How to Prepare Closing Entries: A Step-by-Step Process

Closing entries are an accounting procedure performed at the end of an accounting period. These entries prepare a company’s financial records for the subsequent period by resetting temporary accounts. The process accurately reflects the financial performance of the just-ended period and establishes a clean slate for new transactions. This ensures revenues and expenses are matched to their proper periods, preventing their accumulation over time.

Understanding Accounts That Close

The accounting system uses two types of accounts: temporary and permanent. Understanding this distinction is essential for performing closing entries. Temporary accounts relate to a specific accounting period and are closed at its end. Their purpose is to measure financial activity for a defined timeframe, such as a fiscal quarter or year.

Temporary accounts include all revenue accounts, such such as Sales Revenue or Service Revenue, which track income generated during the period. All expense accounts, like Rent Expense, Salaries Expense, or Utilities Expense, are also temporary because they represent costs incurred within that same period. Dividends or owner’s drawing accounts, which represent distributions to owners, are also temporary. These accounts are emptied to prepare for the next period.

Permanent accounts, in contrast, carry their balances forward from one accounting period to the next. These accounts represent the cumulative financial position of a business at a specific point in time. Their balances are not reset to zero at the end of an accounting period. Instead, they continuously reflect the ongoing financial state of the entity.

Examples of permanent accounts include all asset accounts, such as Cash, Accounts Receivable, and Equipment, which represent economic resources owned by the business. Liability accounts, including Accounts Payable, Notes Payable, and Unearned Revenue, are also permanent, as they represent obligations owed to external parties. Equity accounts, such as Retained Earnings for corporations or Owner’s Capital for sole proprietorships and partnerships, are also permanent, reflecting the owners’ residual claim on the assets of the business.

Executing the Closing Entries

Executing closing entries involves a series of journal entries that transfer temporary account balances to permanent equity accounts. These entries zero out temporary accounts, preparing them for the next accounting cycle, and summarize the period’s net income or loss within the equity section. This ensures financial performance is accurately captured and carried forward.

The first step transfers balances from all individual revenue accounts. Each revenue account, which typically has a credit balance, is debited to bring its balance to zero. The corresponding credit is made to the Income Summary account. This consolidates all revenue streams into a single temporary clearing account.

The second step closes all individual expense accounts. Since expense accounts typically have debit balances, they are credited to reduce their balances to zero. The total amount of these expenses is then debited to the Income Summary account. This aggregates all expenses incurred during the period into the Income Summary account.

Once all revenue and expense accounts are closed, the Income Summary account will represent the net income or net loss for the period. If revenues exceeded expenses, it will have a credit balance (net income). If expenses surpassed revenues, it will have a debit balance (net loss). The third closing entry transfers this balance from the Income Summary account to a permanent equity account.

For corporations, the Income Summary balance is closed to Retained Earnings. If there is net income, Income Summary is debited, and Retained Earnings is credited. If there is a net loss, Retained Earnings is debited, and Income Summary is credited. For sole proprietorships and partnerships, the Income Summary balance is closed to the Owner’s Capital account following the same debit/credit logic.

The final closing entry addresses the dividends account for corporations or the owner’s drawing account for sole proprietorships and partnerships. These accounts represent distributions of earnings to owners and are not considered expenses. Since these accounts typically have debit balances, they are credited to bring their balances to zero. The corresponding debit is made directly to the Retained Earnings account for corporations or the Owner’s Capital account for sole proprietorships and partnerships.

Preparing the Post-Closing Trial Balance

After all closing entries are posted to the general ledger, preparing a post-closing trial balance is the final step in the accounting cycle. Its purpose is to verify the accuracy of the closing process. It ensures that only permanent accounts retain balances and that the fundamental accounting equation, where total debits equal total credits, remains in balance.

The post-closing trial balance exclusively features permanent accounts. This includes all asset accounts (e.g., cash, accounts receivable, property, plant, and equipment). All liability accounts (e.g., accounts payable, notes payable, unearned revenue) will also appear. Lastly, permanent equity accounts, such as Retained Earnings for corporations or Owner’s Capital for sole proprietorships, will reflect their updated balances.

No temporary accounts should appear on the post-closing trial balance. Revenue accounts, expense accounts, and dividends or owner’s drawing accounts should all have zero balances. Their absence from this trial balance confirms they have been properly reset.

The post-closing trial balance acts as a foundational document for the next accounting period. It confirms that financial records are prepared to accurately record new transactions without carrying over balances from the previous period’s temporary accounts. This helps prevent errors and ensures a clean start for the upcoming accounting cycle.