Whether you’re posting entries manually or using accounting software, all revenue and expenses for each accounting period are stored in temporary accounts such as revenue and expenses. 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. The purpose of closing entries is to prepare the temporary accounts for the next accounting period. The expense accounts have debit balances so to get rid of their balances we will do the opposite or credit the accounts. Just like in step 1, we will use Income Summary as the offset account but this time we will debit income summary.
The retained earnings account is reduced by the amount paid out in dividends through a debit, and the dividends expense is credited. Income summary is a holding account used to aggregate all income accounts except for dividend expenses. Income summary is not reported on any financial statements because it is only used during the closing process, and at the end of the closing process the account balance is zero. 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. As mentioned above, Temporary Accounts are closed, and their balances are transferred into a Permanent Account.
Step 4: Closing the drawing/dividends account
Retained Earning is the company’s profit after paying all costs, taxes, and dividends. To complete the Expense account, you must credit all the Accounts and debit the Income Summary account once again. Doing this would bring the balances of the Expenses Account to zero.
The abbreviation REID makes it simple to recall which accounts need to be closed and how they are completed. Revenue, Expense, Income Summary, and Dividend are referred to as REID. To begin the process, you must have prepared three crucial pieces of information. First, it would help if you found the total balances of all the Revenue, Expense, and Dividends. Permanent Accounts are the opposite of Temporary Accounts as they are not closed at the end of the fiscal year, and their balances are carried over to the next fiscal year.
Instead the balances in these accounts are moved at month-end to either the capital account or the retained earnings account. 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. In essence, we are updating the capital balance and resetting all temporary account balances.
Closing Entries
A closing entry is a journal entry that is made at the end of an accounting period to transfer balances from a temporary account to a permanent account. We see from the adjusted trial balance that our revenue accounts have a credit balance. To make them zero we want to decrease the balance or do the opposite. 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.
Prepaid Expense is where the Expense is paid in advance before the expense transaction even happens; since it is paid beforehand, the account is viewed as an asset account. Accounting Expense is a contra account that displays the balance of the assets and liabilities spent to generate Revenue in the business. Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.
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The balances of these accounts are eventually used to construct the income statement at the end of the fiscal year. This process resets both the income and expense accounts to zero, preparing them for the next accounting period. 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. Total revenue of a firm at the end of an accounting period is transferred to the income summary account to ensure that the revenue account begins with zero balance in the following accounting period.
- Rohan has a focus in particular on consumer and business services transactions and operational growth.
- They’d record declarations by debiting Dividends Payable and crediting Dividends.
- We see from the adjusted trial balance that our revenue accounts have a credit balance.
An example would be if the company were to get sued, then a lawyer would be hired, and that fee would need to be paid. Preparing for Closing Entry is simple and quick, as all the required information can be easily found. Closing Entries are designed after Financial Statements for the fiscal periods are created, which means all the needed information is already there; you need to find it.
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The income summary account then transfers the net balance of all the temporary accounts to retained earnings, which is a permanent account on the balance sheet. The balance in dividends, revenues and expenses would all be zero leaving only the permanent accounts for a post closing trial balance. The trial balance shows the ending balances of all asset, liability and equity accounts remaining. The main change from an adjusted trial balance is revenues, expenses, and dividends are all zero and their balances have been rolled into retained earnings.
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 income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet. As mentioned, temporary accounts in the general ledger consist of income statement accounts such as sales or expense accounts.
This transaction increases your capital account and zeros out the income summary account. 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. While these accounts remain on the books, their balance is reset to zero each month, which is done using closing entries. A revenue account is a financial account that records the monetary balances that the business has generated through its sales/services during the fiscal year without considering expenses, taxes, and deductions. As you can tell by the examples of Temporary Accounts, they all belong to 3 types of accounts.
On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent. Whether you’re processing closing entries manually, or letting your accounting software do the work, closing entries are perhaps the most important part of the accounting cycle. If your business is a corporation, you will not have a drawing account, but if you paid stockholders, you will have a dividends account. If you paid dividends for the month, you will need to close that account as well.
