Closing Entry Definition, Explanation, and Examples

For smaller businesses, it might make sense to bypass the income summary account and instead close temporary entries directly to the retained earnings account. An expense account records and tracks the various expenses incurred by a business. The process of recording expenses starts with classifying the expenditure and setting up accounts for recording them. This organization and analysis lead to better and are salaries expenses more effective financial reporting. 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.

The four closing entries are, generally speaking, revenue accounts to income summary, expense accounts to income summary, income summary to retained earnings, and dividend accounts to retained earnings. Closing journal entries are made at the end of an accounting period to prepare the accounting records for the next period. They zero-out the balances of temporary accounts during the current period to come up with fresh slates for the transactions in the next period.

Final thoughts on closing entries

1. If the total debits and credits in your trial balance are the same, you’re ready to produce a balance sheet and income statement (also known as a “profit and loss report” or “P&L”).
2. Before creating your final report, generate a trial balance, and if things are not adding up, check your work and enter adjusting entries until you are ready to create the final financial statement.
3. The total debit to income summary should match total expenses from the income statement.
4. We have completed the first two columns and now we have the final column which represents the closing (or archive) process.

An accounting period is any duration of time that’s covered by financial statements. It can be a calendar year for one business while another business might use a fiscal quarter. 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. In addition, if the company uses several sets of books for its subsidiaries, the results of each subsidiary must first be transferred to the books of the parent company and all intercompany transactions eliminated.

Closing Entries

The income summary is a temporary account used to make closing entries. 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. 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.

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. A credit entry is made in the appropriated retained earnings or equity account to reflect the net income or loss. With these steps completed, the expense account is reset to zero, allowing it to restart recording in the next accounting period.

Similar to the close of the company’s expense accounts, the balance in the company’s revenue accounts is transferred to income summary and then to retained earnings. The resulting debits and credits to retained earnings from the close of both the revenue and expense accounts will leave the company’s net profit or loss for top 9 things you should know about agile product delivery the year remaining in the account. Because expense accounts have a normal debit balance, the accountant will have to record a journal entry that credits each expense account for its year-end balance. The opposite side of the entry will be made to “income summary,” a temporary holding account. Income summary will then be closed out to retained earnings, a balance sheet equity account.

What Is Accounts Payable in Closing Entries?

The purpose of the closing entry is to reset temporary account balances to zero on the general ledger, the record-keeping system for a company’s financial data. Clear the balance of the expense accounts by debiting income summary and crediting the corresponding expenses. 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. 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). Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings.

The entries take place “behind the scenes,” often with no income summary account showing in the chart of accounts or other transaction records. The balance sheet’s assets, liabilities, and owner’s equity accounts, however, are not closed. These permanent accounts and their ending balances act as the beginning balances for the next accounting period. 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.

This resets the balance of the temporary accounts to zero, ready to begin the next accounting period. If the total debits and credits in your trial balance are the same, you’re ready to produce a balance sheet and income statement (also known as a “profit and loss report” or “P&L”). These reports can be generated automatically in your accounting software. They offer an overview of a business’s financial position at the end of the applicable accounting period, whether that’s the previous month or year. To ensure accuracy, it’s important to follow the correct format you can refer to our detailed guide Financial Statement Format to help you with this process.

In this example, the “Advertising Expenses” account tracks the various advertising expenditures incurred by the company in May 2023. Each expense is recorded as a debit entry in the account, increasing its balance. This is closed by doing the opposite – debit the capital account (decreasing the capital balance) and credit Income Summary. To close expenses, we simply credit the expense accounts and debit Income Summary. As you will see later, Income Summary is eventually closed to capital.