What Is a Closing Entry and Why Is It Important?

A closing entry is a journal entry recorded at the end of an accounting period to transfer balances from temporary accounts to permanent accounts. This process resets the temporary account balances to zero, preparing the financial records for the start of the next period. By clearing out the period-specific data, a business ensures a clean slate for tracking the upcoming year’s financial performance. This is a routine part of the accounting cycle that finalizes the period’s results and updates the owner’s equity.

Identifying Accounts for Closure

The first step is to distinguish between temporary and permanent accounts. Temporary accounts, also called nominal accounts, track financial activities over a single accounting period, and their balances are not carried forward. The main types of temporary accounts include all revenue, expense, and owner’s drawing or dividend accounts. Examples are Service Revenue, which tracks earnings, and expense accounts like Rent Expense or Salaries Expense.

Permanent accounts, in contrast, have balances that persist across accounting periods and are reported on the balance sheet. These accounts represent the long-term financial position of a company. The primary categories of permanent accounts are assets, liabilities, and equity. Examples include Cash, Accounts Receivable, Equipment, Accounts Payable, and Owner’s Capital or Retained Earnings.

The Four Steps of the Closing Process

Closing entries involve four steps to move temporary account balances to a permanent equity account. This is often accomplished using a temporary clearing account called the Income Summary. The Income Summary account exists only during the closing process and consolidates all revenue and expense information before the final transfer to equity.

The first step is to close all revenue accounts. Since revenue accounts normally have a credit balance, this requires a journal entry that debits each revenue account for its balance and credits the Income Summary account for the total amount of revenue. This entry transfers the total revenue earned during the period into the Income Summary account, bringing each individual revenue account’s balance to zero.

Next, all expense accounts are closed. Expense accounts typically carry a debit balance, so closing them involves crediting each individual expense account for its balance. The corresponding debit is made to the Income Summary account for the total of all expenses. This action zeroes out each expense account.

The third step involves closing the Income Summary account itself. After the first two steps, the balance in the Income Summary account represents the net income or net loss for the period. If revenues exceeded expenses, the Income Summary will have a credit balance and must be debited to be closed, with the corresponding credit going to a permanent equity account like Retained Earnings. If there was a net loss, the Income Summary has a debit balance and is credited, while the equity account is debited.

Finally, the owner’s drawing or dividends account is closed. This account, which tracks distributions to owners, is not an expense and does not affect net income, so it is closed directly to the permanent equity account. A credit is made to the drawing or dividends account to zero it out, and a corresponding debit is made to the Retained Earnings or Owner’s Capital account, reducing the overall equity.

Preparing the Post-Closing Trial Balance

After all closing entries have been recorded and posted, a post-closing trial balance is prepared. This is a list of all the permanent accounts and their final balances. The purpose of this report is to verify that the general ledger is in balance before the new accounting period begins by confirming that the total of all debit balances equals the total of all credit balances.

This final check also ensures that all temporary accounts have been properly closed and have zero balances. If a temporary account appears on the post-closing trial balance with a non-zero balance, it indicates an error in the closing process that must be corrected. This provides assurance that the accounting records are accurate and ready for the next period’s transactions.