What Is a Temporary Account in Accounting?

Accounts are fundamental tools in accounting, categorizing and tracking all financial transactions. They serve as organized records for every financial event, from sales and purchases to payments and investments. This systematic approach helps businesses maintain a clear picture of their financial health and operations. Not all accounts function in the same manner, leading to different classifications that serve distinct purposes in financial reporting.

Defining Temporary Accounts

Temporary accounts track financial activity over a defined accounting period (e.g., month, quarter, or fiscal year). They measure a company’s financial performance during that timeframe. These accounts begin each new accounting period with a zero balance, accumulating activity only for the current period.

At the conclusion of an accounting period, temporary account balances are reset. This process ensures that the financial performance measured for one period does not carry over and distort the results of the subsequent period. The information gathered is relevant to preparing a company’s income statement, providing insights into revenues and expenses incurred.

Examples of Temporary Accounts

Common temporary accounts track specific financial activities. Revenue accounts, such as Sales Revenue or Service Revenue, record the income generated from a business’s primary operations. These accounts accumulate earnings from selling goods or providing services during an accounting period.

Expense accounts, including Rent Expense, Utilities Expense, or Salaries Expense, track the costs incurred to generate that revenue. These accounts detail outflows, helping to determine the net income or loss. Dividend accounts, or owner’s drawing accounts for sole proprietorships, record distributions of profits to owners.

The Income Summary account is unique because it is used only during the closing process. This account serves as a temporary holding place for the balances of revenue and expense accounts before they are transferred to a permanent equity account. It acts as an intermediate step to consolidate period performance.

The Closing Process Explained

The closing process prepares temporary accounts for the next cycle at the end of each accounting period. This process involves transferring the final balances from revenue, expense, and dividend accounts into a permanent equity account. Common permanent equity accounts include Retained Earnings for corporations, or Owner’s Capital for sole proprietorships and partnerships.

Transferring these balances resets each temporary account to a zero balance. This allows accurate tracking of the upcoming accounting period’s financial performance without any carryover from the previous period. The net effect of this transfer is that the period’s profit or loss, with any distributions, is added to or subtracted from the permanent equity balance. This ensures that the financial statements accurately reflect the company’s performance for a distinct period and its cumulative financial position.

Temporary Versus Permanent Accounts

The distinction between temporary and permanent accounts is fundamental to understanding financial reporting. Unlike temporary accounts that are closed at period-end, permanent accounts carry balances forward from one accounting period to the next. These accounts represent a company’s financial position at a specific point in time.

Permanent accounts include asset accounts, such as Cash, Accounts Receivable, and Equipment, which represent economic resources owned by the business. They also encompass liability accounts, like Accounts Payable, Notes Payable, and Unearned Revenue, which represent obligations the business owes to others. Equity accounts, such as Common Stock and Retained Earnings, are permanent as they reflect the owners’ claims on the company’s assets.

Permanent accounts are not reset to zero through the closing process. Their balances continuously accumulate and are reported on the balance sheet, providing a cumulative view of a company’s financial standing. The ongoing nature of permanent accounts contrasts with the period-specific nature of temporary accounts, which measure performance over discrete intervals.