What Are the 4 Steps in the Closing Process?

The accounting closing process is a series of steps performed at the end of each accounting period to prepare a company’s financial records for the subsequent period. This procedure ensures financial reporting accurately reflects the business’s performance and financial position. Completing the closing process is essential for maintaining accurate financial books and allowing for a fresh start in the new accounting cycle.

Making Adjusting Entries

The first step in the closing process involves making adjusting entries, which are necessary to adhere to the accrual basis of accounting. This method requires revenues to be recognized when earned and expenses when incurred, regardless of when cash is exchanged. Adjusting entries ensure financial statements accurately reflect all revenues earned and expenses consumed during the period. These adjustments are made for items like accrued expenses, such as salaries earned but not yet paid, or unearned revenues, which represent cash received for services not yet rendered.

Adjusting entries also account for depreciation, which allocates the cost of a tangible asset over its useful life. They also cover prepaid expenses, like insurance premiums paid in advance, that are gradually expensed as the benefit is consumed. The purpose of these entries is to update all account balances to their correct amounts before financial statements are prepared. This step ensures financial reports provide a complete and accurate picture of the company’s financial activities.

Developing Financial Statements

After all necessary adjusting entries have been posted and an adjusted trial balance confirms total debits equal total credits, the next step is to develop the primary financial statements. These statements present a comprehensive overview of the company’s financial health and operational outcomes. The income statement, for example, illustrates the company’s financial performance over a period by matching revenues and expenses to determine net income or loss.

The balance sheet, in contrast, provides a snapshot of the company’s financial position at a specific point in time, detailing its assets, liabilities, and equity. The statement of cash flows further clarifies how cash is generated and used through operating, investing, and financing activities. These financial statements are directly derived from the adjusted account balances, providing stakeholders with insight into the business’s profitability, solvency, and liquidity.

Creating Closing Entries

Creating closing entries is a part of the accounting cycle, designed to prepare the books for the next accounting period. These journal entries transfer the balances of temporary accounts to a permanent equity account, typically Retained Earnings for a corporation or Owner’s Capital for a sole proprietorship. Temporary accounts include all revenue, expense, and dividend or drawing accounts, which accumulate balances for only one accounting period.

The purpose of closing entries is to zero out these temporary accounts, allowing them to begin the new accounting period with no balance. This process ensures that each period’s financial performance is measured independently without carrying over previous period’s income or expense figures. In contrast, permanent accounts—assets, liabilities, and equity—carry their balances forward from one period to the next.

Preparing a Post-Closing Trial Balance

The final step in the closing process is preparing a post-closing trial balance. This trial balance is generated after all closing entries have been journalized and posted to the general ledger. Its purpose is to verify that total debits equal total credits in the ledger after the closing process is complete. This step acts as a final check on the mathematical accuracy of the ledger.

The post-closing trial balance will only contain permanent accounts, such as assets, liabilities, and equity accounts, because all temporary accounts have been closed to zero balances. If the debits and credits do not balance, it indicates that an error occurred during the closing entries or posting process. Successfully preparing a post-closing trial balance confirms that the accounting system is ready to accurately record transactions for the new accounting period.