How to Close Entries in Accounting: Step-by-Step

Closing entries are performed at the end of an accounting period to prepare a company’s financial records for the next cycle. This process involves transferring specific account balances to permanent accounts, effectively resetting certain balances to zero. The purpose of these entries is to ensure financial reporting accurately reflects performance for a single, distinct period, preventing the mixing of data across different accounting cycles. Without proper closing entries, it would be challenging to accurately measure a business’s profitability and financial position for any given period. This process helps maintain consistency in financial statements, allowing for meaningful comparisons of performance over time.

Identifying Accounts for Closing

The accounting system categorizes accounts into two main types: temporary and permanent. Temporary accounts, also known as nominal accounts, track financial activity for a specific accounting period (e.g., month, quarter, or year). These accounts are designed to start fresh with a zero balance at the beginning of each new period, ensuring performance metrics are not skewed by data from prior periods.

Examples of temporary accounts include all revenue accounts, which record income generated from sales or services, and all expense accounts, which track costs incurred to generate that revenue. Dividend accounts (for corporations) or owner’s drawing accounts (for sole proprietorships and partnerships), which represent distributions of earnings to owners, are also considered temporary. These accounts are crucial for preparing the income statement, which summarizes a company’s financial performance over a defined period.

In contrast, permanent accounts, also referred to as real accounts, carry their balances forward from one accounting period to the next. These accounts reflect a company’s ongoing financial position and are not reset to zero at the end of a period. Permanent accounts include all asset accounts, such as cash, accounts receivable, and property, plant, and equipment.

Liabilities, like accounts payable and loans payable, are also permanent accounts, as their balances persist until the obligations are settled. Equity accounts, such as Common Stock and Retained Earnings, are permanent as well, reflecting the cumulative financial interest of owners in the business. The balances of these permanent accounts are reported on the balance sheet, providing a snapshot of a company’s financial health at a specific point in time. Only temporary accounts are subject to the closing process, as their balances need to be cleared for the next accounting cycle.

The Closing Process Step-by-Step

The closing process involves four key journal entries, systematically transferring balances from temporary accounts to permanent accounts. This sequence ensures all period-specific data is properly summarized and cleared for the new accounting cycle. Each step utilizes a temporary account called “Income Summary,” which acts as a clearing account to aggregate revenues and expenses before transferring the net result.

The first step closes all revenue accounts, which normally carry a credit balance. To reduce these accounts to zero, a debit is recorded to each revenue account. The corresponding credit is made to the Income Summary account. For instance, if Service Revenue is $100,000, the entry debits Service Revenue for $100,000 and credits Income Summary for $100,000.

Next, close all expense accounts, which typically have a debit balance. To bring these accounts to zero, a credit is recorded to each expense account. The offsetting debit is made to the Income Summary account. For example, if total Rent Expense is $5,000 and Utilities Expense is $2,000, the entry credits Rent Expense for $5,000, credits Utilities Expense for $2,000, and debits Income Summary for $7,000.

Once revenues and expenses are transferred, the Income Summary account holds the net income (credit balance) or net loss (debit balance) for the period. The third step closes the Income Summary account to Retained Earnings (or Owner’s Capital for proprietorships/partnerships). For net income, debit Income Summary and credit Retained Earnings. For a net loss, credit Income Summary and debit Retained Earnings. This updates the equity section of the balance sheet.

The final step addresses the Dividends account (or Owner’s Drawings), which represents distributions to shareholders or owners and typically carries a debit balance. To close this account to zero, a credit is made to Dividends. The corresponding debit is made directly to Retained Earnings. This entry reduces Retained Earnings by the amount of dividends distributed, reflecting that these earnings were paid out rather than reinvested in the business. All temporary accounts are now zeroed out, and financial records are prepared for the new accounting period.

Preparing a Post-Closing Trial Balance

After all closing entries have been successfully recorded and posted, preparing a post-closing trial balance serves as a verification step in the accounting cycle. This document lists all accounts that retain a balance after the closing process, ensuring total debits still equal total credits. The purpose of this trial balance is to confirm that only permanent accounts carry balances forward into the new accounting period.

A post-closing trial balance exclusively features asset, liability, and equity accounts, as these are the permanent accounts whose balances are carried over from one period to the next. Accounts such as Cash, Accounts Receivable, Accounts Payable, Loans Payable, and Retained Earnings will appear with their updated, non-zero balances. This report directly reflects the accounts that constitute the balance sheet.

Temporary accounts, including all revenue, expense, and dividend accounts, should have a zero balance and therefore will not appear on the post-closing trial balance. Their absence confirms their balances were properly transferred and reset, preventing any commingling of financial data between accounting periods. If any temporary accounts still show a balance, it indicates an error in the closing process that requires investigation and correction before the new period begins.

The equality of total debits and total credits on the post-closing trial balance provides assurance that the entire closing process was accurately performed and that the accounting equation (Assets = Liabilities + Equity) remains in balance. This final check ensures a clean and accurate starting point for recording transactions in the subsequent accounting period. It allows businesses to confidently transition into their next operational cycle with a precise financial foundation.