Overview
Financial data is a valuable resource for management, investment, and other decisions. To make it more useful, bookkeepers create temporary accounts to track revenues and expenses. Periodically, they close (zero out) these accounts to start from a new and be able to better evaluate financial activities for just a specific period. This transfer or closing of the account balances is carried out using closing transactions, which help in determination of the results of financial and economic activities and with the transfer of the net profit or loss amount to retained earnings.
For closing transactions, the bookkeepers use an account called the Income summary account. You will see what role it plays in the whole process in just a moment. Afterward, these accounts are again ready to perform the function of temporary data accumulation for the next year. This account, essentially, is going to be the same in total value as the company’s Net income.
Closing process
This process can be broken down into two stages.Stage I. Income statement accounts are closed to the Income Summary account, where essentially information is collected on all income (on credit) and expenses (on debit) of the enterprise for the reporting year.Stage II. The Income summary account is closed either directly to the owner’s capital account or the accumulated retained net income account. Thus, this account plays a supporting “transitional” role in summarizing information about the revenue and expenses of the enterprise at the end of the period. To review if the closing entries are reflected correctly, a Post-Closing Trial Balance can be compiled. This process represents the final stage of the enterprise accounting cycle. However, there is the possibility of another practice, which is called known as postings reversing entries. These records are not mandatory, but only represent a possible alternative that can be used by an accountant to facilitate subsequent work.
Example
Looking at the financial report above, the company has a Revenue account with a credit balance of $42,000 and it needs to get it down to zero. For that, we will debit it for $42,000. We will also credit each expense account to close them as well. However, accounting requires all accounts to be balanced so that no amount of money is left unaccounted for when accessing the books. In other words, credits and debits have to balance. Thus, we will credit the net income amount to the Income summary account.