How to Properly Close Journal Entries

Journal entries record a business’s financial transactions, detailing debits, credits, affected accounts, and dates. Closing entries are performed at the end of an accounting period to prepare financial records for a new period. They transfer balances from certain accounts, ensuring a fresh start for measuring future performance.

Understanding Closing Entries

Closing entries zero out temporary accounts and transfer their balances to permanent equity accounts. This process is essential for accurately measuring a business’s financial performance for a specific accounting period. Temporary accounts, such as revenues, expenses, and dividends or owner’s drawings, accumulate balances only for a single accounting period. Their balances must be reset to zero to avoid mixing data from one period with the next.

Permanent accounts, including assets, liabilities, and most equity accounts like Retained Earnings, carry their balances forward from one accounting period to the next. These accounts reflect the ongoing financial position of a business and are not closed at the end of a period. The transfer of temporary account balances, particularly revenues and expenses, allows for the calculation of net income or loss for the period, which then updates a permanent equity account. This distinction ensures that financial statements accurately portray performance for distinct intervals and a continuous financial position.

Accounts Involved in Closing Entries

The accounts requiring closure at the end of an accounting period are temporary accounts. These accounts track financial activity within a defined timeframe and are reset to zero to begin accumulating new balances in the subsequent period. This category includes revenue accounts, expense accounts, and dividend or owner’s drawing accounts.

Revenue accounts accumulate income from a company’s operations over the accounting period. These can include sales, service, or interest revenue. Their balances contribute to the calculation of net income. Expense accounts track the costs incurred to generate that revenue during the same period, encompassing items like rent, salaries, or utilities. Both revenue and expense account balances are transferred to a summary account to determine the period’s profit or loss.

Dividend accounts (for corporations) or owner’s drawing accounts (for sole proprietorships and partnerships) represent distributions of earnings to owners. These accounts accumulate balances during the period and reduce owner’s equity. Their balances must be cleared at the end of the period to reflect distributions and prepare the books for the next cycle. The balances of these temporary accounts are transferred to a permanent equity account, typically Retained Earnings for corporations, or a capital account for other business structures.

Preparing Closing Entries

The preparation of closing entries involves specific journal entries to transfer the balances of temporary accounts. This process ensures that all temporary accounts begin the new accounting period with a zero balance. These entries are recorded in the general journal.

First, revenue accounts are closed. Since revenue accounts have credit balances, each revenue account is debited to zero it out. The corresponding credit is made to the Income Summary account, which is a temporary clearing account used solely during the closing process. This step aggregates all revenue earned during the period into a single temporary account.

Next, expense accounts are closed. Expense accounts have debit balances, so each expense account is credited to zero it out. The Income Summary account is then debited for the total amount of all expenses. After these two steps, the Income Summary account holds the net income (or net loss) for the period, as it now contains the total revenues credited and total expenses debited.

Subsequently, the Income Summary account is closed. If it has a credit balance (net income), it is debited to zero out its balance. The corresponding credit is made to the Retained Earnings account. If it has a debit balance (net loss), it is credited to zero, and the Retained Earnings account is debited. This action transfers the period’s profit or loss into the permanent equity account, updating the accumulated earnings of the business.

Finally, the Dividends (or Drawing) account is closed. This account has a debit balance, representing distributions to owners. To close it, the Dividends account is credited to zero. The corresponding debit is made to the Retained Earnings account. This final entry ensures that all temporary accounts have been cleared and their effects are reflected in the Retained Earnings account, preparing the books for the next accounting cycle.

Verifying the Closure

After all closing entries have been prepared and posted, the next step is to verify the accuracy of the closure. This verification is accomplished by preparing a post-closing trial balance. The purpose of this financial report is to confirm that total debits equal total credits after all temporary accounts have been zeroed out.

The post-closing trial balance differs from other trial balances as it lists only permanent accounts. These include assets, liabilities, and equity accounts, which are the balances that carry forward into the new accounting period. All revenue, expense, and dividend accounts should have a zero balance and, therefore, will not appear on this report.

The format of a post-closing trial balance is similar to other trial balances, presenting account names, debit balances, and credit balances in separate columns. Assets are listed first, followed by liabilities, and then equity accounts. A balanced post-closing trial balance, where total debits equal total credits, confirms that the closing process was completed accurately. This final check ensures the financial records are correct and ready for the recording of transactions in the upcoming accounting period.