accounts, like the balance sheet that they feed, show the cumulative total of past efforts. So when you close out a temporary account, you add (or subtract) from the totals shown in the permanent accounts. Making closing entries means creating a zero balance in all temporary accounts by carrying those balances over to permanent accounts. This prepares the books for the next accounting period to start. Income Summary AccountWhen the time comes to make closing entries, an accountant will transfer all the balances in the temporary accounts to the Income Summary Account. This account works as a holding account for these balances so that the accountant can then make fewer entries to transfer the balance to the permanent accounts. After all account balances for temporary accounts have been transferred (and a zero balance remains in each), the income summary account should mirror your net income. This is the “bottom line” on the income statement. If this amount is accurate, you’ll then close Income Summary and transfer the balance to permanent accounts. Most often, this means transferring profit into the retained earnings account. How to Post Closing Journal EntriesBecause the closing process relies on double-entry accounting, making closing entries means making a series of debits and credits to the appropriate accounts. Let’s assume Matty P’s Pizza Parlor has a total of $100,000 in income accounts and $40,000 in expense accounts after last month’s accounting period. The first step will be to close out these accounts and transfer those temporary account balances to the income summary account through journal entries. To do so, we’ll debit revenues and credit expenses.
*Note: There may be many accounts that make up your expenses. For instance, you might have a cost of goods sold account and a utilities account. Consult your chart of accounts and make credits for each expense account. This brings us to zero balances in both the expense and revenue accounts. The income summary account now shows a balance of $60,000, which matches the pizza parlor’s net income. Next up, we’ll transfer the income summary account balance to permanent accounts—the retained earnings account in this case. To do so, we’ll make the following journal entries. If any dividend payments need to be made, this is also when they are taken care of by debiting the retained earnings account and crediting the dividend account.
After this, Matty P’s books are ready for the next accounting period. Of course, this process assumes that closing journal entries are made manually. Before wrapping up, it’s important to note that accounting software has changed up the process slightly. For starters, accounting software can generate reports automatically based on the dates transactions are posted. It’s not as important to close out temporary accounts every month in order to generate new reports. Many businesses may opt to only close out those accounts at the end of the year and transfer the balance to the permanent accounts then. Want to learn how ScaleFactor’s automated accounting software can keep your books clean and provide you with accurate financial statements? Schedule a personalized demo today. Learn how to read your statements at a glance.
In simple words, Closing entries are a set of journal entries made at the end of the accounting period to move balances from temporary ledger accountsLedger in accounting records and processes a firm’s financial data, taken from journal entries. This becomes an important financial record for future reference. It is used for creating financial statements. It is also known as the second book of entry.read more like revenue, expense, and withdrawal/dividends to permanent ledger accounts.
You are free to use this image on your website, templates, etc., Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: Closing Entries in Accounting (wallstreetmojo.com) Steps for Posting Closing Entries JournalExample of Closing Journal EntriesTo look at it more practically, let’s take closing entries journal example of a small manufacturing company ABC Ltd which is going for the annual closing of books: ABC Ltd. earned ₹ 1,00,00,000 from sales revenue over the year 2018 so the revenue accountRevenue accounts are those that report the business's income and thus have credit balances. Revenue from sales, revenue from rental income, revenue from interest income, are it's common examples.read more has been credited throughout the year. At the end of the year, it needs to be zeroed out by debiting it and crediting the Income summary account.
Let’s also assume that ABC Ltd incurred expenses of ₹ 45,00,000 in the raw material purchase, machinery purchase, salary paid to its employees, etc., over the accounting year 2018. All these examples of closing entries in journals have been debited in the expense account. At the end of the accounting year 2018, the expense account needs to be credited to clear its balances, and the Income summary account should be debited.
