5 1: Describe and Prepare Closing Entries for a Business Business LibreTexts

From this trial balance, as we learned in the prior section, you make your financial statements. After the financial statements are finalized and you are 100 percent sure that all the adjustments are posted and everything is in balance, you create and post the closing entries. The closing entries are the last journal entries that get posted to the ledger. Other accounting software, such as Oracle’s PeopleSoft™, post closing entries to a special accounting period that keeps them separate from all of the other entries.

What is the purpose of closing entries?

Companies are required to close their books at the end of eachfiscal year so that they can prepare their annual financialstatements and tax returns. However, most companies prepare monthlyfinancial statements and close their books annually, so they have aclear picture of company performance during the year, and giveusers timely information to make decisions. On the other hand, if the cost exceeds the income, a net loss occurs. A closing entry is provided for the closing of income-expenditure accounts. At the end of each accounting period, financial statements are prepared to determine the financial status of the company.

Step 1: Close Revenue accounts

If your expenses for December had exceeded your revenue, you would have a net loss. When closing expenses, you should list them individually as they appear in the trial balance. That’s where automation tools like Autonomous Accounting come in.

Understanding Closing Entries

To get a zero balance in the Income Summary account, there are guidelines to consider. It is the end of the year, December 31, 2018, and you are reviewing your financials for the entire year. You see that you earned $120,000 this year in revenue and had expenses for rent, electricity, cable, internet, gas, and food that totaled $70,000. That’s why most business owners avoid the struggle by investing in cloud accounting software instead. An accounting year-end which is not the calendar year end is sometimes referred to as a fiscal year end.

Closing Entries FAQ

Imagine you own a bakery business, and you’re starting a new financial year on March 1st. The next day, January 1, 2019, you get ready for work, but before you go to the office, you decide to review your financials for 2019. What are your total expenses for rent, electricity, cable and internet, gas, and food for the current year? You have also not incurred any expenses yet for rent, electricity, cable, internet, gas or food. This means that the current balance of these accounts is zero, because they were closed on December 31, 2018, to complete the annual accounting period.

For our purposes, assume that we are closing the books at theend of each month unless otherwise noted. Income summary account is a temporary account which facilitates the closing process. This entry zeros out dividends and reduces retained earnings by total dividends paid.

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Closing entry to account for draws taken for the month, for sole proprietors and partnerships. Most organizations appear to be doing well on the surface while underlying accounting management issues silently sabotage.

For example, $100 in revenue this year does not count as $100 of revenue for next year, even if the company retained the funds for use in the next 12 months. The purpose of the closing entry is to reset the temporary account balances to zero on the general ledger, the record-keeping system for a company’s financial data. A net loss would decrease owner’s capital, so we would do the opposite in this journal entry by debiting the capital account and crediting Income Summary. After the closing journal entry, the balance on the dividend account is zero, and the retained earnings account has been reduced by 200. Clear the balance of the expense accounts by debiting income summary and crediting the corresponding expenses.

Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step. There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again. Temporary accounts are income statement accounts that are used to track accounting activity during an accounting period. For example, the revenues account records the amount of revenues earned during an accounting period—not during the life of the company. We don’t want the 2015 revenue account to show 2014 revenue numbers.

Notice that the balances in interest revenue and service revenue are now zero and are ready to accumulate revenues in the next period. The Income Summary account has a credit balance of $10,240 (the revenue sum). Failing to make a closing entry, or avoiding the closing process altogether, can cause a misreporting of the current period’s retained earnings. It can also create errors and financial mistakes in both the current and upcoming financial reports, of the next accounting period. Accounts are considered “temporary” when they only accumulate transactions over one single accounting period. Temporary accounts are closed or zero-ed out so that their balances don’t get mixed up with those of the next year.

Let’s explore each entry in more detail using Printing Plus’s information from Analyzing and Recording Transactions and The Adjustment Process as our example. The Printing Plus adjusted trial balance for January 31, 2019, is presented in Figure 5.4. However, if the company also wanted to keep year-to-date information from month to month, a separate set of records could be kept as the company progresses through the remaining months in the year.

