How to Prepare Closing Journal Entries

Businesses prepare closing journal entries at the end of an accounting period. These entries reset certain account balances to zero, preparing financial records for the subsequent reporting period. This allows for accurate measurement of new financial activity. Closing entries also update the retained earnings or owner’s capital account with the net results of operations, integrating periodic performance into the cumulative equity balance.

Accounts to Close

Understanding which accounts require closing entries is fundamental, distinguishing between temporary and permanent accounts. Temporary accounts, often called nominal accounts, track financial activity for a specific accounting period. These include all revenue, expense, and dividend or owner’s drawing accounts. Their balances are closed at the end of each period to allow for a fresh start in the next financial cycle, ensuring independent measurement of each period’s performance.

The reason for closing temporary accounts is to isolate the financial results of a single period. If expense accounts were not closed, their balances would continually grow, making it impossible to determine total expenses incurred within a particular quarter or year. By resetting these accounts to zero, the accounting system can accurately accumulate new revenue and expense figures for the next period. This periodic reset is crucial for preparing accurate income statements, which report performance over a defined time.

Conversely, permanent accounts, also known as real accounts, 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. Examples include all asset accounts, such as Cash, Accounts Receivable, and Equipment, as well as liability accounts like Accounts Payable and Notes Payable. Equity accounts, including Retained Earnings for corporations or Owner’s Capital for sole proprietorships and partnerships, are also permanent accounts.

Permanent accounts do not get closed because their balances reflect ongoing financial positions, not period-specific activities. For example, a company’s cash balance at the end of one period becomes its beginning cash balance for the next period. The cumulative nature of these accounts means their balances are never reset to zero unless an actual transaction reduces them. This distinction between temporary and permanent accounts is central to the entire closing process.

The Closing Process Step-by-Step

The closing process involves a four-step procedure to transfer temporary account balances to permanent equity accounts. This sequence ensures all period-specific financial data is summarized and recorded before the new accounting cycle begins. Each step involves specific journal entries to achieve necessary account resets and transfers, accurately reflecting the period’s financial outcomes.

The first step transfers all revenue account balances to the Income Summary account. To do this, every individual revenue account, which carries a credit balance, is debited for its full amount to bring its balance to zero. For instance, Sales Revenue or Service Revenue would be debited. Concurrently, the total debited revenue is credited to the Income Summary account, consolidating all revenue earned into this single temporary account. This prepares the Income Summary account for calculating net income or loss.

The second step closes all expense account balances to the Income Summary account. Since expense accounts carry debit balances, each individual expense account, such as Rent Expense or Salaries Expense, is credited to reduce its balance to zero. This clears the accounts for the next period. The sum of these credited expense amounts is then debited to the Income Summary account. After this entry, the Income Summary account holds total revenues (credit) and total expenses (debit) for the period, setting the stage for determining profitability.

The third step closes the Income Summary balance to the appropriate equity account (Retained Earnings or Owner’s Capital). If the Income Summary account has a credit balance (net income), it is debited to bring its balance to zero. The corresponding credit is made to the Retained Earnings or Owner’s Capital account, increasing the cumulative equity balance.

Conversely, if the Income Summary account has a debit balance (net loss), it is credited to bring its balance to zero. In this scenario, the Retained Earnings or Owner’s Capital account is debited, directly reducing the equity balance. This transfer ensures the period’s profitability or loss directly impacts the cumulative equity.

The final step addresses dividend accounts (for corporations) or owner’s drawing accounts (for sole proprietorships and partnerships). These accounts represent distributions of earnings or withdrawals of capital made to owners, and they carry debit balances. To close these accounts, the dividend or owner’s drawing account is credited for its full balance to bring it to zero.

The corresponding debit is made to the Retained Earnings account (for corporations) or the Owner’s Capital account (for sole proprietorships and partnerships). This entry reduces the equity account by the amounts distributed or withdrawn, as these are not business expenses but a direct reduction of the owners’ claim on company assets. This final entry ensures all temporary accounts are reset and period-specific results are reflected in permanent equity accounts, preparing them for the new accounting period.

Post-Closing Activities

Upon completion of closing journal entries, several post-closing activities ensure the accuracy and readiness of the accounting system for the next period. These steps verify that closing procedures were executed correctly and financial records are prepared for new transactions. The primary activity is preparing a specialized trial balance.

A post-closing trial balance is prepared after all closing entries have been posted to the general ledger. Its purpose is to verify that total debits equal total credits and only permanent accounts retain balances. This means asset, liability, and equity accounts, including Retained Earnings or Owner’s Capital, will appear with their updated balances. All temporary accounts, having been closed, should show a zero balance.

Preparation of a post-closing trial balance confirms the mathematical accuracy of the ledger after the closing process. With temporary accounts reset to zero and permanent accounts updated, the general ledger is prepared for the transactions of the new accounting period. This concludes the accounting cycle, allowing businesses to begin recording new financial activities with a clean slate for accurate reporting.