How to Close a Journal Entry in Your Accounting Cycle

The accounting cycle provides a structured approach to recording and summarizing a business’s financial transactions. Completing this cycle ensures financial records are prepared accurately for reporting and for the subsequent period. A fundamental step in this process involves closing entries, which systematically ready the financial books for a fresh start.

Understanding Closing Entries

Closing entries are specialized journal entries made at the end of an accounting period. Their primary objective is to transfer the balances of certain accounts to a permanent equity account, resetting them to a zero balance. This process is necessary to isolate the financial performance of one period from the next, providing a clear measure of revenue earned and expenses incurred within that timeframe. Clearing these balances allows businesses to assess profitability and prepare for new transactions in the upcoming accounting period.

Identifying Accounts for Closure

Accounts in a company’s ledger are categorized as either temporary or permanent. Temporary accounts accumulate financial data for a single accounting period and are closed at its end. These include all revenue accounts, expense accounts, and dividend or drawing accounts. They are closed to ensure a clean slate for the next period, allowing accurate measurement of income and expenses.

In contrast, permanent accounts carry their balances forward from one accounting period to the next. These accounts represent a business’s ongoing financial position and include assets, liabilities, and equity accounts, such as Cash, Accounts Payable, and Retained Earnings. Permanent accounts are not closed because their balances reflect cumulative activity over the life of the business.

The Closing Process

The core of closing entries involves systematically transferring balances out of temporary accounts. This multi-step process ensures that all revenue and expense information is aggregated to determine net income or loss, which then impacts the company’s equity. Distributions to owners are also accounted for, preparing temporary accounts for the next period.

The first step closes all revenue accounts. Since revenue accounts typically have credit balances, they are debited to bring their balances to zero. The total amount of these debits is then credited to a temporary account called Income Summary. This transfers all earned income for the period into the Income Summary account.

Next, all expense accounts are closed. Expense accounts normally carry debit balances, so they are credited to reduce their balances to zero. The sum of these credits is then debited to the Income Summary account. The Income Summary account will then reflect the net income (if credits exceed debits) or net loss (if debits exceed credits) for the period.

The third step closes the Income Summary account itself. To close it, the Income Summary account is debited, and the Retained Earnings (for corporations) or Owner’s Capital (for sole proprietorships/partnerships) account is credited. If a net loss occurred, Income Summary is credited, and Retained Earnings or Owner’s Capital is debited. This transfer updates the equity account to reflect the period’s profitability.

Finally, any dividend or owner’s drawing accounts are closed. These accounts typically have debit balances, representing distributions of company earnings to owners. To close them, the dividend or drawing account is credited, and the Retained Earnings or Owner’s Capital account is debited.

Post-Closing Verification

Upon completing all closing entries, a post-closing trial balance is prepared. This financial report lists all accounts that retain a balance after the closing process, which are only the permanent accounts. The purpose of this trial balance is to verify that total debits still equal total credits and that all temporary accounts have been reset to zero. It serves as a final check to confirm the accuracy of the closing process and provides a balanced starting point for the new accounting period.