How to Prepare Closing Journal Entries

Closing journal entries are a fundamental part of the accounting cycle, performed at the end of an accounting period. These entries transfer temporary account balances to permanent accounts, resetting temporary accounts to zero for a new period. This process ensures accurate financial reporting, segregating each period’s performance and updating cumulative equity balances. Businesses maintain clear financial records, allowing precise measurement of performance over time.

Understanding Accounts Requiring Closure

In accounting, accounts are categorized as either temporary (nominal) or permanent (real). This distinction determines whether their balances are reset at the end of an accounting period.

Temporary accounts accumulate balances for a specific accounting period and are then closed. These accounts include revenues, expenses, and dividends or drawings. Revenue accounts, such as Sales Revenue, track income from a business’s primary operations. Expense accounts, like Rent Expense, record costs incurred to generate that revenue.

Dividends (for corporations) or drawings (for sole proprietorships and partnerships) represent distributions of earnings to owners. Their balances must be reset to zero to avoid commingling with the next period’s activities, ensuring a clear picture of performance for each timeframe.

Permanent accounts carry their balances forward from one accounting period to the next. These accounts are found on the balance sheet and include assets, liabilities, and equity accounts, such as Capital or Retained Earnings.

Asset accounts, like Cash, represent what the business owns. Liability accounts, like Accounts Payable, represent what the business owes. Equity accounts reflect the owners’ stake in the business. Their balances are not closed; the ending balance of one period becomes the beginning balance of the next, maintaining a continuous record of the entity’s financial health.

Executing the Closing Entries

Executing closing entries involves a series of journal entries made at the close of an accounting period. This process transfers temporary account balances, ultimately updating the permanent equity account.

The first step closes 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 Income Summary. This consolidates all revenues earned during the period. For example, a journal entry might debit Sales Revenue for its total balance and credit Income Summary for the same amount.

Next, all expense accounts are closed. Expense accounts normally carry debit balances, so they are credited to reduce their balances to zero. The total of these credited expenses is then debited to the Income Summary account. This gathers all costs incurred during the period into Income Summary, offsetting previously transferred revenues.

The third step closes the Income Summary account, transferring its balance to Retained Earnings (or the owner’s Capital account for non-corporations). The balance in Income Summary represents the net income or net loss for the period. If Income Summary has a credit balance (revenues exceeded expenses), it indicates net income, and Income Summary is debited while Retained Earnings is credited. Conversely, if Income Summary has a debit balance (expenses exceeded revenues), it signifies a net loss, requiring a credit to Income Summary and a debit to Retained Earnings.

Finally, Dividends or Drawings accounts are closed directly to Retained Earnings. These accounts typically have debit balances, reflecting distributions to owners. To close them, Retained Earnings is debited, and the Dividends or Drawings account is credited, bringing its balance to zero. This ensures all temporary accounts are reset, and Retained Earnings accurately reflects the period’s profitability and distributions.

Verifying Post-Closing Balances

After all closing entries are posted, the final step in the accounting cycle is to prepare a post-closing trial balance. This verifies that all temporary accounts have been closed and that total debits equal total credits for the permanent accounts. It serves as an internal control and provides a clean starting point for the next accounting period.

The post-closing trial balance exclusively lists permanent accounts, including assets, liabilities, and equity accounts like Retained Earnings or Capital. All temporary accounts, such as revenues, expenses, dividends, and Income Summary, should display a zero balance and will not appear. This confirms the period’s income and expense figures have been transferred and reset.

Preparing this trial balance involves listing all ledger accounts with a non-zero balance and summing their debit and credit totals. If total debits equal total credits, the closing process was accurate. This check ensures financial records are balanced and ready for new transactions, preventing errors from rolling forward.