Definition and explanation
Closing entries may be defined as journal entries made at the end of an accounting period to transfer the balances of various temporary ledger accounts to some permanent ledger account.
Temporary accounts (also known as nominal accounts) are ledger accounts used to record transactions for only a single accounting period and are closed at the end of the period by making appropriate closing entries. In next accounting period, these accounts normally start with a zero balance. Temporary or nominal accounts include revenue, expense, dividend and income summary accounts.
Permanent accounts (also known as real accounts) are ledger accounts the balances of which continue to exist beyond the current accounting period (i.e., these accounts are not closed at the end of the period). In the next accounting period these accounts usually (but not always) start with a non-zero balance. All balance sheet accounts are examples of permanent or real accounts.
The permanent account to which all temporary accounts are closed is the retained earnings account in case of a company and owner’s capital account in case of a sole proprietorship.
The process of preparing closing entries
The preparation of closing entries is a simple four step process which is briefly explained below:
Step 1 – closing the revenue accounts:
Transfer the balances of all revenue accounts to income summary account. It is done by debiting various revenue accounts and crediting income summary account. This step closes all revenue accounts.
Step 2 – closing the expense accounts:
Transfer the balances of various expense accounts to income summary account. It is done by debiting income summary account and crediting various expense accounts. This step closes all expense accounts.
Step 3 – closing the income summary account:
After making closing entries in step 1 and step 2, the income summary account shows a credit or debit balance which is transferred to retained earnings account to close the income summary account. The income summary account would have a credit balance if the total of the balances of all revenue accounts is greater than the total of the balances of all expense accounts. If, on the other hand, the total of the balances of all revenue accounts is less than the total of the balances of all expense accounts, the income summary account shows a debit balance. The journal entry to close the income summary account is made as follows:
- If income summary account has a credit balance, it means the business has earned a profit during the period which causes an increase in retained earnings. Therefore, the income summary account is closed by debiting income summary account and crediting retained earnings account.
- If income summary account has a debit balance, it means the business has suffered a loss during the period which causes a decrease in retained earnings. In such a situation, the income summary account is closed by debiting retained earnings account and crediting income summary account.
Step 4 – closing the dividends account:
Transfer the balance of dividends account directly to retained earnings account. Dividends paid to stockholders is not a business expense and is therefore not used while determining net income or net loss. Its balance is not transferred to the income summary account but is directly transferred to retained earnings account.
With the completion of step 4, the necessary closing entries are completed and all temporary accounts (i.e., revenue, expense, dividend and income summary accounts) are closed to a permanent account (i.e., retained earnings account).
Consider the following example for a better understanding of closing entries.
The Business Consulting Company, which closes its accounts at the end of the year, provides you the following adjusted trial balance at December 31, 2015.
Required: Using above trial balance, prepare closing entries required at December 31, 2015.
*82,500 – 64,500: In our example, income summary account has a credit balance because the balance of service revenue earned account ($82,500) is greater than the total of the balances of eight expense accounts ($64,500).