Using Closing Entries to Wrap up Your Accounting Period

Basically, the income summary account is the amount of your revenues minus expenses. You will close the income summary account after you transfer the amount into the retained earnings account, which is a permanent account. Transferring funds from temporary to permanent accounts also updates your small business retained earnings account.

Accountants can close accounts for any reporting period (e.g. monthly, quarterly, and yearly). The remaining balance in Retained Earnings is $4,565 the following Figure 5.6. Our discussion here begins with journalizing and posting the closing entries (Figure 1.26). These posted entries will then translate into a post-closing trial balance, which is a trial balance that is prepared after all of the closing entries have been recorded.

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All revenue and expense accounts must end with a zero balance because they are reported in defined periods and are not carried over into the future. For example, $100 in revenue this year does not count as $100 of revenue for next year, even if the company retained the funds for use in the next 12 months. In this example we will close Paul’s Guitar Shop, Inc.’s temporary accounts using the income summary account method from his financial statements in the previous example.

We see from the adjusted trial balance that our revenue accounts have a credit balance. 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. The statement of retained earnings shows the period-ending retained earnings after the closing entries have been posted. When you compare the retained earnings ledger (T-account) to the statement of retained earnings, the figures must match.

How to Prepare Your Closing Entries

If income summary account has a debit balance, it means the business has suffered a loss during the period which decreased decrease its retained earnings. In such situation, the income summary account is closed by debiting retained earnings account and crediting income summary account. If income summary account has a credit balance, it means the business has earned a profit during the period and increased its retained earnings. The income summary account is, therefore, closed by debiting income summary account and crediting retained earnings account. You begin the closing process by transferring revenue and expense account balances to the income summary account, a temporary account used specifically to transfer revenue and expense account balances. The second entry requires expense accounts close to the Income Summary account.

• Without transferring funds, your financial statements will be inaccurate.
• To update the balance in the owner’s capital account, accountants close revenue, expense, and drawing accounts at the end of each fiscal year or, occasionally, at the end of each accounting period.
• Transferring funds from temporary to permanent accounts also updates your small business retained earnings account.
• Closing entries transfer the balances from the temporary accounts to a permanent or real account at the end of the accounting year.
• During the process of performing closing entries, a company’s net income is transferred to retained earnings which will be listed on the balance sheet.

The $248 transferred to retained earnings appears on the balance sheet template for January. Closing entries prepare a company for the next accounting period by clearing any outstanding balances in certain accounts that should not transfer over to the next period. Closing, or clearing the balances, means returning the account to a zero balance. Having a zero balance in these accounts is important so a company can compare performance across periods, particularly with income. It also helps the company keep thorough records of account balances affecting retained earnings. Revenue, expense, and dividend accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of the time period assumption.

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The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting the entries to the ledger. 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. Any account listed on the balance free retainer invoice template sheet, barring paid dividends, is a permanent account. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent. 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.

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. We do not need to show accounts with zero balances on the trial balances. Now that all the temporary accounts are closed, the income summary account should have a balance equal to the net income shown on Paul’s income statement. Now Paul must close the income summary account to retained earnings in the next step of the closing entries.