How to Do Closing Entries in Accounting

Closing entries are performed at the end of an accounting period to prepare a company’s financial records for the subsequent period. This process involves journal entries that reset certain accounts, allowing for a clear measurement of performance for the new period. By systematically transferring balances, closing entries help ensure that financial statements accurately reflect a company’s activities over distinct timeframes and maintain the integrity of financial data from one period to the next.

Understanding the Purpose of Closing Entries

Closing entries reset temporary accounts to zero, allowing for accurate measurement of financial performance in each new accounting period. Temporary accounts, also known as nominal accounts, include all revenue, expense, and dividend (or owner’s drawing) accounts. These accounts accumulate balances only for a specific period, such as a month, quarter, or year.

Permanent accounts, also known as real accounts, represent assets, liabilities, and equity (excluding dividends/drawings). These accounts are not closed at the end of an accounting period; their balances carry forward continuously from one period to the next. For instance, the cash balance at the end of one day becomes the starting balance for the next. Closing temporary accounts prevents their balances from accumulating indefinitely, ensuring financial results, like net income or loss, are clearly attributable to a defined period.

The Income Summary account plays a temporary role in this process. It acts as a clearing account where all revenues and expenses are transferred to calculate the period’s net income or loss. Once determined, its balance is then transferred to a permanent equity account, typically Retained Earnings for corporations or Owner’s Capital for proprietorships. This provides a clean slate for the next reporting period.

Preparing for Closing Entries

The adjusted trial balance is needed before preparing closing entries. This document lists the final balances of all accounts after all regular transactions and necessary adjusting entries. It provides the figures for all revenue, expense, and dividend accounts that must be closed.

Accounts requiring closing are temporary accounts. These include every revenue account, such as Sales Revenue or Service Revenue, and every expense account, like Rent Expense, Salaries Expense, or Utilities Expense. Additionally, the Dividends account (for corporations) or Owner’s Drawing account (for sole proprietorships) must also be closed. These accounts’ balances will be transferred to a permanent equity account.

Permanent accounts—assets (e.g., Cash, Accounts Receivable, Equipment), liabilities (e.g., Accounts Payable, Notes Payable), and most equity accounts (e.g., Common Stock, Retained Earnings/Owner’s Capital)—do not get closed. Their balances naturally carry over to the next accounting period. The adjusted trial balance distinguishes between these temporary and permanent accounts, making it easier to select the correct balances for the closing process.

The Steps for Making Closing Entries

The process of making closing entries involves four distinct journal entries to systematically transfer temporary account balances.

Closing Revenue Accounts

Revenue accounts have credit balances. To close them, each revenue account is debited for its full balance to bring it to zero, and the total is credited to the Income Summary account. For example, if a company has $50,000 in Service Revenue, the entry is a debit to Service Revenue for $50,000 and a credit to Income Summary for $50,000.

Closing Expense Accounts

Expense accounts carry debit balances. To close them, the Income Summary account is debited for the total amount of all expenses, and each individual expense account is credited for its balance. For instance, if total expenses are $30,000 (e.g., Salaries Expense $20,000, Rent Expense $10,000), the entry is a debit to Income Summary for $30,000, and individual credits to Salaries Expense for $20,000 and Rent Expense for $10,000.

Closing Income Summary

The balance in the Income Summary account represents the net income or net loss for the period. This balance is transferred to Retained Earnings (or Owner’s Capital). If Income Summary has a credit balance (net income), Income Summary is debited and Retained Earnings is credited. If it has a debit balance (net loss), Retained Earnings is debited and Income Summary is credited. For example, with a $20,000 credit balance in Income Summary, the entry is a debit to Income Summary for $20,000 and a credit to Retained Earnings for $20,000.

Closing Dividends (or Owner’s Drawing)

The Dividends (or Owner’s Drawing) account has a debit balance. To close it, Retained Earnings (or Owner’s Capital) is debited, and the Dividends account is credited for its full balance, bringing it to zero. For instance, if $5,000 in dividends were paid, the entry is a debit to Retained Earnings for $5,000 and a credit to Dividends for $5,000.

Verifying the Closing Process

After all closing entries are made and posted to the ledger, the final step is to prepare a post-closing trial balance. This document verifies that closing procedures were performed accurately. Its purpose is to confirm all temporary accounts (revenues, expenses, and dividends) now have zero balances, and that total debits equal total credits for the remaining permanent accounts.

The post-closing trial balance includes only permanent accounts: assets, liabilities, and equity accounts, such as Common Stock and Retained Earnings (or Owner’s Capital). The balances shown for these accounts carry forward as the beginning balances for the new accounting period.

If the post-closing trial balance does not balance, it indicates an error in the journalizing or posting of the closing entries. Correcting such discrepancies before the start of the next period ensures the accuracy of future financial statements.