What Are Temporary Accounts and Why Do They Close?

Financial reporting provides a structured view into a business’s operations, allowing stakeholders to understand its financial health. This process involves categorizing transactions into various accounts, which collectively paint a picture of economic activities. Accurate reporting ensures that performance and financial position are clearly presented, supporting informed decision-making. Different types of accounts serve distinct purposes in achieving this comprehensive overview.

Understanding Their Nature

Temporary accounts, also known as nominal accounts, are accounting records used to track financial activities over a specific period, typically a fiscal year. These accounts begin each new period with a zero balance, accumulating data related to revenues, expenses, and withdrawals for that defined timeframe. Their “temporary” nature means their balances are reset at the end of every accounting cycle. This reset is essential for measuring a business’s performance accurately for a given period, such as annual profitability or quarterly results.

Categories of Temporary Accounts

Temporary accounts primarily include those related to a company’s income statement and distributions to owners. Revenue accounts track the income generated from sales of goods or services. These accounts increase when a business earns money, reflecting its operational inflows.

Expense accounts record the costs incurred during business operations, such as rent, salaries, utilities, and advertising. These accounts capture the outflow of economic resources necessary to generate revenue. Lastly, dividend accounts, or owner’s draws for sole proprietorships and partnerships, track money distributed from the business to its owners. This reflects a reduction in the owners’ equity in the business.

The Annual Closing Procedure

At the conclusion of an accounting period, temporary accounts undergo a process known as closing entries. The purpose of these entries is to prepare the accounts for the subsequent period by resetting their balances to zero, and to transfer their net effect to a permanent equity account. This ensures that each accounting period stands alone for performance measurement.

The closing procedure typically involves four steps. First, all revenue accounts are closed by transferring their balances to an “Income Summary” account. Next, all expense accounts are also closed and their balances are transferred to the Income Summary account. The Income Summary account is itself a temporary account, serving as a holding place to calculate the net income or loss for the period.

Once all revenues and expenses are transferred, the balance of the Income Summary account, representing the net income or loss, is then transferred to the Retained Earnings account for corporations, or an owner’s capital account for sole proprietorships and partnerships. Finally, any dividend or owner’s draw accounts are closed directly to the Retained Earnings or owner’s capital account. This final step updates the owner’s equity to reflect the period’s profitability and distributions.

Distinguishing Them from Permanent Accounts

Temporary accounts differ fundamentally from permanent accounts, also known as real accounts. Permanent accounts, which include assets, liabilities, and equity accounts, carry their balances forward from one accounting period to the next. Their balances are not reset to zero at year-end.

This distinction highlights their differing purposes in financial reporting. Permanent accounts provide a snapshot of a business’s financial position at a specific point in time, reflecting what the company owns, owes, and the owners’ stake. In contrast, temporary accounts measure a business’s financial performance over a defined period, such as a month, quarter, or year. The closing process ensures that the slate is wiped clean for temporary accounts, allowing for clear, period-by-period comparisons of operational results.