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.
Overview: What are temporary 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:
- Income summary
- Drawing/dividends account
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 vs. permanent accounts: What's the difference?
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.
How do temporary accounts work
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.
Examples of temporary accounts
Take a look at these temporary accounts examples, as well as the journal entries that are needed for closing each account appropriately:
- Revenue: The revenue account is used to track all money earned in a specific period of time. All money received for goods and services provided during the specified accounting period is recorded in the revenue account. Recall, according to the revenue recognition principle, all revenue is recognized at the time it is earned, not when it’s received. At the end of the accounting period, whether it’s a monthly, quarterly, or yearly period, the balance in the revenue account is zeroed out by transferring the balance to your income summary account.
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.
- Expenses: Like revenue, operating expenses are tracked each accounting period. Expenses are tracked in order to determine how much is spent on business operations, expenses such as rent, advertising, office supplies, and utilities. At the end of the accounting period, like your revenue account, your expense totals are moved into your income summary account, zeroing out the expense totals for the period. While you will need to keep track of each expense category in your expense ledger, you only have to transfer your expense total at the end of the accounting period.
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.
- Income summary: Now that both your revenue and expenses for the accounting period have been moved to the income summary account, it’s time to move the balance of the income summary account to your capital account or retained earnings account. The amount that you will need to transfer will be the difference between the amount of revenue that was transferred, which was $4,500, less expenses transferred, which was $2,800:
$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.
Capital or Retained Earnings
This transaction zeroes out the income summary account, transferring money to capital or retained earnings, which is a permanent account.
- Drawing/dividends: If you’re a sole proprietor or your business is a partnership, you’ll also have to transfer activity from your drawing account for any funds received from the business. Unlike the other account types, you don’t have to close your drawing account to an income summary account, but instead can simply transfer the balance in the drawing account to your capital account.
Don’t forget to close your temporary accounts
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 Blueprint’s accounting software reviews.