What Are Closing Entries and How Do You Record Them?
Learn how to effectively record closing entries and understand their role in preparing accurate financial statements.
Closing entries are a critical part of the accounting cycle, resetting temporary accounts for the new fiscal period. This ensures revenue and expense accounts start each period at zero, enabling businesses to track financial performance accurately.
Accounts Subject to Closing
Temporary accounts such as revenues, expenses, and dividends are closed at the end of each fiscal period to determine a company’s net income or loss and ensure financial statements reflect the results of operations for that period.
Revenue accounts, which record income from business activities, are closed to the Income Summary account. For example, $500,000 in sales revenue is debited from the revenue account and credited to the Income Summary account, resetting the revenue account to zero.
Expense accounts, which track costs incurred during the period, are also closed to the Income Summary account. For instance, $300,000 in operating expenses would be credited from the expense accounts and debited to the Income Summary account, ensuring all expenses are included in calculating net income.
Dividends, representing earnings distributed to shareholders, are closed to the Retained Earnings account. For example, $50,000 in dividends is debited from Retained Earnings, reducing the balance available for future use or distribution.
Process of Recording Closing Entries
Closing entries transfer balances from temporary accounts to permanent ones, ensuring accurate financial reporting. The process begins by transferring revenue balances to the Income Summary account through debiting each revenue account and crediting the Income Summary account, which temporarily holds the period’s net income or loss.
Expense account balances are credited to reset them to zero, with corresponding debits made to the Income Summary account. The net balance in the Income Summary, which represents net income or loss, is then transferred to Retained Earnings by debiting the Income Summary and crediting Retained Earnings, completing the closure of the Income Summary.
Post-Closing Trial Balance
The post-closing trial balance ensures the ledger is balanced after closing entries are completed. It includes only permanent accounts, such as assets, liabilities, and equity, which carry forward into the next accounting period. This process confirms all temporary accounts have been closed and the books are ready for the new fiscal year.
Accountants prepare the post-closing trial balance by listing all remaining ledger balances, compiling account titles and their respective debit or credit balances in a structured format. The total debits must equal total credits, confirming the accuracy of the closing process. Discrepancies signal errors that require review and correction.
The post-closing trial balance is essential for meeting financial reporting standards like GAAP or IFRS. It provides a clear snapshot of a company’s financial position, crucial for external audits and regulatory filings. For example, publicly listed companies must meet strict reporting criteria, making the accuracy of the post-closing trial balance vital.