Many business owners are familiar with the term “closing the books,” which refers to the process of finalizing a company’s financial information and creating reports after an accounting period has ended. An accounting period can be a month, a quarter, or a year. How frequently businesses go through the closing process depends on their needs (though we’d argue there’s a lot of value in doing it every month).
In today’s modern age, businesses are no longer closing literal books. Those big ledgers with handwritten entries for every single transaction? They’re more or less gone. Instead, almost everything is done digitally through accounting and bookkeeping software solutions that make the process much less manual.
Even though much of the closing process is now done behind the scenes, it’s still incredibly important for business owners to understand what exactly is going on with their finances throughout the process. Without an understanding of the accounting close process, they’ll be less equipped to understand their financial reports—and put them to use.
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The Accounting Cycle
Accounting is cyclical. After each accounting period has ended, businesses start anew. They earn and spend money, track those transactions, and then create reports that look back at all those transactions. Then they do it all again.
This process is called the accounting cycle. Depending on who you ask, the accounting cycle is made up of 5-9 steps—all of which are geared toward making sure that every penny is accounted for and that the financial reports generated are accurate.
The closing process is part of the accounting cycle.
Some refer to the very final step of making closing entries the “closing process,” but it’s more accurate to say that the closing process begins as soon as the accounting period ends. So if your accounting period ends on December 31, the close process kicks off in earnest on January 1.
At that time, your accountant will gather together all the financial transactions, make sure that they’re all mapped to the correct accounts, fix and mistakes or errors, create financial statements, and prepare your books to start again.
So let’s break down all those steps in more detail. First up, gathering together all financial transactions.
Create an Unadjusted Trial Balance
Modern businesses should be keeping track of their transactions throughout the accounting period. If you spend $50 on office snacks on the first of the month, it’s best to snap a photo of the receipt and classify the transaction right away. The longer you hold on to receipts, the harder it will be to classify the transaction correctly and the higher the risk of losing them. So get that out of the way during the accounting period so that you can kick off your accounting close process by checking that everything is accurate.
This is done by creating an unadjusted trial balance, also simply referred to as a trial balance. Under double-entry bookkeeping, every transaction should be reflected in your books as both a debit and a credit. When preparing an unadjusted trial balance, your accountant is checking that your debits and credits are equal. If not, they’ll start to investigate where something was classified incorrectly. Then they’ll make adjusting journal entries.
Make Adjusting Journal Entries
Adjusting journal entries are simply corrections to your accounting work. They help to tidy up your books and ensure that total credits do, in fact, equal total debits. They’re made on the last day of the accounting period to wrap up the period.
But if you’re keeping up with bookkeeping throughout the month, why would there be a need for adjusting entries? Making adjustments is a very normal part of the process, and it’s not a reflection of poor bookkeeping.
For example, your business might have completed work for a customer, but the invoice has not yet been processed. So the revenue you thought you would recognize this month needs to be pushed to the next month, which requires an adjusting journal entry.
Create an Adjusted Trial Balance
The adjusted trial balance is like triple checking your work. You take the unadjusted trial balance, add a column for adjusting entries, and then check again that your debits and credits are equal. Assuming you made all the adjusting journal entries you need, your adjusted trial balance should simply be a signal that you’re ready to create financial statements.
Pull Together Financial Statements
Financial statements are your business’ best historical record of what happened during an accounting period. That’s why so much care and energy is put into making sure that they’re as accurate as possible.
The two financial statements that must be developed as a part of the accounting closing process are the income statement and the balance sheet. (We’re big fans of the cash flow statement as well, but that one is more like an added bonus.)
The income statement answers the question, “How did we do?” It is a breakdown of performance during the accounting period and shows a high-level picture of your revenues and expenses.
The balance sheet, on the other hand, answers the question, “Where are we at?” It’s a snapshot of your company’s health at that specific moment in time.
The differences between these two reports are important to understand because they help to inform what happens next in the accounting cycle: closing entries.
Your ultimate guide to SMB accounting
Let’s get those books in order.
It’s Time to Make Closing Entries
As we mentioned earlier, some people refer to this final step of making closing entries as the entirety of the accounting closing process. While we argue it’s simply one step of the closing process, it is an important one.
Closing entries tie out the accounting period at hand and allow us to focus on the next one. Done by hand, the process is slightly complex, but software has simplified it a great deal.
The goal of closing entries is to close out all temporary accounts and to adjust permanent ones. So to understand closing entries, we first need to understand the difference between temporary and permanent accounts.
Temporary vs. Permanent Accounts
Temporary accounts are associated with the income statement. They show balances for a very specific period of time. Most businesses will have at least two temporary accounts—expenses and revenues—though they may choose to create more by subdividing these accounts into more detailed ones. Dividends are another temporary account.
As we mentioned earlier, the income statement answers the question, “How did we do?” The answer to that question comes from the temporary accounts, which show us exactly what happened with expenses and revenues over that specific period of time. It doesn’t show us how the company is doing as a whole. Rather, the scope of the income statement is narrowed to a small sliver of time in the lifespan of the business. In other words, it’s temporary.
In contrast to this is the balance sheet, which answers the question, “Where are we at?” The balance sheet does not take time or performance into account. Rather, it shows the state of the business as a whole through assets, liabilities, and equity.
The accounts on the balance sheet are like running totals for your business. This is where your permanent accounts, like retained earnings, live.
The process of closing out temporary accounts means that you’re looking at how much you made (or lost) during the accounting period and adding it to your business’ running total of profits. If you made $200,000 in net income last month, for example, and have retained earnings of $1.2 million, your retained earnings would jump up to $1.4 million as a result of closing entries and you’d have a clean slate for next month’s income statement.
Here’s how to make these entries.
How to Make Closing Entries
The process of closing out your temporary accounts starts by reviewing the income statement. The first step is to locate your revenue and expenses and to move those balances into an account called the “Income Summary” account.
To do so, you’ll debit revenue and credit expenses into your Income Summary account.
After these entries, your Income Summary account will have $15,000 in it. The Income Summary account is directly related to net income, so the amount in your Income Summary account should equal net income.
The next step is to move your net income to retained earnings, your permanent account. To do so, you’ll debit Income Summary and credit Retained Earnings.
If your business experienced a loss during the last accounting period, the entries above would simply be flipped, and retained earnings would be debited.
This process moves all money in your temporary account over to your permanent account, freeing up those temporary accounts to start reflecting the transactions of the new accounting period.
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