What Is a Closing Entry in Accounting?

Closing entries are a fundamental practice in accounting, performed at the end of each accounting period, such as a fiscal quarter or year. This process involves transferring account balances from the general ledger to prepare financial records for a new period. By clearing out temporary account balances, closing entries ensure financial statements accurately reflect a company’s performance and financial position for the subsequent accounting cycle.

Understanding Account Types and Their Purpose in Closing

Closing entries are necessary due to the distinction between temporary and permanent accounts. Temporary accounts track financial activity for a limited period. Examples include all revenue accounts, all expense accounts, and dividends or owner’s drawing accounts. Their balances must be reset to zero at the end of each period. This ensures a clean slate for the next period, preventing the accumulation of figures from prior periods.

In contrast, permanent accounts, also known as real accounts, carry their balances forward indefinitely. These accounts represent a company’s financial position at a specific point in time and include all asset, liability, and equity accounts, such as Retained Earnings or Owner’s Capital. Their balances are not closed because they represent cumulative values that persist beyond a single reporting cycle. The purpose of closing entries is to transfer the net effect of temporary accounts into a permanent equity account, summarizing the period’s performance and preparing the system for the next cycle.

The Process of Creating Closing Entries

Creating closing entries involves a four-step process using an intermediate account called Income Summary. This temporary account serves as a clearinghouse for revenues and expenses before their net effect, representing the period’s net income or loss, is transferred to a permanent equity account.

Closing Revenue Accounts

The first step closes all revenue accounts. This involves debiting each revenue account for its balance, effectively reducing its balance to zero, and crediting the total amount to the Income Summary account.

Closing Expense Accounts

Next, all expense accounts are closed. This requires debiting the Income Summary account for the total of all expenses and crediting each expense account for its balance. This action reduces the balance of every expense account to zero, bringing the accumulated expenses into the Income Summary account. After these two steps, the Income Summary account holds the net income (if credits exceed debits) or net loss (if debits exceed credits) for the period.

Closing the Income Summary Account

The third step involves closing the Income Summary account. If the company generated net income, the Income Summary account will have a credit balance, which is then debited to bring its balance to zero. This amount is simultaneously credited to a permanent equity account, such as Retained Earnings or Owner’s Capital. Conversely, if the Income Summary account shows a net loss, it will have a debit balance, which is credited to close it, and the corresponding amount is debited from the permanent equity account.

Closing Dividends or Owner’s Drawing Accounts

The final step addresses dividends or owner’s drawing accounts. These temporary accounts represent distributions of company earnings. To close them, the dividends or owner’s drawing account is credited for its balance, reducing it to zero. The corresponding debit is made to a permanent equity account, typically Retained Earnings or Owner’s Capital, reflecting the reduction in equity due to these distributions.

The Post-Closing Trial Balance

After all closing entries are journalized and posted to the general ledger, a post-closing trial balance is prepared. This financial document serves as a final verification step, ensuring the ledger’s accuracy before a new accounting period begins. Its purpose is to confirm that all temporary accounts (revenues, expenses, and dividends or drawings) have zero balances, allowing for a fresh start.

The post-closing trial balance lists only the permanent accounts, such as assets, liabilities, and equity, along with their respective balances. A crucial aspect of this trial balance is to verify that the total debits still equal the total credits among these remaining permanent accounts. This equality confirms the fundamental accounting equation remains in balance. The post-closing trial balance acts as a control measure, ensuring the ledger is accurate and ready for the recording of transactions in the next fiscal period.