Where Do Temporary Account Balances Go at the End of the Period?

Temporary accounts track financial activity for a specific accounting period. These accounts measure performance over a defined timeframe, such as a month, quarter, or year. At the close of each period, their balances must be reset and transferred to prepare financial records for the subsequent period. This ensures that financial results of one period do not mix with those of the next.

Understanding Temporary Accounts

Temporary accounts are distinct from permanent accounts because their balances relate only to a specific accounting period. Unlike assets, liabilities, and owner’s equity accounts, which carry their balances forward indefinitely, temporary accounts are closed at the end of each period.

Revenue accounts are a type of temporary account, tracking the income generated from business activities within a period. Examples include Sales Revenue from goods sold or Service Revenue from services provided to customers.

Expense accounts also fall into the temporary category, recording the costs incurred to generate revenue during the period. Common examples are Rent Expense for the use of property, Salaries Expense paid to employees, and Utilities Expense for services like electricity. These expenses are matched against the revenues they helped produce.

Dividend accounts, or owner’s drawing accounts for sole proprietorships and partnerships, track distributions of profits to owners or withdrawals made by owners during a period. These accounts reflect amounts taken out of the business by its owners. At the end of the accounting period, all these temporary accounts are designed to be zeroed out.

The Purpose of Closing Entries

Closing entries prepare the books for a new period. By resetting temporary accounts to a zero balance, these entries ensure that revenue, expense, and dividend accounts accurately reflect activity for only the upcoming period. This prevents the accumulation of balances from one period to the next, which would distort financial performance measurement.

The ultimate goal of closing entries is to transfer the net impact of revenues and expenses into the owner’s equity. This net effect, whether a net income or a net loss, along with any distributions to owners, is moved into a permanent equity account like Retained Earnings for corporations or Owner’s Capital for proprietorships. This process directly links the income statement’s results to the balance sheet’s equity section.

This transfer ensures that financial statements present a clear picture of performance for each distinct period. Without closing entries, it would be impossible to determine the profitability of a specific year or quarter. The process facilitates the preparation of accurate financial reports that stakeholders rely on for decision-making.

The Mechanics of Closing Entries

The balances of temporary accounts are transferred through a specific four-step process involving a temporary clearing account called Income Summary. This account is used exclusively during closing to consolidate revenue and expense balances before their net effect is moved to equity.

The first step involves closing all revenue accounts. Since revenue accounts typically have credit balances, they are debited to bring their balance to zero. The corresponding credit is made to the Income Summary account.

Next, all expense accounts are closed. Expense accounts normally carry debit balances, so they are credited to reduce their balances to zero. The total of these expense credits is then debited to the Income Summary account.

After revenues and expenses are transferred, the Income Summary account holds the period’s net income or net loss. If revenues exceeded expenses, Income Summary will have a credit balance, representing net income. This balance is then debited from Income Summary and credited to Retained Earnings (or Owner’s Capital) to increase equity. If expenses exceeded revenues, Income Summary will have a debit balance, indicating a net loss, which is then credited from Income Summary and debited from Retained Earnings, decreasing equity.

The final step addresses dividends or owner’s drawings. These accounts typically have debit balances, so they are credited to achieve a zero balance. The corresponding debit is made directly to Retained Earnings (or Owner’s Capital), reflecting the reduction in equity due to distributions to owners.

After the Closing Process

Following the completion of closing entries, all temporary accounts, including revenue, expense, and dividend/drawing accounts, will have zero balances. This reset ensures they are prepared to accumulate financial activity for the start of the new accounting period. The zero balances are essential for accurately measuring the performance of the upcoming cycle without carryover from the prior period.

The permanent accounts, specifically Retained Earnings or Owner’s Capital, now reflect the cumulative impact of the previous period’s operations. The net income or net loss, along with any owner distributions, has been incorporated into these equity accounts.

To verify the accuracy of the ledger after closing, a post-closing trial balance is prepared. This trial balance includes only permanent accounts: assets, liabilities, and equity. Its purpose is to confirm that total debits still equal total credits and that only accounts intended to carry balances forward actually do.