What Are Closing Entries in Accounting?

Closing entries are a standard accounting procedure performed at the end of each accounting period. They finalize financial results, allowing businesses to accurately measure performance and prepare records for the next period. This process provides a clear starting point for new transactions and contributes to the integrity of financial statements, which are essential for evaluating a company’s profitability and financial position.

Types of Accounts Involved

Accounts are broadly categorized into temporary and permanent. Understanding this distinction is essential for the closing process. Temporary accounts, also known as nominal accounts, track financial activities for a specific accounting period and are reset to zero at the end of that period. These include all revenue accounts, such as sales or service revenue, and expense accounts like rent, utilities, salaries, and depreciation. The dividends account, representing distributions of earnings to owners, is also temporary.

Permanent accounts, or real accounts, carry their balances forward from one accounting period to the next. They are not closed at the end of a period because they represent the ongoing financial position of the entity. Assets (e.g., cash, accounts receivable, equipment), liabilities (e.g., accounts payable, notes payable), and equity accounts (e.g., Common Stock, Retained Earnings) are all permanent. These balances provide a cumulative view of a company’s financial standing.

The Role of Closing Entries

Closing entries prepare financial records for a new accounting period. Their primary purpose is to transfer temporary account balances to a permanent equity account, such as Retained Earnings or Owner’s Capital. This transfer allows temporary accounts to begin the next period with a zero balance, ensuring each period’s financial performance is measured independently. The process facilitates the accurate calculation of net income or loss, which is then reflected in the equity section of the balance sheet. This aligns with the matching principle, recognizing expenses in the same period as the revenues they helped generate. Without closing entries, cumulative balances would distort performance measurement in subsequent periods, impacting the integrity of financial reporting.

Steps for Closing Accounts

The closing process involves four distinct steps, executed after all regular transactions and adjusting entries are recorded. These steps systematically transfer temporary account balances to permanent accounts, zeroing out temporary accounts through specific debit and credit actions.

Close Revenue Accounts

The first step closes all revenue accounts to the Income Summary account. Revenue accounts normally carry a credit balance. To close them, a debit is made to each revenue account, and an equivalent credit is made to the Income Summary account. The Income Summary account acts as a temporary holding account for revenues and expenses during this process.

Close Expense Accounts

The second step closes all expense accounts to the Income Summary account. Expense accounts typically have a debit balance. To close them, a credit is posted to each expense account, and a corresponding debit is made to the Income Summary account. This accumulates total expenses within the Income Summary account.

Close Income Summary

The third step closes the Income Summary account balance to the Retained Earnings account (or Owner’s Capital). This account holds the net result of revenues and expenses. If revenues exceeded expenses, it will have a credit balance, indicating net income; to close this, debit Income Summary and credit Retained Earnings. If expenses exceeded revenues, it will have a debit balance, signifying a net loss, requiring a credit to Income Summary and a debit to Retained Earnings.

Close Dividends

The final step closes the Dividends account (or Owner’s Drawings) to the Retained Earnings account. The Dividends account typically has a debit balance, representing distributions to owners. To close it, a credit is made to the Dividends account, and a corresponding debit is made to Retained Earnings. This reduces total retained earnings by the amount distributed.

The Post-Closing Trial Balance

After all closing entries are made and posted, a post-closing trial balance is prepared. This document is the final step in the accounting cycle. Its primary purpose is to verify that all temporary accounts (revenues, expenses, and dividends) have been successfully closed and carry a zero balance. The post-closing trial balance includes only permanent accounts: assets, liabilities, and equity. These balances are carried forward to the next accounting period, forming the basis for future financial reporting. This trial balance confirms that total debits equal total credits among permanent accounts, ensuring the accounting equation remains in balance. Preparing it helps detect errors before the new accounting period begins. This final check ensures the financial system is ready to accurately record new transactions and that foundational figures are correct.