How to Close the Books in Accounting

“Closing the books” in accounting refers to the systematic process of finalizing a business’s financial records at the end of a specific accounting period, such as a month, quarter, or year. This process involves verifying account balances, resolving discrepancies, and preparing financial statements that accurately represent the business’s financial status. It is a fundamental step in the accounting cycle, ensuring financial performance and position are distinct between periods. This procedure maintains accurate financial records, complies with accounting standards, and prepares for the subsequent accounting period. By completing this process, businesses ensure a clean slate for recording new transactions, which is essential for effective financial management.

Steps Before Closing

Before closing entries are made, several preparatory steps ensure the accuracy and completeness of financial records. These actions lay the groundwork for a smooth and reliable closing process. Without these steps, financial data carried forward would be unreliable, leading to inaccurate financial statements.

Verify All Transactions

First, verify that all transactions for the accounting period have been accurately recorded. This involves confirming all sales, purchases, payments, and receipts have been entered into the accounting system. Overlooked or incorrectly recorded transactions can significantly distort the financial picture of the period. This initial review helps identify and correct any omissions or errors.

Reconcile Balance Sheet Accounts

Next, reconcile all balance sheet accounts. This involves comparing internal account balances with external statements or supporting documentation. For instance, bank accounts should be reconciled with bank statements, and credit card accounts should match credit card statements. Accounts receivable and accounts payable balances should also be verified against customer and vendor records.

Perform Adjusting Entries

Performing adjusting entries is another preparatory step. Adjusting entries ensure revenues and expenses are recognized in the correct accounting period, adhering to the accrual basis of accounting. Examples include recording depreciation expense, accrued expenses (like utility bills incurred but not yet paid), unearned revenue (cash received but services not rendered), and prepaid expenses (like insurance premiums paid in advance, adjusted to reflect the portion of the expense used during the period).

Prepare Adjusted Trial Balance

Finally, after all adjusting entries have been made and posted, an adjusted trial balance is prepared. This trial balance lists all accounts with their updated balances and serves as a check to ensure total debits equal total credits. It provides a summary of all account balances after necessary adjustments, confirming the accounting equation remains in balance before proceeding to formal closing entries.

Account Categories for Closing

Understanding account categories is fundamental to grasping the purpose of closing entries. Accounts are classified into two main types based on how their balances are treated at the end of an accounting period. This distinction dictates which accounts are reset to zero and which carry their balances forward.

Temporary Accounts

Temporary accounts, also known as nominal accounts, track financial activity for a specific accounting period. These accounts are designed to measure a business’s performance over a defined interval, typically a month, quarter, or year. Examples include all revenue accounts, expense accounts, and dividend accounts (for corporations) or drawing accounts (for sole proprietorships and partnerships). The balances in these accounts accumulate only for the current period and must be cleared out for the next.

Permanent Accounts

Permanent accounts, also referred to as real accounts, carry their balances forward from one accounting period to the next. These accounts represent a business’s cumulative financial position at a specific point in time. Asset accounts (e.g., cash, accounts receivable, equipment), liability accounts (e.g., accounts payable, loans payable), and equity accounts (e.g., Retained Earnings for corporations or Owner’s Capital for sole proprietorships and partnerships) are permanent.

The purpose of closing entries is to transfer the balances of temporary accounts to a permanent equity account. For corporations, this is typically Retained Earnings; for sole proprietorships and partnerships, it is often the Owner’s Capital account. This transfer allows temporary accounts to be reset to a zero balance, providing a clean slate for recording transactions in the new accounting period.

Making Closing Journal Entries

Once preparatory steps are complete and the adjusted trial balance confirms the equality of debits and credits, the process of making closing journal entries begins. These entries transfer temporary account balances to permanent accounts, preparing the books for the next accounting period. There are typically four main types of closing journal entries.

Close Revenue Accounts

The first closing entry involves closing all revenue accounts. To reduce each revenue account balance to zero, a debit is made to each individual revenue account. The sum of these debits is then credited to an Income Summary account.

Close Expense Accounts

The second closing entry focuses on closing all expense accounts. This step requires debiting the Income Summary account for the total amount of all expenses incurred. Each individual expense account is credited to bring its balance to zero.

Close Income Summary Account

The third closing entry transfers the balance from the Income Summary account to a permanent equity account. If the Income Summary account has a credit balance (net income), it is debited to zero it out, and the Retained Earnings account (or Owner’s Capital account) is credited. If it has a debit balance (net loss), the Retained Earnings or Owner’s Capital account is debited, and the Income Summary account is credited.

Close Dividends/Drawing Accounts

The final closing entry involves closing the Dividends account (for corporations) or the Drawing account (for sole proprietorships/partnerships). These accounts represent distributions of earnings or withdrawals by owners. To close these accounts, the Retained Earnings account (or Owner’s Capital account) is debited, and the Dividends or Drawing account is credited to bring its balance to zero.

Verifying the Closed Books

After all closing journal entries have been made and posted, a final verification step ensures the books are properly closed and ready for the next accounting period.

Prepare Post-Closing Trial Balance

The first verification step is to prepare a post-closing trial balance. This trial balance should only contain permanent accounts, such as assets, liabilities, and equity accounts. All temporary accounts—revenue, expenses, and dividends/drawings—should now have zero balances. The purpose of this post-closing trial balance is to confirm that total debits still equal total credits after the closing entries.

Generate Final Financial Statements

Next, final financial statements are generated to reflect the results of the closed period. This includes the Income Statement, which summarizes revenues and expenses. The Balance Sheet is also prepared, presenting the company’s financial position and reflecting the updated equity balance. A Statement of Retained Earnings or Owner’s Equity is also prepared, detailing changes in equity due to net income or loss and any distributions to owners.

Finally, once these verification steps are complete, the accounting system is ready to record transactions for the new accounting period. The zero balances in temporary accounts allow for accurate measurement of financial activity specific to the upcoming period.