How to Properly Close Accounts in Accounting

Closing accounts in accounting involves transferring balances from temporary accounts to permanent accounts at the end of an accounting period. This process prepares financial records for the next period by resetting certain account balances to zero. It ensures accurate financial reporting and allows businesses to track financial activity period by period.

Understanding Account Types for Closing

In accounting, accounts are categorized into two main types: temporary (nominal) and permanent (real). Temporary accounts relate to a specific accounting period and are closed to reset their balances for the next period. These include revenues, expenses, and dividends or owner’s drawings. Closing them allows for the accurate measurement of financial performance, such as net income or loss, for each distinct period.

Permanent accounts carry their balances forward from one accounting period to the next. These accounts represent a business’s cumulative financial position and include assets, liabilities, and equity (excluding dividends or drawings). Permanent accounts are not closed because their balances reflect ongoing financial positions. For example, a Cash account balance at the end of one year becomes the starting balance for the next year.

The Step-by-Step Closing Process

The closing process involves a series of four sequential journal entries designed to transfer balances from temporary accounts to permanent ones. Each entry clears a specific type of temporary account, ultimately updating the owner’s equity or retained earnings.

The first step closes all revenue accounts, which usually have credit balances. To zero them out, each revenue account is debited for its full balance, and the total is credited to a temporary account called Income Summary. This moves all revenue earned into the Income Summary account.

Following the revenue accounts, all expense accounts are closed. Expense accounts typically have debit balances. To close them, the Income Summary account is debited for the total of all expense balances, and each individual expense account is credited. This transfers all period expenses into the Income Summary account.

The third closing entry focuses on the Income Summary account. After revenues and expenses have been transferred, its balance represents the net income or net loss for the period. This net amount is then transferred to the Retained Earnings account for corporations, or the Owner’s Capital account for sole proprietorships. For net income, Income Summary is debited and Retained Earnings (or Owner’s Capital) is credited.

The final closing entry deals with dividends (for corporations) or owner’s drawings (for sole proprietorships). These accounts represent distributions of profits to owners and typically have debit balances. To close them, Retained Earnings (or Owner’s Capital) is debited, and the Dividends or Owner’s Drawing account is credited for its full balance. This reduces the equity account by the amount of distributions made during the period.

Creating the Post-Closing Trial Balance

After all closing entries are posted to the general ledger, the next step is to prepare a post-closing trial balance. This is a list of all permanent accounts and their balances. The purpose of this trial balance is to verify that all temporary accounts now have zero balances, confirming that they are ready for the next accounting period.

The post-closing trial balance also ensures that the total debits still equal the total credits for the remaining permanent accounts. This equality confirms the accuracy of the closing process. The balances presented serve as the starting point for recording transactions in the subsequent accounting period.