A Guide to Closing Entries: How to Prepare Them

The accounts involved in closing journal entries are the temporary accounts for revenue, expenses and dividends, and a permanent account from the balance sheet called retained earnings. They close out either to a temporary income summary account, or directly to retained earnings. The income summary account, if used, will then be closed out to the retained earnings account. The amount left in the retained earnings account is the gain or loss for the year.

• To close the account, we need to debit the income summary account and credit all the relevant individual expenses accounts such as utilities expense, wages expense depreciation expense, etc.
• In some cases, accounting software might automatically handle the transfer of balances to an income summary account, once the user closes the accounting period.
• The total debit to income summary should match total expenses from the income statement.
• This transaction increases your capital account and zeros out the income summary account.
• To close the income summary account to the retained earnings account as mentioned earlier, we need to debit the income summary account and credit retained earnings account.
• KLO’s adjusted trial balance for the current month is presented below and the temporary accounts are highlighted to demonstrate how these accounts will be closed.

This reflects your net income for the month, and increases your capital account by $250. The end result is equally accurate, with temporary accounts closed to the retained earnings account for presentation in the company’s balance sheet. The closing entries are also recorded so that the company’s retained earnings account shows any actual increase in revenues from the prior year and also shows any decreases from dividend payments and expenses.

Closing Entries – A Practical Exercise:

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. We see from the adjusted trial balance that our revenue accounts have a credit balance. The credit to income How, When And Why Do You Prepare Closing Entries? summary should equal the total revenue from the income statement. Closing entries are prepared to shift the nominal account balances to capital, that is, retained earnings, after taking into account adjusting entries and preparing the financial statements.

The net result of these activities is to move the net profit or net loss for the period into the retained earnings account, which appears in the stockholders’ equity section of the balance sheet. The accountant can choose either method as eventually all the accounts will be transferred to the retained earnings account on the balance sheet. In this section, we explore the final steps (steps 8 and 9) of the accounting cycle, the closing process. This is an optional step in the accounting cycle that you will learn about in future courses should you decide to do an accounting major/minor.

Closing Entries as Part of the Accounting Cycle

This will ensure that the balance has been transferred on the balance sheet. To close the account, we need to debit the income summary account and credit all the relevant individual expenses accounts such as utilities expense, wages expense depreciation expense, etc. Below are some of the examples of closing entries that can be used to transfer revenue and expense account balances into income summary and from there to the retained earnings. A temporary account records balances for a single accounting period, whereas a permanent account stores balances over multiple periods.

At this point, the accounting cycle is complete, and the business can begin a new cycle in the next accounting period. It is worth mentioning that there is one step in the process that a business may or may not include, step 10, reversing entries. Reversing entries reverse an adjusting entry made in a prior period at the start of a new period. We do not cover reversing entries in this chapter, but you might approach the subject in future accounting courses. If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account. You can do this by debiting the income summary account and crediting your capital account in the amount of $250.

Examples of Closing Entries

The four-step method described above works well because it provides a clear audit trail. For smaller businesses, it might make sense to bypass the income summary account and instead close temporary entries directly to the retained earnings account. Some common examples of closing entries include the closing of revenue accounts, expense accounts, and dividend accounts. Income summary is a holding account used to aggregate all income accounts except for dividend expenses.

After financial statements are prepared, businesses conduct the closing process. Businesses are required to close their books at the end of each accounting period. 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 business can compare performance across periods, particularly with income.

Carbon Collective partners with financial and climate experts to ensure the accuracy of our content. Closing entry to account for draws taken for the month, for sole proprietors and partnerships. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Retained earnings are those earnings not distributed to shareholders as dividends, but retained for further investment, often in advertising, sales, production, and equipment.

When you compare the retained earnings ledger (T-account) to the statement of change in equity, the figures must match (i.e. the retained earnings account now has the correct balance at the end of the period). It is important to understand retained earnings is not closed out, it is only updated. Retained Earnings is the only account that appears in the closing entries that does not close.

The Purpose of Closing Entries

One very good site where you can find many tools to help you study this topic is Accounting Coach which provides a tool that is available to you free of charge. Visit the website and take a quiz on accounting basics to test your knowledge. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. The articles and research https://kelleysbookkeeping.com/view-a-labor-budget-to-actual-report/ support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Advisory services provided by Carbon Collective Investment LLC (“Carbon Collective”), an SEC-registered investment adviser.

The direct method is faster and less complicated as there is no intermediate account involved and requires ones less step. The method of first moving the balances to an income summary account and then shifting the balances to the retained earnings account will be more time consuming for the company. However, it will provide a better audit trail for the accountants who review these at a later point in time. 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. The dividend account is a temporary account where monies to be paid to the stockholders are accounted for. At the end of the year, this account is closed out to the retained earnings account.

What are the four closing entries in order?

This will ensure that the balances of those expenses account are transferred to the income summary account. Many students who enroll in an introductory accounting course do not plan to become accountants. They will work in a variety of jobs in the business field, including managers, sales, and finance. Accounting software can perform such tasks as posting the journal entries recorded, preparing trial balances, and preparing financial statements.