One of the most important steps in the accounting cycle is creating and posting your closing entries.
Your closing journal entries serve as a way to zero out temporary accounts such as revenue and expenses, ensuring that you begin each new accounting period properly.
Unlike permanent accounts such as assets, liabilities, and equity accounts, which maintain a balance each period, temporary accounts serve as a holding vessel, which allows you to calculate revenue and track business expense totals for each specific period.
Depending on the size and complexity of your business, the best way to track your income and expenses is to use accounting software, which automates the entire closing entry process, handling all closing entries behind the scenes, eliminating the need to enter transactions manually or record them in a ledger.
Overview: What are closing entries?
Closing entries are completed at the end of each accounting period after your adjusted trial balance has been run.
The closing entry process accomplishes two tasks: it enables you to determine net income or retained earnings for the current accounting period and it resets the account balance to zero, so you can properly track income and categorize business expenses for the next accounting period and all periods that follow.
What is the closing entry process?
Whether you’re posting entries manually or using accounting software, all revenue and expenses for each accounting period are stored in temporary accounts such as revenue and expenses.
While these accounts remain on the books, their balance is reset to zero each month, which is done using closing entries.
You begin the closing process by transferring revenue and expense account balances to the income summary account, a temporary account used specifically to transfer revenue and expense account balances.
Once this is done, you take the current balance in the income summary account and transfer it to either the capital account, if your business is a sole proprietorship or partnership, or to the retained earnings account if your business is a corporation.
This process resets both the income and expense accounts to zero, preparing them for the next accounting period.
|Cash in Bank||5,000.00|
|Furniture & Fixtures||1,000.00|
To begin, you want to run an adjusted trial balance, which is used to prepare your closing entries, moving both the revenue and the expense account balances, as well as drawing account and/or dividend account balances.
Step 1: Closing the revenue account
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.
Step 2: Closing the expense accounts
Next, you transfer expense balances.
In order to close out your expense accounts, you will need to debit the income summary account, and credit each line item expense listed in the trial balance, which reduces the expense account balances to zero.
Since we credited income summary in Step 1 for $5,300 and debited income summary for $5,050 in Step 2, the balance in the income summary account is now a credit of $250.
The $250 also reflects your net income for the month. If your expenses for December had exceeded your revenue, you would have a net loss.
If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account. You can do this by debiting the income summary account and crediting your capital account in the amount of $250. This reflects your net income for the month, and increases your capital account by $250.
Corporations will close the income summary account to the retained earnings account.
Step 3: Closing the income summary account
|Capital Account (Retained Earnings)||250.00|
Step 4: Closing the drawing/dividends account
It’s important to note that neither the drawing nor the dividends accounts need to be transferred to the income summary account.
Instead the balances in these accounts are moved at month-end to either the capital account or the retained earnings account.
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.
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.
The entry below assumes that you paid $3,000 in dividends in December, which would show as a debit balance on your trial balance.
Because you paid dividends, you will need to reduce your retained earnings account, which is what this entry accomplishes.
Step 5: Running reports
Once all of the required entries have been made, you can run your post-closing trial balance, as well as other reports such as an income statement or statement of retained earnings.
Final thoughts on closing entries
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.
These entries allow you to account for all income and expense activities for the month, keep you informed about the financial health of your business as well as help prepare you to properly track your income and expenses for the next accounting period.