As part of the closing entry process, the net income (NI) is moved into retained earnings on the balance sheet. The assumption is that all income from the company in one year is held onto for future use. Any funds that are not held onto incur an expense that reduces NI.
The first one is to close out the revenue account to the income summary account. You are a newly hired accountant for Boss Consultants Inc (« Boss »), a consulting firm located in Chicago. Boss just started its business this year as a simple operation that offers a premium, boutique service.
Step 2: Close all expense accounts to Income Summary
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Companies are required to close their books at the end of each fiscal year so that they can prepare their annual financial statements and tax returns. In addition, if the accounting system uses subledgers, it must close out each subledger for the month prior to closing the general ledger for the entire company. If the subsidiaries also use their own subledgers, then their subledgers must be closed out before the results of the subsidiaries can be transferred to the books of the parent company.
We will debit the revenue accounts and credit the Income Summary account. The credit to income summary should equal the total revenue from the income statement. Since dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account. These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. A temporary account records balances for a single accounting period, whereas a permanent account stores balances over multiple periods.
In this example, it is assumed that there is just one expense account. Clear the balance of the revenue account by debiting revenue and crediting income summary. To close expenses, we simply credit the expense accounts and debit Income Summary. ‘Retained earnings‘ account is credited to record the closing entry for income summary. Closing entries are an important part of accounting as it helps in preparing accurate financial statements.
Temporary vs. permanent accounts
Use the chart below to determine which accounts are decreased by debits and which are decreased by credits. Now, all the temporary accounts stand tall with their respective figures, showcasing the revenue your bakery has generated, the expenses the difference between the periodic and perpetual inventory systems it has incurred, and the dividends declared throughout the past year. These permanent accounts form the foundation of your business’s balance sheet. Let’s investigate an example of how closing journal entries impact a trial balance.
In the next accounting period, these accounts usually (but not always) start with a non-zero balance. All balance sheet accounts are examples of permanent or real accounts. Notice that the balances in the expense accounts are now zero and are ready to accumulate expenses in the next period.
Example of Closing Entries
The Income Summary account has a new credit balance of $4,665, which is the difference between revenues and expenses in Figure 1.29. The balance in Income Summary is the same figure as what is reported on Printing Plus’s Income Statement. The purpose of the closing entry is to reset the temporary account balances to zero on the general ledger, the record-keeping system for a company’s financial data.
We need to do the closing entries to make them match and zero out the temporary accounts. Only income statement accounts help us summarize income, so only income statement accounts should go into income summary. All of these entries have emptied the revenue, expense, and income summary accounts, and shifted the net profit for the period to the retained earnings account. Temporary account balances can either be shifted directly to the retained earnings account or to an intermediate account known as the income summary account beforehand.
Close dividend accounts
However, you might wonder, “Where are the revenue, expense, and dividend accounts? If we expand the view, we’ll find the usual suspects—the temporary accounts. These accounts were reset to zero at the end of the previous year to start afresh. On the statement of retained earnings, we reported the ending balance of retained earnings to be $15,190.
Closing entries zero out temporary accounts, preparing them to be used for the next accounting period. The closing process in accounting prepares accounting books for a new fiscal period by resetting income statement account balances to zero. This is done through a four-step process often known by the acronym REID (Revenue, Expenses, Income Summary, Dividends). The four most common closing entries are entries to close out the balances in revenue, expense, income summary and dividend accounts. As part of the close, the debit and credit balances from the expense and revenue accounts are transferred to the income summary account. Subsequently, the net debit or credit balance from the income summary is posted to retained earnings.
- An income statement tracks information for a period of time and returns to zero at the end of that accounting period, usually one fiscal year.
- Closing entries are an important part of accounting as it helps in preparing accurate financial statements.
- Notice that revenues, expenses, dividends, and income summary all have zero balances.
- They close out either to a temporary income summary account, or directly to retained earnings.
Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period. These are general account ledgers that record transactions over the period and accounting cycle. These account balances are ultimately used to prepare the income statement at the end of the fiscal year. Examples of temporary accounts include revenue, expense and dividends paid accounts.
One such expense that is determined at the end of the year is dividends. The last closing entry reduces the amount retained by the amount paid out to investors. Permanent accounts, on the other hand, track activities that extend beyond the current accounting period. They are housed on the balance sheet, a section of the financial statements that gives investors an indication of a company’s value, including its assets and liabilities. Temporary accounts are used to record accounting activity during a specific period.
- And so, the amounts in one accounting period should be closed so that they won’t get mixed with those in the next period.
- For example, if your accounting periods last one month, use month-end closing entries.
- It is also possible to bypass the income summary account and simply shift the balances in all temporary accounts directly into the retained earnings account at the end of the accounting period.
- In this example, it is assumed that there is just one expense account.
- By doing so, the company moves these balances into permanent accounts on the balance sheet.
It will decrease retained earnings by the amount of the dividend payout for the accounting period being closed. If your revenues are greater than your expenses, you will debit your income summary account and credit your retained earnings account. When closing the revenue account, you will take the revenue listed in the trial balance and debit it, to reduce it to zero. As a corresponding entry, you will credit the income summary account, which we mentioned earlier.
Step 3: Close Income Summary to the appropriate capital account
The revenue and expense accounts should start at zero each period, because we are measuring how much revenue is earned and expenses incurred during the period. However, the cash balances, as well as the other balance sheet accounts, are carried over from the end of a current period to the beginning of the next period. Examples of temporary accounts are the revenue, expense, and dividends paid accounts. Any account listed in the balance sheet (except for dividends paid) is a permanent account.