How to Close Income Summary to Retained Earnings

An Income Summary account acts as a temporary holding place for all revenue and expense balances accumulated over a specific accounting period. Retained Earnings, on the other hand, represents the portion of a company’s cumulative net income that has been kept within the business rather than distributed to owners as dividends. The process of closing entries is a fundamental step in the accounting cycle, serving to prepare these accounts for the subsequent financial period.

Understanding Key Accounts: Income Summary and Retained Earnings

The Income Summary account is a temporary account used at the end of an accounting period to aggregate all revenue and expense accounts. Its purpose is to facilitate the calculation of net income or net loss for that period. After its balance is transferred, the Income Summary account is reset to zero.

Retained Earnings is a permanent equity account that appears on the balance sheet, reflecting accumulated profits a company has retained since its inception. This account increases with net income and decreases with net losses and dividends declared. Unlike temporary accounts, Retained Earnings carries its balance forward from one accounting period to the next.

The Role of Closing Entries

Closing entries are a necessary step performed at the end of each accounting period to prepare financial records for the next cycle. Their primary objective is to zero out all temporary accounts, including revenues, expenses, and dividends. This process ensures that financial statements, particularly the income statement, accurately reflect activity only for the specific period they cover.

By resetting temporary accounts, closing entries enable the precise measurement of a company’s profitability or loss for a defined period. The net effect of all revenues and expenses (net income or net loss) is then transferred to a permanent equity account. The closing of the Income Summary account to Retained Earnings is the final step in this process, occurring after individual revenue and expense accounts have already been closed into the Income Summary.

Performing the Closing Entry for Income Summary

To close the Income Summary account, its final balance (net income or net loss) must first be determined. This balance is calculated by summing all credit balances (revenues) and subtracting all debit balances (expenses) previously closed into the Income Summary. Once established, a journal entry transfers this net amount to the Retained Earnings account.

If the Income Summary account has a credit balance, indicating net income, the closing entry involves debiting Income Summary and crediting Retained Earnings. For example, if Income Summary holds a $30,000 credit balance, the entry would be: Debit Income Summary $30,000; Credit Retained Earnings $30,000. This action reduces the Income Summary balance to zero and increases Retained Earnings by the net income.

Conversely, if the Income Summary account has a debit balance, signaling a net loss, the closing entry requires debiting Retained Earnings and crediting Income Summary. For instance, if Income Summary shows a $15,000 debit balance, the entry would be: Debit Retained Earnings $15,000; Credit Income Summary $15,000. This entry decreases Retained Earnings by the net loss and brings the Income Summary account to a zero balance, clearing it for the new accounting period.

Impact on Financial Reporting

The closing entry for the Income Summary account directly influences the presentation of a company’s financial position and performance. After this entry, the Income Summary account holds a zero balance and does not appear on any financial statements, as its purpose is purely to facilitate internal accounting processes.

The net income or net loss transferred from Income Summary directly updates the Retained Earnings account. This updated balance is displayed on the company’s balance sheet under the equity section, providing a clear picture of accumulated profits reinvested in the business. This amount is also a component in the Statement of Retained Earnings, which details changes in this equity account over the period. This ensures the balance sheet accurately reflects ownership’s equity and the income statement reflects the financial performance of the new period.