How to Journalize Closing Entries in 4 Steps

Closing entries are part of the accounting cycle, performed at the end of an accounting period to prepare a company’s financial records for the next. They involve transferring account balances to ensure financial reporting accurately reflects performance for specific periods. This process maintains the integrity of financial statements and provides a clear starting point for new accounting cycles.

Understanding Temporary and Permanent Accounts

Accounts are categorized as either temporary or permanent, which dictates how they are treated at the end of an accounting period. Temporary accounts track financial activity for a specific period, such as a month, quarter, or year. These include revenues, expenses, and dividends (or owner’s drawings). Their balances are closed to zero at the end of each period to allow for a clear measurement of performance for each new accounting cycle.

In contrast, permanent accounts continuously track a company’s financial position and carry their balances forward. These accounts appear on the balance sheet and include assets, liabilities, and equity accounts, such as Cash, Accounts Payable, and Retained Earnings. Permanent accounts reflect ongoing values, so their balances are not closed at the end of the period. The ending balance of a permanent account becomes its beginning balance for the next, ensuring a continuous record.

Journalizing Closing Entries

Journalizing closing entries transfers temporary account balances into permanent accounts, primarily Retained Earnings for corporations or Owner’s Capital for sole proprietorships. This is done in the general journal. An intermediate account called Income Summary is used to consolidate revenues and expenses before transferring the net result. This ensures temporary accounts begin each new period with a zero balance.

First, all revenue accounts are closed. Since revenue accounts have credit balances, they are debited to zero. The corresponding credit is made to the Income Summary account. For example, if a company had $15,000 in Service Revenue, the entry would be a Debit to Service Revenue for $15,000 and a Credit to Income Summary for $15,000.

Next, all expense accounts are closed. Expense accounts have debit balances, so they are credited to zero. The total of these credited expense amounts is then debited to the Income Summary account. For instance, if a company had $7,000 in Rent Expense and $3,000 in Utilities Expense, the entry would include a Debit to Income Summary for $10,000, a Credit to Rent Expense for $7,000, and a Credit to Utilities Expense for $3,000.

Following the closing of revenues and expenses, the Income Summary account itself is closed. Its balance, which represents the net income (or net loss) for the period, is transferred to the Retained Earnings account. If the Income Summary has a credit balance (indicating net income), it is debited, and Retained Earnings is credited. Conversely, if there was a net loss, the Income Summary would have a debit balance, requiring a credit and a debit to Retained Earnings. An example for a net income of $5,000 would be a Debit to Income Summary for $5,000 and a Credit to Retained Earnings for $5,000.

Finally, the Dividends account (or Owner’s Drawings for a sole proprietorship) is closed. Dividends represent distributions to owners and have a debit balance. To close this account, Dividends are credited, and Retained Earnings is debited. For example, if $2,000 in Dividends were paid, the entry would be a Debit to Retained Earnings for $2,000 and a Credit to Dividends for $2,000.

Preparing the Post-Closing Trial Balance

After all closing entries have been journalized and posted to the ledger, a post-closing trial balance is prepared. This step is a verification tool, ensuring the accuracy of the closing process and preparing the accounting system for the next period’s transactions. Its primary purpose is to confirm that all temporary accounts, such as revenues, expenses, and dividends, now have zero balances.

The post-closing trial balance lists only the permanent accounts, which include assets, liabilities, and equity accounts, along with their updated balances. It serves as a snapshot of the company’s financial position at the end of the accounting period, with the balances listed becoming the opening balances for the subsequent period. The process involves listing all permanent accounts with their debit or credit balances and then totaling both columns.

The fundamental principle of double-entry accounting dictates that total debits must equal total credits. If the post-closing trial balance shows equal debit and credit totals, it confirms that the closing entries were correctly prepared and posted, and that the accounting equation (Assets = Liabilities + Equity) remains in balance. Any discrepancy in the totals, or the presence of a non-zero balance in a temporary account, indicates an error in the closing process that requires investigation and correction before the new accounting period begins.