Closing entries are essential steps in the accounting cycle that help companies prepare accurate financial statements. These entries transfer temporary account balances to permanent accounts at the end of each accounting period.
There are four primary closing entries that accountants make on balance sheets
Closing Revenue to Income Summary
The first closing entry transfers your revenue account balances to an income summary account. This effectively closes out your revenue accounts like sales, fees earned, and interest income so they start the next period with a zero balance.
For example, let’s say your company earned $100,000 in sales and $15,000 in fees during the accounting period. You would make the following closing entry
Debit Income Summary $115.000Credit Sales $100.000Credit Fees Earned $15000
This closes out the revenue accounts and leaves their balances at zero for the new period. The income summary now holds the total revenues to be used in later closing entries.
Closing Expenses to Income Summary
Next, you’ll close out your expense accounts. This involves debiting all the expense accounts and crediting the income summary account.
Closing expenses works just like closing revenues. It resets all the temporary expense accounts to zero and transfers those balances to the income summary.
For example, if your company had $80,000 in salary expense and $20,000 in rent expense, you would make this entry:
Debit Salary Expense $80,000
Debit Rent Expense $20,000
Credit Income Summary $100,000
Now the expense accounts start fresh with no balances, and the income summary collects all the expenses to calculate net income.
Closing Income Summary to Retained Earnings
After revenues and expenses have been closed, the income summary account holds the company’s total net income (or net loss) for the period. This balance now needs to be transferred to retained earnings.
Retained earnings is a permanent balance sheet account that accumulates the profits and losses of your business over time. Closing income summary to retained earnings updates the balance in this permanent account.
For example, if your income summary ended with a $10,000 credit balance, that is your net income. You would make this entry:
Debit Income Summary $10,000
Credit Retained Earnings $10,000
This moves the net income balance into retained earnings where it remains as part of the company’s cumulative earnings. The income summary goes back to a zero balance ready for the next period.
Closing Dividends to Retained Earnings
The final closing entry deals with dividends paid to shareholders. Dividends get deducted from retained earnings because they represent distributions of the company’s net income.
Any dividend accounts need to be closed by debiting dividends and crediting retained earnings. For example:
Debit Dividends $5,000
Credit Retained Earnings $5,000
This reduces retained earnings to account for the dividends paid out to owners. It resets the dividends account to zero preparing it for future dividend declarations.
Why Closing Entries Matter
Closing entries serve several important purposes on the balance sheet:
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They update permanent account balances like retained earnings and dividends paid.
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They reset temporary accounts like revenues and expenses to zero for the next period.
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They produce an accurate calculation of net income for the period.
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They allow clean reporting on financial statements without extraneous account balances.
Without closing entries, temporary accounts would grow extremely large and retained earnings would not reflect reality. Closing entries produce a clean set of books for each new accounting cycle.
The Closing Process Step-By-Step
Closing entries are usually made at the end of each accounting year, but can be done at the end of any reporting period. Here are the key steps:
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Total all revenue account balances and debit Income Summary. Credit all revenue accounts to zero.
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Total all expense account balances and credit Income Summary. Debit all expense accounts to zero.
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Determine if Income Summary is a debit or credit balance. This is your net income or loss.
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Debit Income Summary if a credit balance. Credit Retained Earnings for the amount of net income.
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Credit Income Summary if a debit balance. Debit Retained Earnings for the amount of net loss.
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Debit any dividend accounts paid and credit Retained Earnings to reduce the balance.
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Prepare financial statements from the resulting account balances.
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Close the books for the period. Revenue, expense, and dividend accounts now start with zero balances.
Key Accounting Rules for Closing
When processing closing entries, accountants must follow these key accounting rules:
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Permanent accounts like assets, liabilities, and equity are not closed. Only temporary accounts are closed.
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The income summary account acts as a temporary holding account for net income or loss.
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Total debits must equal total credits for each closing entry.
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Retained earnings gets updated with profit/loss amounts and dividend distributions.
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Close books at the end of each accounting time period, not just annually.
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Closing entries impact the balance sheet only, not the income statement.
Understanding these foundational rules helps ensure closing gets done accurately.
Common Questions About Closing Entries
What happens if you don’t do closing entries?
Not performing closing entries will leave temporary account balances overstated. Expenses and revenues would accumulate over time rather than resetting to zero. The retained earnings balance would also not reflect reality. This distorts financial reporting.
Can you do closing entries more than once a year?
Yes, closing can be done at the end of any reporting period. Companies that prepare monthly financial statements will do closing entries monthly. The frequency depends on management preferences.
Where do closing entries get recorded?
Closing entries are journalized like any other accounting journal entry. Most companies use accounting software to automate the process, but they may still print out the closing entry journal for auditing.
Do closing entries affect the income statement?
No, closing entries only update balance sheet accounts. The income statement is already prepared before closings are done. Closing entries don’t impact revenues or expenses on the income statement.
Can you do closings without an income summary account?
While it is possible, using an income summary facilitates the closing process. The income summary provides a temporary holding place for the net income calculation before posting to retained earnings.
Consult an Accountant for Help
Closing entries can get complex, especially for larger companies with many revenue streams and expenses. If you need help understanding closings or implementing them properly in your accounting system, consult a professional accountant. They can ensure your closing entries are done accurately and on time.
Recording a Closing Entry
An established sequence of journal entries encompasses the entire closing procedure:
- All revenue accounts are transferred to income summary. This is done through a journal entry debiting all revenue accounts and crediting income summary.
- The same process is performed for expenses. All expenses are closed out by crediting the expense accounts and debiting income summary.
- The income summary account is closed and credited to retained earnings.
- The balance is transferred from the dividends account to retained earnings if a dividend was paid out.
Modern accounting software automatically generates closing entries.
Special Considerations
The closing entry entails debiting income summary and crediting retained earnings when a company’s revenues are greater than its expenses. The income summary account must be credited and retained earnings reduced through a debit in the event of a loss for the period.
Dividends are closed directly to retained earnings. The retained earnings account is reduced by the amount paid out in dividends through a debit and the dividends expense is credited.
