How to Close Net Income and Other Temporary Accounts

Closing net income is a process at the conclusion of every accounting period. This involves transferring account balances to prepare them for the subsequent financial cycle. The primary objective is to reset temporary accounts to zero, allowing for accurate performance measurement in the upcoming period. It also ensures the net financial outcome of the period is properly reflected within the business’s permanent equity. This step is essential for maintaining organized and accurate financial records.

Understanding Account Types for Closing

The accounting system distinguishes between two types of accounts for closing purposes: temporary and permanent. Temporary accounts, also known as nominal accounts, include revenues, expenses, and owner drawings or dividends. These accounts track financial activity for a specific period and are then reset to zero. Resetting them allows for accurate performance measurement and comparison across different periods.

In contrast, permanent accounts, or real accounts, include assets, liabilities, and equity (specifically Retained Earnings for corporations or Owner’s Capital for sole proprietorships/partnerships). These accounts carry their balances forward from one accounting period to the next, reflecting the cumulative financial position of the business. The net effect of temporary accounts, which is the net income or loss, is ultimately transferred to a permanent equity account, updating the overall financial standing of the business. This transfer is why temporary accounts must be closed, as their balances directly impact the permanent equity accounts.

Closing Revenue and Expense Accounts

The closing process begins by transferring the balances of revenue and expense accounts. Revenue accounts have credit balances, reflecting income earned. To close these, each revenue account is debited for its full balance. The corresponding credit is made to the “Income Summary” account, consolidating all revenues for the period.

Expense accounts carry debit balances, representing costs incurred. To close these, each expense account is credited for its full balance. The offsetting debit is recorded in the Income Summary account. After these entries, the Income Summary account will hold the total revenues as a credit and total expenses as a debit. This account acts as a temporary holding place to calculate the net income or loss for the period before transferring it to a permanent equity account.

Closing Net Income and Drawings

After all revenue and expense accounts are transferred, the Income Summary account holds the period’s net income or net loss. If total revenues exceeded total expenses, the Income Summary account will have a credit balance, indicating net income. This net income is then transferred to a permanent equity account: Retained Earnings for corporations, or Owner’s Capital for sole proprietorships and partnerships. The journal entry to close net income involves debiting the Income Summary account and crediting the appropriate equity account for the net income amount. If expenses exceeded revenues, resulting in a net loss (a debit balance in Income Summary), the entry would be a credit to Income Summary and a debit to the equity account.

The final step involves closing the Dividends account for corporations or the Drawings account for sole proprietorships/partnerships. These accounts represent distributions of company earnings to owners or shareholders and typically have debit balances. To close these, the Dividends or Drawings account is credited, bringing its balance to zero. The corresponding debit is made directly to the Retained Earnings account (for dividends) or the Owner’s Capital account (for drawings). This entry reduces the business’s equity by the amount of distributions made during the period.

Preparing the Post-Closing Trial Balance

Following the completion of all closing entries, the next step involves preparing a post-closing trial balance. The purpose of this financial report is to verify that all temporary accounts, such as revenues, expenses, and drawings/dividends, have been successfully reset to a zero balance. This ensures the accounting system is prepared to accurately record financial activity for the new accounting period.

The post-closing trial balance lists only permanent accounts: assets, liabilities, and the updated equity account (Retained Earnings or Owner’s Capital). It serves as a final check to confirm that total debits still equal total credits. A balanced post-closing trial balance indicates the closing process was executed correctly, providing a solid foundation for the subsequent accounting cycle.