How to Do Closing Entries: The 4-Step Process

Closing entries are specialized journal entries made at the end of an accounting period to prepare financial records for the next cycle. They reset certain account balances to zero. The purpose of these entries is to accurately reflect a company’s financial performance for a specific period, preventing data from mixing between periods. Closing entries ensure the accuracy and continuity of financial reporting, allowing a fresh start for tracking transactions in the upcoming accounting period.

Understanding Temporary and Permanent Accounts

Accounts in a business’s general ledger are categorized as either temporary or permanent. This distinction is important for understanding why closing entries are necessary.

Temporary accounts, also known as nominal accounts, track financial activity for a specific accounting period. These accounts include revenues, expenses, and dividends (or owner’s drawings for sole proprietorships and partnerships). They measure a business’s income or loss over a defined timeframe. At the end of each period, their balances must be closed to prevent data accumulation across multiple periods, ensuring a clear slate for each new period. For example, if revenue accounts were not closed, the total revenue reported would combine sales from all past periods, making it impossible to see the revenue generated in a single year.

Permanent accounts, often called real accounts, maintain ongoing records of a business’s financial position. These accounts represent assets, liabilities, and equity. Unlike temporary accounts, their balances are not reset at the end of an accounting period; instead, they carry forward from one period to the next. For instance, the cash balance at the end of one day becomes the cash balance at the beginning of the next, and similarly for accounts like accounts receivable or long-term debt. These accounts appear on the balance sheet, which provides a snapshot of a company’s financial standing at a specific point in time.

The Income Summary account is a temporary holding account where all revenue and expense balances are transferred during the closing process. This step allows for the calculation of net income or loss for the period within a single account. It provides a useful audit trail. This account is opened and closed within the same accounting period and does not appear on the final financial statements.

The Four-Step Closing Entry Process

The closing entry process systematically transfers the balances of temporary accounts to permanent accounts, preparing the books for the next accounting period. This process involves four distinct journal entries.

The first step involves closing all revenue accounts. Since revenue accounts typically have credit balances, a debit entry is made to each revenue account to zero them out. The total of these debits is then credited to the Income Summary account. For instance, if a business had $50,000 in Service Revenue and $5,000 in Interest Revenue, the journal entry would debit Service Revenue for $50,000, debit Interest Revenue for $5,000, and credit Income Summary for $55,000.

The second step focuses on closing all expense accounts. Expense accounts normally carry debit balances. To zero out these balances, a credit entry is made to each expense account. The sum of these credits is then debited to the Income Summary account. For example, if a company had $30,000 in Salaries Expense and $10,000 in Rent Expense, the journal entry would credit Salaries Expense for $30,000, credit Rent Expense for $10,000, and debit Income Summary for $40,000.

Following the closure of revenue and expense accounts, the third step involves closing the Income Summary account. At this point, the Income Summary account holds the net result of the period’s operations: a credit balance indicates net income, while a debit balance signifies a net loss. If the Income Summary has a credit balance (net income), it is debited to zero out the account, and the corresponding amount is credited to the Retained Earnings account for corporations or the Owner’s Capital account for sole proprietorships and partnerships. For example, if the Income Summary has a $15,000 credit balance representing net income, the entry would debit Income Summary for $15,000 and credit Retained Earnings for $15,000. Conversely, if there’s a net loss (a debit balance), the Income Summary is credited, and Retained Earnings (or Owner’s Capital) is debited.

The final step addresses the Dividends account (or Owner’s Drawings account). This account represents distributions of company earnings to owners or shareholders. Dividends typically have a debit balance. To close this account, a credit entry is made to the Dividends account to bring its balance to zero. The corresponding debit entry is made to the Retained Earnings account (or Owner’s Capital account). For instance, if $12,000 in dividends were paid, the journal entry would debit Retained Earnings for $12,000 and credit Dividends for $12,000.

Preparing the Post-Closing Trial Balance

After all closing entries are recorded and posted, the next step is to prepare a post-closing trial balance. This document serves as a final verification step in the accounting cycle. Its primary purpose is to confirm that all temporary accounts, such as revenues, expenses, and dividends/owner’s drawings, now have zero balances.

The post-closing trial balance includes only permanent accounts: assets, liabilities, and equity accounts. Since temporary accounts have been closed out, they will not appear on this trial balance. The report is structured to list all permanent accounts with their respective debit or credit balances, and the total debits must equal the total credits. This equality confirms the mathematical accuracy of the ledger after the closing process.

Creating this trial balance acts as a check on the accuracy of the closing entries. If any temporary account still shows a balance, or if the total debits and credits do not match, it indicates an error in the closing process that requires investigation and correction before the new accounting period officially begins. The balances presented on the post-closing trial balance become the starting balances for the next accounting period, providing a clear and accurate foundation for future financial reporting. This final report closely resembles a balance sheet, as it contains the same categories of accounts.