If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account. You can do this by debiting the income summary account and crediting your capital account in the amount of $250. This reflects your net income for the month, and increases your capital account by $250. In a partnership, separate entries are made to close each partner’s drawing account to his or her own capital account. If a corporation has more than one class of stock and uses dividend accounts to record dividend payments to investors, it usually uses a separate dividend account for each class.
Revenue is one of the four accounts that needs to be closed to the income summary account. This is the adjusted trial balance that will be used to make your closing entries. One of the most important steps in the accounting cycle is creating and posting your closing entries.
Financial Accounting
Your closing journal entries serve as a way to zero out temporary accounts such as revenue and expenses, ensuring that you begin each new accounting period properly. Having just described the basic closing entries, we must also point out that a practicing accountant rarely uses any of them, since these steps are handled automatically by any accounting software that a company uses. Instead, the basic closing step is to access an option in the software to close the reporting period. Doing so automatically populates the retained earnings account for you, and prevents any further transactions from being recorded in the system for the period that has been closed. The purpose of closing entries is to prepare the temporary accounts for the next accounting period. After closing the revenue accounts, the next step in compiling the document is to close all the expense accounts.
- For sole proprietorships and partnerships, you’ll close your drawing account to your capital account, because you will need to reduce your capital account by the draws taken for the month.
- So, even though the process today is slightly (or completely) different than it was in the days of manual paper systems, the basic process is still important to understand.
- The income summary account is a temporary account that the company uses at the end of the accounting period to transfer the resulting of net income or net loss to the retained earnings account.
When dividends are declared by corporations, they are usually recorded by debiting Dividends Payable and crediting Retained Earnings. Note that by doing this, it is already deducted from Retained Earnings (a capital account), hence will not require a closing entry. Looking at the revenue account balance, all the revenue-generating sources, whether operating or non-operating business functions are included in the process. Once all the revenue streams have been compiled, businesses credit them to transfer to the summary. The first step in preparing it is to close all the revenue accounts. From this trial balance, as we learned in the prior section, you make your financial statements.
What are Closing Entries?
After the financial statements are finalized and you are 100 percent sure that all the adjustments are posted and everything is in balance, you create and post the closing entries. The closing entries are the last journal entries that get posted to the ledger. This process resets both the income and expense accounts to zero, preparing them for the next accounting period. To close the drawing account to the capital account, we credit the drawing account and debit the capital account.
Temporary accounts include all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole proprietorships and partnerships (dividends for corporations). A net loss would decrease owner’s capital, so we would do the opposite in this journal entry by debiting the capital account and crediting Income Summary. After that, the income summary account will be transferred further to the retained earnings account in the balance sheet. Transferring the expense account to the account is similar to the revenue account process.
Closing entries are completed at the end of each accounting period after your adjusted trial balance has been run. Since the income summary account is only a transitional account, it is also acceptable to close directly to the retained earnings account and bypass the income summary account entirely. The net result of these activities is to move the net profit or net loss for the period into the retained earnings account, which appears in the stockholders’ equity section of the balance sheet.
Step 4: Close withdrawals to the capital account
When closing expenses, you should list them individually as they appear in the trial balance. Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is equal to all income minus all expenses. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. If your expenses for December had exceeded your revenue, you would have a net loss. The number of closing activities may be quite substantially longer than the list shown here, depending upon the complexity of a company’s operations and the number of subsidiaries whose results must be consolidated.
Closing the net income to retained earnings
The use of closing entries resets the temporary accounts to begin accumulating new transactions in the next period. Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period. To begin, you want to run an adjusted trial balance, which is used to prepare your closing entries, moving both the revenue and the expense account balances, as well as drawing account and/or dividend account balances.
While income summaries can provide significant benefits to companies that use them for accounting purposes, there are also some disadvantages to keep in mind. Many of these come in the form of understanding what each section of the document means and interpreting it. In many cases, the computer never even shows the income summary or has a record. This entry zeros out dividends and reduces retained earnings by total dividends paid.
However, like every accounting tool, it must be used correctly and in coordination with other accounting tools to operate smoothly and provide value. Often confused with income statements, the two are very different and should not be interpreted as being the other. To gain a better understanding of what these temporary accounts are, take a look at the following example. The Income Summary balance is ultimately closed to the capital account.