So for posting the closing entries in the general ledger, the balances from revenue and expense account will be moved to the income summary account. Income summary account is also a temporary account that is just used at the end of the accounting period to pass the closing entries journal. It is not reported anywhere. The net balance of the income summary account would be the net profit or net loss incurred during the period. In the above case, a net credit of ₹ 55,00,000 or profit will finally be moved to the retained earnings account by debiting the Income summary account. The accounting assumptionAccounting assumptions are a set of rules that ensures an organization's business operations are conducted efficiently and as per the standards defined by the FASB (Financial Accounting Standards Board), which ultimately helps lay the groundwork for consistent, reliable and valuable information.read more here is that any profit earned during the period needs to be retained for use in future company investments.
Something noteworthy here is that the above closing entry can be passed even without using the income summary accountAn income summary is a transitory account created to transfer all the expenses and revenue accounts at the end of the accounting period. An increase in credit side balance exhibits profit, while a higher debit side balance shows a loss.read more. i.e., moving the balances directly from revenue and expense accountExpense accounting is the accounting of business costs incurred to generate revenue. Accounting is done against the vouchers created at the time the expenses are incurred.read more to the retained earnings account. But using the income summary account was used to give a clear view of the company’s performance when there was only manual accounting. Usually, where the accounting is automated or done using software, this intermediate income summaryAn income summary is a transitory account created to transfer all the expenses and revenue accounts at the end of the accounting period. An increase in credit side balance exhibits profit, while a higher debit side balance shows a loss.read more account is not used, and the balances are directly transferred to the retained earnings account. The temporary accounts need to be zero at the end of an accounting period. Coming back to our initial example, let’s suppose that ABC Ltd also paid out dividends worth ₹ 5,00,000 to its shareholders during the accounting year 2018, i.e., the dividend account has a debit balanceIn a General Ledger, when the total credit entries are less than the total number of debit entries, it refers to a debit balance. A debit balance is a net amount often calculated as debit minus credit in the General Ledger after recording every transaction.read more of ₹ 5,00,000, which needs to be credited and then directly debiting the retained earnings account. Since the dividends account is not an income statement account, it is directly moved to the retained earnings account.
Eventually, after following the above steps, the temporary account balance will be emptied into the balance sheet accounts. TypesBelow are the types of Closing Entries segregated into Temporary and Permanent accounts: You are free to use this image on your website, templates, etc., Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: Closing Entries in Accounting (wallstreetmojo.com) #1 – Temporary accountsTemporary Accounts entries are only used to record and accumulate the accounting or financial transactions over the accounting year, and they do not reflect the company’s financial performance. So it is essential to clear the balances of temporary accountTemporary accounts are nominal accounts that start with zero balance at the beginning of the financial year. The balance is visible in the income statement at the year-end and then transferred to the permanent as reserves and surplus.read more so that, for example, revenues and expenses for ABC Ltd. for the accounting year 2018 should be isolated and not be mixed with revenues and expenses of the year 2019. #2 – Permanent accountsPermanent Account entries show the long-standing financial position of a company. It is necessary to transfer the balances to this account because it takes into account the appropriate consideration of assets or liabilities for future utilization, e.g., Let’s suppose ABC Ltd. incurred an expense to buy machinery to be used for manufacturing, it is going to be utilized in the future years and not just in the accounting year in which it was recorded, so it needs to be moved to the balance sheet accountA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more from the temporary account. So, if the closing entries journal is not posted, there will be incorrect reporting of financial statements. And not having an accurate depiction of change in retained earnings might mislead the investors about a company’s financial position. Hence, strong accounting regulations and policies restrict the public listed companies from abusing certain loopholes while producing their financial reports. Apart from the guidelines, there are strict auditing rules to protect and ensure the integrity of the numbers being reported for any accounting periodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more. Having an intermediate income summary account proves helpful to the accountant here as it provides a trail of accounting closing entries for each financial transaction. Recommended ArticlesThis article has been a guide to what Closing Entries in Accounting are. Here we discussed types of Closing Entries Journal along with practical examples. You can learn more about accounting with the following articles – |
What entries are made to eliminate the balances of the nominal accounts to ready them for the next accounting period?
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