A Guide to Closing Entries: How to Prepare Them

The purpose of closing entries is to merge your accounts so you can determine your retained earnings. Retained earnings represent the amount your business owns after paying accounting expenses and dividends for a specific time period. Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings.

• Because the effect of nominal accounts cannot be shown in the following year, they are closed in the year in which they are created.
• If your company doesn’t have dividends then you won’t need to do this step.
• Once adjusting entries have been made, closing entries are used to reset temporary accounts and transfer their balances to permanent accounts.
• 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.
• Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings.

This challenge becomes even more daunting as your business expands. Manual processes struggle to handle the increasing volume of financial transactions and complexities. All accounts can be classified as either permanent (real) or temporary (nominal) (Figure 5.3). You can close your books, manage your accounting cycle, issue invoices, pay back vendor bills, and so much more, from any device with an internet connection, just by downloading the Deskera mobile app. Instead,  as a form of distribution of a firm’s accumulated earnings, dividends are treated as a distribution of equity of the business.

Trial Balance

However, your business is also free to handle closing entries monthly, quarterly, or every six months. Clear the balance of the revenue account by debiting revenue and crediting income summary. This is closed by doing the opposite – debit the capital account (decreasing the capital balance) and credit Income Summary. Balances of permanent accounts are carried forward to the subsequent accounting period.

• The last closing entry reduces the amount retained by the amount paid out to investors.
• It is really determined by a company’s need for financial reporting.
• Now that we have closed the temporary accounts, let’s review what the post-closing ledger (T-accounts) looks like for Printing Plus.
• A business will use closing entries in order to reset the balance of temporary accounts to zero.
• When closing expenses, you should list them individually as they appear in the trial balance.

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. After preparing the closing entries above, Service Revenue will now be zero. Instead, companies transfer the net income or net loss from the revenue and expense accounts to a temporary account called “Income Summary,” and then to the owner’s capital. All the temporary accounts, including revenue, expense, and dividends, have been reset to zero. The balances from these temporary accounts have been transferred to the permanent account, retained earnings.

Understanding the accounting cycle and preparing trial balances is a practice valued internationally. The Philippines Center for Entrepreneurship and the government of the Philippines hold regular seminars going over this cycle with small business owners. They are also transparent with their internal trial balances in several key government offices. Check out this article talking about the seminars on the accounting cycle and this public pre-closing trial balance presented by the Philippines Department of Health. This time period, called the accounting period, usually reflects one fiscal year.

Close all dividend or withdrawal accounts

Keep in mind, however, that this account is only purposeful for closing the books, and thus, it is not recorded into any accounting reports and has a zero balance at the end of the closing process. Thus, the income summary temporarily holds only revenue and expense balances. As you will see later, Income Summary is eventually closed to capital. Lastly, you’ll repeat the process for each temporary account that you have to close. Alright, with a high-level understanding let’s dive into the 4-step close process. After closing, the dividend account will have a zero balance and be ready for the next period’s dividend payments.

This transaction increases your capital account and zeros out the income summary account. Revenue is one of the four accounts that needs to be closed to the income summary account. This is the adjusted trial balance that will be used to make your closing entries.

Final thoughts on closing entries

However, if the company also wanted to keep year-to-date information from month to month, a separate set of records could be kept as the company progresses through the remaining months in the year. For our purposes, assume that we are closing the books at the end of each month unless otherwise noted. Lastly, if we’re dealing with a company that distributes dividends, we have to transfer these dividends directly to retained earnings. In other words, they represent the long-standing finances of your business.

Overview: What are closing entries?

Let’s investigate an example of how closing journal entries impact a trial balance. Imagine you own a bakery business, and you’re starting a new financial year on March 1st. In this case, if you paid out a dividend, the balance would be moved to retained earnings from the dividends account. Once this has been completed, a post-closing trial balance will be reviewed to ensure accuracy.

However, some corporations use a temporary clearing account for dividends declared (let’s use “Dividends”). They’d record declarations by debiting Dividends Payable and crediting Dividends. If this is the case, then this temporary dividends account needs to be closed at the end of the period to the capital account, Retained Earnings. As we mentioned, the income summary is a temporary account in itself. You will start by clearing out the income accounts from the income statement (revenue) and crediting the income summary.

Any remaining balances will now be transferred and a post-closing trial balance will be reviewed. All modern accounting software automatically generates closing entries, so these entries are no longer required of the accountant; it is usually not even apparent that these entries are being made. The income statement summarizes your income, as does income summary.

Examples of Closing Entries

The company transfers temporary account balances to the permanent owner’s equity account, Owner’s Capital, using closing entries at the end of each accounting period. A sole proprietor or partnership often uses a separate drawings account to record withdrawals of cash by the owners. Although the drawings account is not an income statement account, it is still classified as a temporary account and needs a closing journal entry to zero the balance for the next accounting period. Although it is not an income statement account, the dividend account is also a temporary account and needs a closing journal entry to zero the balance for the next accounting period. The process of preparing the post-closing trial balance is the same as you have done when preparing the unadjusted trial balance and adjusted trial balance.

Now for this step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited it in step 2 for $8,790. To close that, we debit Service Revenue for the full amount and credit Income Summary for the same. Once the closing entries have been posted, the trial balance calculation is performed to help detect any errors that may have occurred in the closing process. 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.