Closing Entry Definition, Explanation, and Examples

The retained earnings account is reduced by the amount paid out in dividends through a debit and the dividends expense is credited. Income summary is a holding account used to aggregate all income accounts except for fort lauderdale bookkeepers dividend expenses. It’s not reported on any financial statements because it’s only used during the closing process and the account balance is zero at the end of the closing process. Temporary account balances can be shifted directly to the retained earnings account or an intermediate account known as the income summary account. Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow. The total of the income summary account after the all temporary accounts have been close should be equal to the net income for the period.

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In essence, we are updating the capital balance and resetting all temporary account balances. Income and expenses are closed to a temporary clearing account, usually Income Summary. Afterwards, withdrawal or dividend accounts are also closed to the capital account. As you will see later, Income Summary is eventually closed to capital. The $10,000 of revenue generated through the accounting period will be shifted to the income summary account.

Income Summary

1. All expense accounts are then closed to the income summary account by crediting the expense accounts and debiting income summary.
2. 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.
3. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.

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It can also create errors and financial mistakes in both the current and upcoming financial reports, of the next accounting period. Now, it’s time to close the income summary to the retained earnings (since we’re dealing with a company, not a small business or sole proprietorship). As mentioned, one way to make closing entries is by directly closing the temporary balances to the equity or retained earnings account. All of Paul’s revenue or income accounts are debited and credited to the income summary account. This resets the income accounts to zero and prepares them for the next year.

Accounts are considered “temporary” when they only accumulate transactions over one single accounting period. Temporary accounts are closed or zero-ed out so that their balances don’t get mixed up with those of the next year. Permanent accounts are accounts that show the long-standing financial position of a company. These accounts carry forward their balances throughout multiple accounting periods.

What are the transactions made at the end of an accounting period?

Temporary accounts can either be closed directly to the retained earnings account or to an intermediate account called the income summary account. The income summary account is then closed to the retained earnings account. At the end of the year, all the temporary accounts must be closed or reset, so the beginning of the following year will have a clean balance to start with. In other words, revenue, expense, and withdrawal accounts always have a zero balance at the start of the year because they are always closed at the end of the previous year. The $1,000 net profit balance generated through the accounting period then shifts.

Whether you’re processing closing entries manually, or letting your accounting software do the work, closing entries are perhaps the most important part of the accounting cycle. If your business is a corporation, you will not have a drawing account, but if you paid stockholders, you will have a dividends account. If you paid dividends for the month, you will need to close that account as well. Instead the balances in these accounts are moved at month-end to either the capital account or the retained earnings account. It’s important to note that neither the drawing nor the dividends accounts need to be transferred to the income summary account. In addition, if the accounting system uses subledgers, it must close out each subledger for the month prior to closing the general ledger for the entire company.

An accounting period is any duration of time that’s covered by financial statements. It can be a calendar year for one business while another business might use a fiscal quarter. This time period, called the accounting period, usually reflects one fiscal year. However, your business is also free to handle closing entries monthly, quarterly, or every six months.