Remember the income statement is like a moving picture of a business, reporting revenues and expenses for a period of time (usually a year). We want income statements to start every year from zero, but for accounts like equipment, debt, and cash accounts—reported on the balance sheet—we want to keep a running balance from the beginning of the business. In a partnership, separate entries are made to close each partner’s drawing account to his or her own capital account. If a corporation has more than one class of stock and uses dividend accounts to record dividend payments to investors, it usually uses a separate dividend account for each class.
You begin the closing process by transferring revenue and expense account balances to the income summary account, a temporary account used specifically to transfer revenue and expense account balances. The purpose of closing entries is to prepare the temporary accounts for the next accounting period. In other words, the income and expense accounts are «restarted». In order to close out your expense accounts, you will need to debit the income summary account, and credit each line item expense listed in the trial balance, which reduces the expense account balances to zero. Your closing journal entries serve as a way to zero out temporary accounts such as revenue and expenses, ensuring that you begin each new accounting period properly. Instead, the basic closing step is to access an option in the software to close the reporting period.
This transaction increases your capital account and zeros out the income summary account. Since we credited income summary in Step 1 for $5,300 and debited income summary for $5,050 in Step 2, the balance in the income summary account is now a credit of $250. Revenue is one of the four accounts that needs to be closed to the income summary account. This is the adjusted trial balance that will be used to make your closing entries. We’ll use a company called MacroAuto that creates and installs specialized exhaust systems for race cars. Here are MacroAuto’s accounting records simplified, using positive numbers for increases and negative numbers for decreases instead of debits and credits in order to save room and to get a higher-level view.
Both closing entries are acceptable and both result in the same outcome. All temporary accounts eventually get closed to retained earnings and are presented on the balance sheet. 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. On the statement of retained earnings, we reported the ending balance of retained earnings to be $15,190. We need to do the closing entries to make them match and zero out the temporary accounts.
This process resets both the income and expense accounts to zero, preparing them for the next accounting period. 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. Income and expenses are closed to a temporary clearing account, usually Income Summary. Afterwards, withdrawal or dividend accounts are also closed to the capital account.
- Since the income summary account is only a transitional account, it is also acceptable to close directly to the retained earnings account and bypass the income summary account entirely.
- This process resets both the income and expense accounts to zero, preparing them for the next accounting period.
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- Now for this step, we need to get the balance of the Income Summary account.
One of the most important steps in the accounting cycle is creating and posting your closing entries. Below are the T accounts with the journal entries already posted. The Income Summary balance is ultimately closed to the capital account. This entry donating to charity zeros out dividends and reduces retained earnings by total dividends paid. Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is equal to all income minus all expenses.
The credit to income summary should equal the total revenue from the income statement. As mentioned, temporary accounts in the general ledger consist of income statement accounts such as sales https://simple-accounting.org/ or expense accounts. When the income statement is published at the end of the year, the balances of these accounts are transferred to the income summary, which is also a temporary account.
When closing expenses, you should list them individually as they appear in the trial balance. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Answer the following questions on closing entries and rate your confidence to check your answer. We have completed the first two columns and now we have the final column which represents the closing (or archive) process. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
What is a Closing Entry?
The income summary is a temporary account used to make closing entries. For sole proprietorships and partnerships, you’ll close your drawing account to your capital account, because you will need to reduce your capital account by the draws taken for the month. Instead the balances in these accounts are moved at month-end to either the capital account or the retained earnings account. It’s important to note that neither the drawing nor the dividends accounts need to be transferred to the income summary account. Closing entries are completed at the end of each accounting period after your adjusted trial balance has been run. Since the income summary account is only a transitional account, it is also acceptable to close directly to the retained earnings account and bypass the income summary account entirely.
What are Temporary Accounts?
Closing entries, also called closing journal entries, are entries made at the end of an accounting period to zero out all temporary accounts and transfer their balances to permanent accounts. In other words, the temporary accounts are closed or reset at the end of the year. Closing entries are journal entries used to empty temporary accounts at the end of a reporting period and transfer their balances into permanent accounts. Temporary accounts are used to accumulate income statement activity during a reporting period. The use of closing entries resets the temporary accounts to begin accumulating new transactions in the next period.
Module 4: Completing the Accounting Cycle
We see from the adjusted trial balance that our revenue accounts have a credit balance. To make them zero we want to decrease the balance or do the opposite. We will debit the revenue accounts and credit the Income Summary account.
However, some corporations use a temporary clearing account for dividends declared (let’s use «Dividends»). They’d record declarations by debiting Dividends Payable and crediting Dividends. If this is the case, then this temporary dividends account needs to be closed at the end of the period to the capital account, Retained Earnings.
Doing so automatically populates the retained earnings account for you, and prevents any further transactions from being recorded in the system for the period that has been closed. 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. In a sole proprietorship, a drawing account is maintained to record all withdrawals made by the owner. In a partnership, a drawing account is maintained for each partner. All drawing accounts are closed to the respective capital accounts at the end of the accounting period. The income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet.
The total of the income summary account after the all temporary accounts have been close should be equal to the net income for the period. Temporary accounts can either be closed directly to the retained earnings account or to an intermediate account called the income summary account. The income summary account is then closed to the retained earnings account.
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. Remember that all revenue, sales, income, and gain accounts are closed in this entry. In essence, we are updating the capital balance and resetting all temporary account balances. Whether you’re processing closing entries manually, or letting your accounting software do the work, closing entries are perhaps the most important part of the accounting cycle. In addition, if the accounting system uses subledgers, it must close out each subledger for the month prior to closing the general ledger for the entire company. If the subsidiaries also use their own subledgers, then their subledgers must be closed out before the results of the subsidiaries can be transferred to the books of the parent company.