How to Make Closing Entries: A Four-Step Process

Closing entries are a fundamental part of the accounting cycle, serving to prepare financial records for a new accounting period. This process ensures that certain accounts are reset to a zero balance, maintaining accuracy. The primary purpose of these entries is to transfer the balances of temporary accounts to permanent accounts, thereby reflecting a company’s financial performance for a specific period.

Identifying Accounts to Close

In accounting, accounts are categorized as either temporary (nominal) or permanent (real). Understanding this distinction is essential because only temporary accounts are closed at the end of an accounting period.

Temporary accounts track financial activities for a specific period, such as a month, quarter, or year, and their balances do not carry forward to the next period. Examples of temporary accounts include revenue and expense accounts, and the Dividends account. These accounts are designed to measure performance over a defined timeframe, and resetting them to zero allows for a fresh start in the new period. The Income Summary account also functions as a temporary holding account, summarizing revenues and expenses before transferring the net result.

Permanent accounts, in contrast, track cumulative financial activity that extends beyond a single accounting period; these include assets, liabilities, and most equity accounts, and their balances carry over from one period to the next.

The Four-Step Closing Process

The core of preparing financial records for a new period involves a four-step process of making specific journal entries to close out temporary accounts. This systematic approach ensures that all period-specific financial results are transferred to the appropriate permanent equity account, typically Retained Earnings.

The first step in the closing process involves closing all revenue accounts. Revenue accounts typically have credit balances, reflecting income earned during the period. To bring these accounts to a zero balance, each revenue account is debited for its full amount. The total of these debits is then credited to the Income Summary account.

The second step focuses on closing all expense accounts. Expense accounts normally carry debit balances, representing costs incurred. To zero out these accounts, each expense account is credited for its balance. The sum of these credits is then debited to the Income Summary account. After these first two steps, the balance in the Income Summary account will represent the net income (if revenues exceeded expenses, resulting in a credit balance) or net loss (if expenses exceeded revenues, resulting in a debit balance) for the period.

The third step involves closing the Income Summary account itself. If the Income Summary account has a credit balance, indicating a net income, it is debited. This net income amount is then credited to the Retained Earnings account. Conversely, if the Income Summary account has a debit balance, signifying a net loss, it is credited, and the net loss amount is debited to Retained Earnings.

The fourth and final step is to close the Dividends account. Dividends, which represent distributions of earnings to shareholders, typically have a debit balance. To close this account, the Dividends account is credited for its full amount. This amount is then debited directly to the Retained Earnings account.

Preparing a Post-Closing Trial Balance

After all closing entries have been journalized and posted to the general ledger, the next step in the accounting cycle is to prepare a post-closing trial balance. This document serves as a verification step, ensuring the accuracy of the accounting records before the commencement of a new period. It confirms that only permanent accounts retain balances and that total debits equal total credits.

The post-closing trial balance exclusively lists permanent accounts, which include assets, liabilities, and equity accounts. Temporary accounts, such as revenues, expenses, and dividends, have zero balances and do not appear on this trial balance. The presence of any temporary account with a non-zero balance on this trial balance indicates an error in the closing process that requires correction. This final trial balance signifies that the books are ready to record transactions for the upcoming accounting period.