Closing entries are journal entries made at the end of an accounting cycle to set the balance of temporary accounts to zero to begin the next accounting period. The temporary accounts that are closed are revenue, expense, and drawing accounts. The assets, liabilities, and owner's equity accounts are not closed. They are permanent account and their ending balances are the beginning balances for the next accounting period.
Why do Closing Entries?
When the revenue, expense, and drawing accounts (the temporary accounts) are closed, their balance returns to zero in preparation for the new accounting period. That is the first reason closing entries are prepared. The second reason closing entries are prepared is so the company's retained earnings account will show an increase from revenues from the prior year and a decrease from dividends and expenses.
The Income Summary Account
The income summary account is a temporary account used only during the closing process. It contains all the company's revenues and expenses for the current accounting time period. In other words, it contains net income. The income summary account is never used when preparing the financial statement because its only purpose is to be used during the closing process.
Four Steps to Complete Closing Entries
There are four steps to complete the closing entries:
- Look for the revenue accounts in the trial balance. You will see that they have a credit balance. You want them to go to zero. You must debit each revenue account to the income summary.
- Look for the expense accounts in the trial balance. You will see that they have a debit balance. You also want the expense accounts to go to zero. You must credit each expense account to the income summary.
- If the income summary has a credit balance, that is the company's net income. Now, the income summary must be closed to retained earnings. Debit income summary and credit retained earnings.
- The last step is to close the dividend account to retained earnings. The dividend account has a debit account. Credit the dividend account and debit the retained earnings account. Retained earnings now has the appropriate amount of the net income that was allocated to it in it.
For most companies, this is the end of the accounting cycle.