The Income Summary is very temporary since it has a zero balance throughout the year until the year-end closing entries are made. Starting with zero balances in the temporary accounts each year makes it easier to track revenues, expenses, and withdrawals and to compare them from one year to the next. This is no different from what will happen to a company at the end of an accounting period.
The Opening Trial Balance Snapshot:
The process of transferring the balances of the temporary accounts into owner’s equity permanent account is called closing the accounts. The Journal entries made for the purpose of closing the temporary accounts are called closing entries. It is common practice to close the accounts only once a year at the end of accounting period. 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.
Four Steps in Preparing Closing Entries
Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period. The balance in dividends, revenues and expenses would all be zero leaving only the permanent accounts for a post closing trial balance. The trial balance shows the ending balances of all asset, liability and equity accounts remaining. The main change from an adjusted trial balance is revenues, expenses, and dividends are all zero and their balances have been rolled into retained earnings. We do not need to show accounts with zero balances on the trial balances.
What Are Closing Entries in Accounting?
If this is the case, the corporation’s accounting department makes a compound entry to close each dividend account to the retained earnings account. You need to use closing entries to reduce the value of your temporary accounts to zero. That way, your next accounting period does not have a balance in your revenue or expense account from the previous period. This process ensures that your temporary accounts are properly closed out sequentially, and the relevant balances are transferred to the income summary and ultimately to the retained earnings account. These entries effectively transfer the balances from these temporary accounts to an income summary account. The income summary account acts as a temporary holding place for the net income or loss for the period.
Introduction to the Closing Entries
Since QuickBooks automates the year-end close, you don’t have to get caught up with all of these manual entries unless something was to go wrong. Even then you can get a bit of help or an accountant to sort you out. Imagine we are doing a month-end or year-end close, we’re going to follow these steps. The account is then cleared out and transferred to retained earnings, which we will explain.
Close the income summary account by debiting income summary and crediting retained earnings. The income summary is a temporary account used to make closing entries. Balances cashing old checks of permanent accounts are carried forward to the subsequent accounting period. Income and expenses are closed to a temporary clearing account, usually Income Summary.
Purpose of Closing Entries
To make the balance zero, debit the revenue account and credit the Income Summary account. After preparing the closing entries above, Service Revenue will now be zero. Suppose we have a small business, ABC Electronics, and it’s the end of the fiscal year (December 31). https://www.business-accounting.net/ We need to close the temporary accounts (revenue and expenses) and transfer the net income to Retained Earnings. After this closing entry has been posted, each of these revenue accounts has a zero balance, whereas the Income Summary has a credit balance of $7,400.
- If your revenues are greater than your expenses, you will debit your income summary account and credit your retained earnings account.
- You want your total credits to be the same number as your total debits—if they aren’t, go back and check your work.
- Because you paid dividends, you will need to reduce your retained earnings account, which is what this entry accomplishes.
- The Printing Plus adjusted trial balance for January 31, 2019, is presented in Figure 5.4.
- When you make closing accounting entries, you can follow the same steps.
When closing the revenue account, you will take the revenue listed in the trial balance and debit it, to reduce it to zero. As a corresponding entry, you will credit the income summary account, which we mentioned earlier. No, closing entries are performed after adjusting entries in the accounting cycle. Adjusting entries ensure that revenues and expenses are appropriately recognized in the correct accounting period. Income summary account is a temporary account used to make closing entries.
The Printing Plus adjusted trial balance for January 31, 2019, is presented in Figure 5.4. 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. 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. For our purposes, assume that we are closing the books at the end of each month unless otherwise noted. We have completed the first two columns and now we have the final column which represents the closing (or archive) process.
Imagine you own a bakery business, and you’re starting a new financial year on March 1st. First, you are going to start by identifying the temporary accounts that need to be closed. As we mentioned, these include revenue, expense, and dividend accounts. Temporary accounts include all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole proprietorships and partnerships (dividends for corporations).
In contrast, temporary accounts capture transactions and activities for a specific period and require resetting to zero with closing entries. A closing entry is a journal entry that is made at the end of an accounting period to transfer balances from a temporary account to a permanent account. Closing journal entries are made at the end of an accounting period to prepare the accounting records for the next period. They zero-out the balances of temporary accounts during the current period to come up with fresh slates for the transactions in the next period. For this reason, these types of accounts are called temporary or nominal accounts. When an accountant closes an account, the account balance returns to zero.
As you will learn in Corporation Accounting, there are three components to the declaration and payment of dividends. The first part is the date of declaration, which creates the obligation or liability to pay the dividend. The second part is the date of record that determines who receives the dividends, and the third part is the date of payment, which is the date that payments are made. Printing Plus has $100 of dividends with a debit balance on the adjusted trial balance.
Permanent (real) accounts are accounts that transfer balances to the next period and include balance sheet accounts, such as assets, liabilities, and stockholders’ equity. These accounts will not be set back to zero at the beginning of the next period; they will keep their balances. Understanding the accounting cycle and preparing trial balances is a practice valued internationally.
In other words, revenue, expense, and withdrawal accounts always have a zero balance at the start of the year because they are always closed at the end of the previous year. The purpose of the income summary is to show the net income (revenue less expenses) of the business in more detail before it becomes part of the retained earnings account balance. Only income statement accounts help us summarize income, so only income statement accounts should go into income summary. Let’s investigate an example of how closing journal entries impact a trial balance.
Afterwards, withdrawal or dividend accounts are also closed to the capital account. To close the drawing account to the capital account, we credit the drawing account and debit the capital account. This is closed by doing the opposite – debit the capital account (decreasing the capital balance) and credit Income Summary. To close expenses, we simply credit the expense accounts and debit Income Summary. 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.
Because you paid dividends, you will need to reduce your retained earnings account, which is what this entry accomplishes. If your business is a corporation, you will not have a drawing account, but if you paid stockholders, you will have a dividends account. If you paid dividends for the month, you will need to close that account as well. 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.
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. If it all seems a bit complex or maybe you are a small business owner who takes on their own accounting, you may wonder if you really need to know closing entries in practice. The beautiful thing is that some accounting programs like QuickBooks, make these entries for you. And so, the amounts in one accounting period should be closed so that they won’t get mixed with those in the next period.
Now Paul must close the income summary account to retained earnings in the next step of the closing entries. A sole proprietor or partnership often uses a separate drawings account to record withdrawals of cash by the owners. Although the drawings account is not an income statement account, it is still classified as a temporary account and needs a closing journal entry to zero the balance for the next accounting period. Lastly, prepare a post-closing trial balance to verify that the balances of the permanent accounts are correct and that the temporary accounts have been reset to zero. One account you’ll want to be aware of when performing closing entries is the income summary account.
