They help calculate retained earnings
The profits (or losses) from each period get rolled into retained earnings, which is important from both business operations and investor perspectives. This affects how much capital is available to reinvest, pay dividends, or just show the long-term value of the business. If you skip this step, your balance sheet won’t reflect reality.
They make financial reporting make sense
Financial reporting is the name of the game when it comes to investor transparency, and any publicly traded company will attest to the reporting hoops that the U.S. Securities and Exchange Commission (SEC) requires them to jump through to maintain their public listing.
How to record and use a closed entry
To close out your books at the end of the year (or month), you start by clearing out your revenue accounts. This means taking all the income your business earned and moving it into a holding account, which for many accountants is referred to as an “income summary.” So, if you made $100,000, you’d record that as a debit from revenue and a credit to income summary. Think of it like transferring all your “money earned” into a single tally sheet before you figure out the final score.
Next, you do the same with your expenses by adding up everything you spent on supplies, rent, marketing, and so on. You move that total into the income summary account. If your total expenses were $70,000, you’d debit the income summary and credit your expense account. What you’re left with in the income summary is your profit or loss. You then take that final number and shift it over to your retained earnings, basically the company’s “savings” account. So if you had a profit of $30,000, that gets added to your retained earnings; if it was a loss, the amount comes out of it.
And finally, if you paid out any dividends (say, to yourself or shareholders), that gets subtracted from retained earnings, too. For example, if you paid $5,000 in dividends, you’d reduce retained earnings accordingly. When all that’s done, your temporary accounts (revenue, expenses, dividends) are cleared out, and your books are ready for a fresh start in the new period.
