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.
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 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.
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Permanent 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 Account
When 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 Entries
Because 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.
|Income Summary Account||$100,000|
|Income Summary Account||$40,000|
*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.
|Income Summary Account||$60,000|
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.
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