What Is a Temporary Account in Accounting?

Temporary accounts, also known as nominal accounts, are fundamental tools in accounting that help businesses measure their financial performance over specific periods. They track income, expenses, and withdrawals within a defined accounting cycle, such as a month, quarter, or year. Their balances are not carried forward indefinitely, making them distinct from other account types.

Understanding Temporary Accounts

Temporary accounts are named because their balances are reset to zero at the end of each accounting period. This allows each new period to begin with a fresh slate, enabling accurate measurement of financial activity specific to that period. Businesses track revenues and expenses through these accounts to understand profitability over a defined duration. For example, a company’s sales revenue for a given year is recorded in a temporary account, then cleared at year-end for the next year’s sales.

The primary purpose of temporary accounts is to summarize financial activities that contribute to a company’s net income or loss. This summary is used to prepare the income statement, a key financial report showing a business’s performance over a period.

Categories of Temporary Accounts

Temporary accounts primarily include revenue, expense, and dividend accounts. Revenue accounts record all income generated by a business from its primary operations, such as sales of goods or services, and can also include interest income. Expense accounts track the costs incurred to generate that revenue, encompassing items like salaries, rent, utilities, and advertising. These two categories are essential for calculating a company’s net income or loss for the period.

Dividend accounts, or drawing accounts for sole proprietorships, record distributions of profits to owners or shareholders. While not directly affecting net income, dividend accounts reflect a reduction in the company’s equity and are closed at the end of the accounting period. The Income Summary account is an additional temporary account often used in the closing process, acting as an intermediary to consolidate all revenues and expenses before transferring the net result.

The Closing Entry Process

Temporary accounts are closed through a process called closing entries. These specialized journal entries are made at the end of an accounting period to transfer the balances of all temporary accounts to a permanent equity account, typically Retained Earnings. This procedure updates the company’s equity for the period’s net income or loss and resets temporary account balances to zero.

The closing process typically involves four main steps. First, all revenue accounts are closed by transferring their credit balances to the Income Summary account, zeroing them out. Second, all expense accounts are closed by transferring their debit balances to the Income Summary account, also reducing their balances to zero. At this point, the Income Summary account holds the net income or loss for the period.

Third, the balance from the Income Summary account is transferred to the Retained Earnings account. A net profit results in a credit balance in Income Summary, which is debited to close it and credited to Retained Earnings. Conversely, a net loss results in a debit balance in Income Summary, which is credited to close it and debited to Retained Earnings. Finally, any dividend accounts are closed directly to the Retained Earnings account.

Temporary Accounts and Permanent Accounts

Understanding the distinction between temporary and permanent accounts is fundamental to comprehending a company’s financial position and performance. Permanent accounts, also known as real accounts, include assets, liabilities, and most equity accounts. Unlike temporary accounts, permanent accounts carry their balances forward from one accounting period to the next, reflecting a cumulative financial status. For instance, the cash balance at the end of one year becomes the beginning cash balance for the next.

Temporary accounts measure performance over a specific period and provide information for the income statement. Permanent accounts are reported on the balance sheet, presenting a snapshot of a company’s financial health at a specific point in time. The net effect of temporary accounts—the net income or loss—is ultimately transferred to a permanent equity account, such as Retained Earnings, during the closing process. This links performance measured by temporary accounts directly to the overall financial position reflected in permanent accounts.