How to Do Closing Entries: The Four Main Steps

Closing entries are a fundamental practice in accounting, performed at the end of an accounting period to prepare a business’s financial records for the next cycle. They involve transferring balances from temporary accounts to permanent accounts, effectively resetting the temporary accounts to zero. This process ensures that financial reporting accurately reflects performance for a specific period and prevents data from one period from mixing with another. Without proper closing entries, it would be challenging to evaluate period-by-period financial performance and maintain the integrity of financial statements.

Identifying Accounts for Closure

Understanding the types of accounts that require closure is an important preliminary step. In accounting, accounts are broadly categorized into “temporary” (or nominal) and “permanent” (or real) accounts. Only temporary accounts are closed at the end of an accounting period; permanent accounts carry their balances forward into the next period.

Temporary accounts track financial activity for a single accounting period and include revenues, expenses, and dividends or owner’s draws. These accounts must be reset to zero to begin a new accounting period, allowing for accurate performance measurement. Revenue accounts record income earned from operations, such as sales or service revenue. Expense accounts capture costs incurred to generate revenue, including rent, salaries, or utilities. Dividends or owner’s draw accounts reflect distributions of company earnings to shareholders or withdrawals by the owner.

Permanent accounts, in contrast, represent a business’s ongoing financial position and include assets, liabilities, and equity accounts like Common Stock and Retained Earnings. Their balances carry over from one period to the next, forming the beginning balances for the new period. This distinction dictates which balances are reset and which continue to accumulate.

Recording Closing Entries

Recording closing entries involves four distinct journal entries to transfer temporary account balances. These entries ensure that all revenue and expense balances are consolidated to determine the period’s net income or loss, which is then transferred to a permanent equity account. The process also accounts for any distributions made to owners or shareholders during the period.

The first step involves closing all revenue accounts. Since revenue accounts typically have credit balances, they are debited to bring their balances to zero. The corresponding credit is made to the Income Summary account, a temporary account used to summarize revenues and expenses. This action effectively transfers the total revenue earned during the period into the Income Summary.

Next, all expense accounts are closed. Expense accounts normally carry debit balances, so they are credited to zero. The total of these credited expense amounts is then debited to the Income Summary account. At this point, the Income Summary account holds the combined effect of all revenues and expenses for the period, with a credit balance indicating net income and a debit balance indicating a net loss.

Following the closure of revenue and expense accounts, the Income Summary account itself is closed. If the business has a net income (a credit balance), the Income Summary account is debited to zero it out. The corresponding credit is made to the Retained Earnings account (or Owner’s Capital), increasing the business’s accumulated earnings. Conversely, if there is a net loss (a debit balance), the Income Summary account is credited, and the Retained Earnings account is debited, decreasing accumulated earnings. This moves the period’s profit or loss into the permanent equity section.

The final closing entry addresses the Dividends account (or Owner’s Draw). This account represents distributions to owners and typically has a debit balance. To close it, the Dividends account is credited to zero. The corresponding debit is made directly to the Retained Earnings account (or Owner’s Capital), reducing accumulated earnings by the distribution amount. Completing these four entries ensures all temporary accounts are reset for the next period, and net results are reflected in permanent equity accounts.

Preparing a Post-Closing Trial Balance

After all closing entries have been successfully recorded and posted, the next step is to prepare a post-closing trial balance. This document serves as an important verification tool, confirming that the accounting records are accurate and ready for the start of a new accounting period. Its primary purpose is to ensure that total debits still equal total credits after the closing process and that only permanent accounts retain balances.

The post-closing trial balance will exclusively list permanent accounts, such as assets, liabilities, and equity (including the updated Retained Earnings balance). All temporary accounts, including revenues, expenses, and dividends or owner’s draws, should now have zero balances and therefore will not appear on this trial balance. This absence of temporary accounts is an indicator that the closing process has been performed correctly.

To prepare it, one simply lists all general ledger accounts that still have a balance after closing entries, placing their balances in the appropriate debit or credit column. The totals of the debit column and the credit column must match, confirming the fundamental accounting equation remains in balance. If the debits and credits do not equal, or if any temporary accounts still show a balance, it signals an error in the closing entries that must be identified and corrected before proceeding. A successful post-closing trial balance signifies that the books are balanced, all period-specific accounts are reset, and the financial system is prepared to accurately record transactions for the upcoming accounting cycle.