Closing entries prepare a company for the next accounting period by clearing any outstanding balances in certain accounts that should not transfer over to the next period. Closing, or clearing the balances, means returning the account to a zero balance. Having a zero balance in these accounts is important so a company can compare performance across periods, particularly with income. It also helps the company keep thorough records of account balances affecting retained earnings. Revenue, expense, and dividend accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of the time period assumption.

This trial balance gives the opening balances for the next accounting period, and contains only balance sheet accounts including the new balance on the retained earnings account as shown below. The statement of retained earnings shows the period-ending retained earnings after the closing entries have been posted. When you compare the retained earnings ledger (T-account) to the statement of retained earnings, the figures must match. It is important to understand retained earnings is not closed out, it is only updated. Retained Earnings is the only account that appears in the closing entries that does not close. You should recall from your previous material that retained earnings are the earnings retained by the company over time—not cash flow but earnings.

1. All of Paul’s revenue or income accounts are debited and credited to the income summary account.
2. The net result of these activities is to move the net profit or net loss for the period into the retained earnings account, which appears in the stockholders’ equity section of the balance sheet.
3. All of these entries have emptied the revenue, expense, and income summary accounts, and shifted the net profit for the period to the retained earnings account.
4. The first entry closes revenue accounts to the Income Summary account.
5. Retained earnings represent the amount your business owns after paying expenses and dividends for a specific time period.

Any account listed on the balance sheet, barring paid dividends, is a permanent account. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent. Let’s move on to learn about how to record closing those temporary accounts. All of Paul’s revenue or income accounts are debited and credited to the income summary account.

We will debit the revenue accounts and credit theIncome Summary account. The credit to income summary should equalthe total revenue from the income statement. Whether you’re posting entries manually or using accounting software, all revenue and expenses for each accounting period are stored in temporary accounts such as revenue and expenses.

Printing Plus has a $4,665 credit balance in its Income Summary account before closing, so it will debit Income Summary and credit Retained Earnings. The business has been operating for several years but does not have the resources for accounting software. This means you are preparing all steps in the accounting cycle by hand. Adjusting entries are used to modify accounts so that they’re in compliance with the accrual concept of recording income and expenses. We at Deskera offer the best accounting software for small businesses today. Our program is specifically developed for you to easily set up your closing process and initiate book closing within seconds – no prior technical knowledge necessary.

The last step of an accounting cycle is to prepare post-closing trial balance. It’s important to note that neither the drawing nor the dividends accounts need to be transferred to the income summary account. Corporations will close the income summary account to the retained earnings account. Closing entries are completed at the end of each accounting period after your adjusted trial balance has been run. To close revenue accounts, subtract the total revenue earned during a period from the initial balance. The general journal is used to record various types of accounting entries, including closing entries at the end of an accounting period.

Closing entries are journal entries made at the end of an accounting period, that transfer temporary account balances into a permanent account. If a company’s revenues are greater than its expenses, the closing entry entails debiting income summary and crediting retained earnings. In the event of a loss for the period, the income summary account needs to be credited and retained earnings reduced through a debit. Since dividend and withdrawal accounts https://www.bookkeeping-reviews.com/ are not income statement accounts, they do not typically use the income summary account. These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. Notice that the effect of this closing journal entry is to credit the retained earnings account with the amount of 1,400 representing the net income (revenue – expenses) of the business for the accounting period.

Instead, companies transfer the net income or net loss from the revenue and expense accounts to a temporary account called “Income Summary,” and then to the owner’s capital. Closing entries are journal entries required to close all nominal or temporary accounts at the end of a financial or accounting period or year. If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account. You can do this by debiting the income summary account and crediting your capital account in the amount of $250.

The accounts that need to start with a clean or $0 balance going into the next accounting period are revenue, income, and any dividends from January 2019. To determine the income (profit or loss) from the month of January, the store needs to close the income statement information from January 2019. We see from the adjusted trial balance that our revenue account has a credit balance. To make the balance zero, debit the revenue account and credit the Income Summary account.

First, all the various revenue account balances are transferred to the temporary income summary account. This is done through a journal entry that prepaid expenses meaning journal entry and examples debits revenue accounts and credits the income summary. All temporary accounts must be reset to zero at the end of the accounting period.