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Temporary accounts in accounting are used to record financial transactions for a specific accounting period. At the end of that period, all balances in temporary accounts must be transferred to permanent accounts.
Temporary accounts are accounts that are designed to track financial activity for a specific period of time. In order to have accurate financial statements, you must close each temporary account at the end of the accounting period.
Closing these accounts helps to ensure that transactions that occurred in the current accounting period are not included in the following period.
In Accounting 101, you learned about the five main types of accounts:
Whether you’re a small business bookkeeper or an accountant for a Fortune 500 company, all accounting transactions are recorded using these accounts. For instance, when you pay your monthly rent of $1,500, you are directly impacting both an asset and an expense account.
When you accept a customer payment in the amount of $150, you are impacting both an asset and an income account. Keeping this process in mind makes it much easier to understand the purpose of temporary accounts and why they’re so important.
There are four main temporary accounts that need to be closed each accounting period:
These accounts need to be closed each month in order to accurately represent revenue and expenses on your financial statements. For example, let’s say your rental expenses were $15,000 in 2019, and earned revenue was $75,000.
By closing your temporary accounts at the end of 2019, your year end balances would accurately reflect both your expenses and your revenue.
But more importantly, what happens if those accounts remain open? At the end of 2020, when you or your accountant want to review your expense and revenue totals, they will be overinflated by the amounts that were left in those two accounts, directly impacting all of your financial statements.
Temporary accounts are accounts where the balance is not carried forward at the end of an accounting period. Instead, the balance in these accounts are transferred at the end of the period to the appropriate permanent account.
Permanent accounts, on the other hand, have their balances carried forward for each accounting period.
Assets, liabilities, and equity accounts are all permanent accounts and are found on your balance sheet, while income and expense accounts are temporary accounts that are found on your income statement, and must be closed each accounting period.
While the convenience of using accounting software has eliminated the need to manually close temporary accounts each accounting period, you should still understand the concept of temporary accounts and why they are so important in the accounting process.
Temporary accounts work by serving as a repository for all revenue and expense transactions. These transactions accumulate throughout the month or until the accounting period is over.
This period can be a month, a quarter, or even a year. Once the period comes to a close, you or your bookkeeper will need to perform closing entries, which will move the balances in these accounts to the appropriate permanent accounts.
Take a look at these temporary accounts examples, as well as the journal entries that are needed for closing each account appropriately:
Date | Account | Debit | Credit |
---|---|---|---|
4/30/20 |
Revenue Income Summary |
$4,500 | $4,500 |
Remember, in order to zero revenue out, you will need to debit your revenue account, since debiting an income or revenue account decreases the balance.
Date | Account | Debit | Credit |
---|---|---|---|
4/30/20 |
Income Summary Expenses |
$2,800 | $2,800 |
In this case, you will need to credit your business expenses account in order to zero it out, since a credit will decrease an expense account balance.
$4,500 - $2,800 = $1,700
Subtracting your expenses from your revenue leaves you with a balance of $1,700, which is what you will need to transfer out of the income summary account into the capital account.
Date | Account | Debit | Credit |
---|---|---|---|
4/30/20 |
Income Summary Capital or Retained Earnings |
$1,700 | $1,700 |
This transaction zeroes out the income summary account, transferring money to capital or retained earnings, which is a permanent account.
Date | Account | Debit | Credit |
---|---|---|---|
4/30/20 |
Capital/Retained Earnings Drawing Account |
$1,000 | $1,000 |
Using temporary accounts will help you keep track of your account balances accurately. But closing temporary accounts is just as important as using them in the first place.
Tracking and closing temporary accounts is a time-consuming process when you’re using manual accounting systems or spreadsheets, and it’s more challenging to produce accurate financial statements such as an income statement or balance sheet.
Instead, why not look at automating the entire process with the use of accounting software? If you’re looking for information on what application would be right for your business, be sure to check out The Ascent’s accounting software reviews.
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