What Are the Closing Entries? A Step-by-Step Process

Closing entries are part of the accounting cycle, performed at the end of an accounting period. These entries prepare a business’s financial records for the next period’s transactions by resetting specific accounts. The process ensures each new accounting period begins with a clear slate for measuring performance, maintaining accurate financial reporting and providing a true picture of profitability over distinct timeframes.

Understanding Temporary and Permanent Accounts

The distinction between temporary and permanent accounts is important for closing entries. Temporary accounts, also known as nominal accounts, relate to a specific accounting period and track financial activity within that timeframe. These accounts include all revenue accounts, expense accounts, and dividends or owner’s drawing accounts for non-corporate entities.

Permanent accounts, also known as real accounts, carry their balances forward from one accounting period to the next. These accounts represent the cumulative financial position of a business and are not reset at the end of a period. Assets (e.g., cash, accounts receivable), liabilities (e.g., accounts payable, notes payable), and most equity accounts (e.g., retained earnings, owner’s capital) fall into this category.

Closing entries specifically target temporary accounts. Their balances, which reflect activity over a defined period, must be brought to zero before the next period begins. This ensures that revenues and expenses of one period are not commingled with those of another, allowing for precise measurement of profitability for each distinct reporting cycle. Permanent accounts retain their balances and are not affected by the closing process.

Purpose of Closing Entries

The purpose of closing entries is to zero out the balances of all temporary accounts at the conclusion of an accounting period, preparing them to accumulate new financial data for the subsequent period. Without this reset, it would be impossible to accurately determine a business’s revenues and expenses for any single period, as balances would simply roll over indefinitely.

Closing entries also transfer the net income or net loss generated during the period, along with any dividends or owner’s draws, into a permanent equity account, typically Retained Earnings for corporations or Capital for sole proprietorships. This ensures cumulative profit or loss and distributions are reflected in the business’s overall equity. The process supports the matching principle in accounting, which dictates that expenses should be recognized in the same period as the revenues they helped generate.

The Step-by-Step Closing Process

The closing process involves a systematic series of journal entries to transfer temporary account balances. This procedure typically occurs after all regular transactions and adjusting entries have been made.

Close Revenue Accounts

The first step is to close all revenue accounts. Revenue accounts normally have credit balances. To bring these balances to zero, a debit entry is made to each individual revenue account for its full balance. A corresponding credit entry is then made to Income Summary for the total amount of all revenues.

Close Expense Accounts

Next, all expense accounts are closed. Expense accounts typically carry debit balances. To zero these accounts, a credit entry is made to each individual expense account for its full balance. A corresponding debit entry is then made to the Income Summary account for the total sum of all expenses. At this point, Income Summary holds the net difference between total revenues and total expenses, representing the net income or net loss for the period.

Close Income Summary Account

The third step involves closing the Income Summary account. If the business generated a net income, Income Summary will have a credit balance. To close it, a debit is made to Income Summary, and a credit is made to Retained Earnings (for corporations) or Capital (for sole proprietorships). If a net loss occurred, Income Summary would have a debit balance, requiring a credit to Income Summary and a debit to Retained Earnings or Capital. This entry transfers the period’s profitability into the business’s permanent equity.

Close Dividends/Owner’s Draws Account

Finally, the dividends account (or owner’s draws account) is closed. Dividends represent distributions of earnings to owners and normally have a debit balance. To close this account, a credit entry is made for its full balance. A corresponding debit entry is then made directly to the Retained Earnings account or Capital account. This reduces the equity of the business by the amount of dividends distributed during the period.

After Closing Entries

Once all closing entries are made and posted to the general ledger, the next step is creating a post-closing trial balance. This specialized trial balance verifies that all temporary accounts now hold a zero balance. Its purpose is to ensure the accounting equation remains in balance before the new accounting period begins.

The post-closing trial balance differs from previous trial balances in that it contains only permanent accounts: assets, liabilities, and equity. Their balances are carried forward into the next fiscal period. The absence of revenue, expense, and dividend accounts on this trial balance signifies correct completion of the closing process. If any temporary accounts still show a balance, it indicates an error that must be corrected.

The balances on the post-closing trial balance are the starting balances for the new accounting period. This allows for accurate tracking and reporting of financial performance from day one, preventing the commingling of data from prior periods. The equality of debits and credits provides assurance of ledger accuracy before new transactions are recorded.