How to Make Closing Entries in Accounting

Closing entries are performed at the end of each fiscal period to prepare a company’s financial records for the subsequent period. This involves resetting certain accounts to a zero balance. By transferring temporary account balances to permanent equity accounts, closing entries ensure financial statements accurately reflect performance for a specific timeframe and update the overall financial position of a business. This process is essential for maintaining consistency and comparability in financial reporting.

Understanding Temporary and Permanent Accounts

Temporary and permanent accounts are central to the closing entry process. Temporary accounts, also known as nominal accounts, track financial activities for a specific accounting period and are closed at the period’s end. Examples include all revenue accounts, such as Sales Revenue or Service Revenue, and all expense accounts, like Rent Expense, Utilities Expense, or Salary Expense. The Dividends account is also a temporary account. These accounts are reset to zero to measure performance independently for each new period.

Conversely, permanent accounts, or real accounts, carry their balances forward from one accounting period to the next. These accounts represent the cumulative financial status of a business and are not closed at the end of the period. Asset accounts, such as Cash, Accounts Receivable, and Equipment, are permanent accounts. Liability accounts like Accounts Payable and Notes Payable, along with equity accounts like Common Stock and Retained Earnings, are also classified as permanent. They appear on the balance sheet and provide an ongoing snapshot of a company’s financial health.

Closing Revenue and Expense Accounts

Closing revenue and expense accounts involves transferring their balances to an intermediate account called Income Summary. This temporary account acts as a clearing house for all revenue and expense balances before their net effect is moved to a permanent equity account.

To close revenue accounts, which typically have credit balances, each individual revenue account is debited for its balance, reducing it to zero. Concurrently, the Income Summary account is credited for the total amount of all revenues. For instance, if a business has $75,000 in Sales Revenue and $25,000 in Service Revenue, Sales Revenue would be debited for $75,000, Service Revenue debited for $25,000, and Income Summary credited for $100,000.

Expense accounts normally carry debit balances. To close these accounts, the Income Summary account is debited for the total sum of all expenses. Following this, each individual expense account is credited for its balance, effectively bringing their balances to zero. For example, if Rent Expense is $10,000 and Salary Expense is $40,000, Income Summary would be debited for $50,000, Rent Expense credited for $10,000, and Salary Expense credited for $40,000.

Closing Income Summary and Dividends Accounts

After closing revenue and expense accounts, the balance in the Income Summary account, which now represents the net income or net loss for the period, is transferred to the Retained Earnings account. This step updates the permanent equity account with the period’s profitability.

If the Income Summary account has a credit balance, it signifies a net income. To close this balance, the Income Summary account is debited, and the Retained Earnings account is credited for the same amount. For example, a $60,000 credit balance in Income Summary would result in a debit to Income Summary for $60,000 and a credit to Retained Earnings for $60,000. Conversely, if the Income Summary account holds a debit balance, indicating a net loss, Retained Earnings is debited, and Income Summary is credited to close the account.

The Dividends account, representing distributions to owners, is a temporary account that must be closed at the end of the period. Its balance is transferred directly to the Retained Earnings account. To achieve this, the Retained Earnings account is debited, and the Dividends account is credited for the balance. For instance, if $15,000 was paid out in dividends, Retained Earnings would be debited for $15,000, and Dividends credited for $15,000. This action reduces the retained earnings by the amount of dividends distributed.

Preparing a Post-Closing Trial Balance

The final step in the accounting cycle, after all closing entries have been made, involves preparing a post-closing trial balance. This document serves as a verification tool, confirming that all temporary accounts now have zero balances and that the total debits equal the total credits for all remaining permanent accounts. It is a foundational check before the next accounting period begins.

To prepare this trial balance, only the permanent accounts are listed, along with their balances after the closing entries have been posted. These accounts include assets, liabilities, and equity accounts, appearing in the same order as they would on a balance sheet. The debit balances are then summed, and the credit balances are independently summed. The totals of both columns must match, ensuring the accounting equation (Assets = Liabilities + Equity) remains in balance. This step provides assurance that the accounting records are accurate and ready for the recording of transactions in the new fiscal period.