All temporary accounts must be reset to zero at the end of the accounting period. To do this, their balances are emptied into the income summary account. The income summary account then transfers the net balance of all the temporary accounts to retained earnings, which is a permanent account on the balance sheet. If a temporary account has a debit balance it is credited to bring it to zero, and the retained earnings account is credited to balance the closing entry. Likewise, if a temporary account has a credit balance, it is debited to bring it to zero and the retained earnings account is credited.
The income statement reflects your net income for the month of December. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Net income is the portion of gross income that’s left over after all expenses have been met. Retained earnings are defined as a portion of a business’s profits that isn’t paid out to shareholders but is rather reserved to meet ongoing expenses of operation.
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. As mentioned, temporary accounts in the general ledger consist of income statement accounts such as sales or expense accounts. When the income statement is published at the end of the year, the balances of these accounts are transferred to the income summary, which is also a temporary account. The permanent accounts in which balances are transferred depend upon the nature of business of the entity.
Step 1 of 3
All temporary accounts eventually get closed to retained earnings and are presented on the balance sheet. Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step. There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again. Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow.
Module 4: Completing the Accounting Cycle
While these accounts remain on the books, their balance is reset to zero each month, which is done using closing entries. Closing entries are the journal entries used at the end of an accounting period. Remember that all revenue, sales, income, and gain accounts are closed in this entry. 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.
In this example we will close Paul’s Guitar Shop, Inc.’s temporary accounts using the income summary account method from his financial statements in the previous example. Temporary accounts are income statement accounts that are used to track accounting activity during an accounting period. For example, the revenues account records the amount of revenues earned during an accounting period—not during the life of the company. We don’t want the 2015 revenue account to show 2014 revenue numbers. Income summary is a holding account used to aggregate all income accounts except for dividend expenses.
Notice how only the balance in retained earnings has changed and it now matches what was reported as ending retained earnings in the statement of retained earnings and the balance sheet. Because you paid dividends, you will need to reduce your retained earnings account, which is what this entry accomplishes. 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 franchise income summary account is now a credit of $250. Let’s move on to learn about how to record closing those temporary accounts. Clear the balance of the revenue account by debiting revenue and crediting income summary. These accounts are be zeroed and their balance should be transferred to permanent accounts.
Here are MacroAuto’s accounting records simplified, using positive numbers for increases and negative numbers for decreases instead of debits and credits in order to save room and to get a higher-level view. The process of using of the income summary account is shown in the diagram below. 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 callable preferred stock taken for the month. If your expenses for December had exceeded your revenue, you would have a net loss.
- After the financial statements are finalized and you are 100 percent sure that all the adjustments are posted and everything is in balance, you create and post the closing entries.
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- All revenue and expense accounts must end with a zero balance because they’re reported in defined periods.
- Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings.
Cash Flow Statement
The expense accounts have debit balances so to get rid of their balances we will do the opposite or credit the accounts. Just like in step 1, we will use Income Summary as the offset account but this time we will debit income summary. The total debit to income summary should match total expenses from the income statement. Remember the income statement is like a moving picture of a business, reporting revenues and expenses for a period of time (usually a year). We want income statements to start every year from zero, but for accounts like equipment, debt, and cash accounts—reported on the balance sheet—we want to keep a running balance from the beginning of the business.
Since dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account. These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. The income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet.
Permanent Accounts
There are various journals for example cash journal, sales journal, purchase journal etc., which allow users to record transactions and find out what caused changes in the existing balances. Closing entries are mainly used to determine the financial position of a company at the end of a specific accounting period. In order to produce more timely information some businesses issue financial statements for periods shorter than a full fiscal or calendar year. Such periods are referred to as interim periods and the accounts produced as interim financial statements. Any account listed on the balance sheet is a permanent account, barring paid dividends.
When closing expenses, you should list them individually as they appear in the trial balance. An accounting year-end which is not the calendar year end is sometimes referred to as a fiscal year end. An individual might define their net income as the portion of their paycheck they can spend on discretionary expenses after taxes have been withheld and they’re reserved an adequate portion to meet their monthly budget. The term can also mean whatever they receive in their paycheck after taxes have been withheld. Answer the following questions on closing entries and rate your confidence to check your answer.
The balance in dividends, revenues and expenses would all be zero leaving only the permanent accounts for a post closing trial balance. The trial balance shows the ending balances of all asset, liability and equity accounts remaining. The main change from an adjusted trial balance is revenues, expenses, and dividends are all zero and their balances have been rolled into retained earnings.
We have completed the first two columns and now we have the final column which represents the closing (or archive) process. Closing entries help in the reconciliation of accounts which facilitates in controlling the overall financials of a firm. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent, a Motley Fool service, does not cover all offers on the market. Closing entry to account for draws taken for the month, for sole proprietors and partnerships.
It’s not reported on any financial statements because it’s only used during the closing process and the account balance is zero at the end of the closing process. Permanent accounts track activities that extend beyond the current accounting period. They’re housed on the balance sheet, a section of financial statements that gives investors an indication of a company’s value including its assets and liabilities. These entries are made to update retained earnings to reflect the results of operations and to eliminate the balances in the revenue and expense accounts, enabling them to be used again in a subsequent period. Now that the journal entries are prepared and posted, you are almost ready to start next year. Remember, modern computerized accounting systems go through this process in preparing financial statements, but the system does not actually create or post journal entries.