After closing entries have been posted, the balance in Retained earnings will be

What Is a Closing Entry?

A closing entry is a journal entry made at the end of accounting periods that involves shiftingdata from temporary accounts on the income statement to permanent accounts on the balance sheet. Temporary accounts include revenue, expenses, and dividends, and these accounts must be closed at the end of the accounting year.

Key Takeaways:

• A closing entry is a journal entry made at the end of the accounting period.
• It involves shiftingdata from temporary accounts on the income statement to permanent accounts on the balance sheet. 
• All income statement balances are eventually transferred to retained earnings.

How to Make a Closing Entry

Understanding Closing Entries

The purpose of the closing entry is to reset the temporary account balances to zero on the general ledger, the record-keeping system for a company's financial data.

Temporary accounts are used to record accounting activity during a specific period. All revenue and expense accounts must end with a zero balance because they are reported in defined periods and are not carried over into the future. For example, $100 in revenue this year does not count as $100 of revenue for next year, even if the company retained the funds for use in the next 12 months.

Permanent accounts, on the other hand, track activities that extend beyond the current accounting period. They are housed on the balance sheet, a section of the financial statements that gives investors an indication of a company’s value, including its assetsand liabilities. 

Any account listed on the balance sheet, barring paid dividends, is a permanent account. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent.

As part of the closing entry process, the net income (NI) is moved into retained earnings on the balance sheet. The assumption is that all income from the company in one year is held onto for future use. Any funds that are not held onto incur an expense that reduces NI. One such expense that is determined at the end of the year is dividends. The last closing entry reduces the amount retained by the amount paid out to investors.

Income Summary Account

Temporary account balances can either be shifted directly to the retained earnings account or to an intermediate account known as the income summary account beforehand.

Income summary is a holding account used to aggregate all income accounts except for dividend expenses. Income summary is not reported on any financial statements because it is only used during the closing process, and at the end of the closing process the account balance is zero.

Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings. Balances from temporary accounts are shifted to the income summary account first to leave an audit trail for accountants to follow. 

Recording a Closing Entry

There is an established sequence of journal entries that encompass the entire closing procedure:

1. First, all revenue accounts are transferred to income summary. This is done through a journal entry debiting all revenue accounts and crediting income summary. 
2. Next, the same process is performed for expenses. All expenses are closed out by crediting the expense accounts and debiting income summary.
3. Third, the income summary account is closed and credited to retained earnings.
4. Finally, if a dividend was paid out, the balance is transferred from the dividends account to retained earnings.

Important

Modern accounting software automatically generates closing entries.

Special Considerations

If a company’s revenues are greater than its expenses, the closing entry entails debiting income summary and crediting retained earnings. In the event of a loss for the period, the income summary account needs to be credited and retained earnings reduced through a debit.

Finally, 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.

When you manage your accounting books by hand, you are responsible for a lot of nitty-gritty details. One of your responsibilities is creating closing entries at the end of each accounting period.

What are closing entries?

Closing entries are entries used to shift balances from temporary to permanent accounts at the end of an accounting period. These journal entries condense your accounts so you can determine your retained earnings, or the amount your business has after paying expenses and dividends. Creating closing entries is one of the last steps of the accounting cycle.

Create closing entries to reflect when your accounting period ends. For example, if your accounting periods last one month, use month-end closing entries. However, businesses generally handle closing entries annually. Whatever accounting period you select, make sure to be consistent and not jump between frequencies.

Temporary vs. permanent accounts

In accounting, some of your accounts are temporary and must reset when a new period starts. These accounts track your funds during a specific accounting period. Temporary accounts include:

• Revenues
• Expenses
• Dividends

You also need to use permanent accounts to track your business’s financial health from period to period. Permanent accounts include:

• Assets
• Liabilities
• Equity

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Purpose of closing entries accounting

Without closing revenue accounts, you wouldn’t be able to compare how much your business earns each period because the amount would build up. And without closing expense accounts, you couldn’t compare your business expenses from period to period.

You need to use closing entries to reduce the value of your temporary accounts to zero. That way, your next accounting period does not have a balance in your revenue or expense account from the previous period.

Transferring funds from temporary to permanent accounts also updates your small business retained earnings account. You can report retained earnings either on your balance sheet or income statement. Without transferring funds, your financial statements will be inaccurate.

How to create closing entries

Accounting software automatically handles closing entries for you. If you don’t have accounting software, you must manually create closing entries each accounting period.

You can create a closing entry by closing your revenue and expense accounts and transferring the balances into an account called “income summary account.”

The income summary account is only used in closing process accounting. Basically, the income summary account is the amount of your revenues minus expenses. You will close the income summary account after you transfer the amount into the retained earnings account, which is a permanent account.

Here are the steps to creating closing entries:

1. Close revenue accounts by transferring funds to income summary account
2. Close expense accounts by transferring funds to income summary account
3. Close income summary account by transferring funds to retained earnings account
4. Close dividends by transferring funds to retained earnings account (if applicable)

So how exactly do you close the accounts?

You need to create closing journal entries by debiting and crediting the right accounts. Use the chart below to determine which accounts are decreased by debits and which are decreased by credits.

Close revenue accounts

As you can see, revenue accounts are decreased by debits. You must debit your revenue accounts to decrease it, which means you must also credit your income summary account.

Close expense accounts

Because expenses are decreased by credits, you must credit the account and debit the income summary account.

Close income summary account

Whether you credit or debit your income summary account will depend on whether your revenue is more than your expenses.

If your revenues are greater than your expenses, you will debit your income summary account and credit your retained earnings account. This increases your retained earnings account.

If your revenues are less than your expenses, you must credit your income summary account and debit your retained earnings account. This decreases your retained earnings account.

Close dividend accounts

If you paid out dividends during the accounting period, you must close your dividend account. Now that the income summary account is closed, you can close your dividend account directly with your retained earnings account.

Debit your retained earnings account and credit your dividends expense. This reduces your retained earnings account.

Closing journal entries example

Let’s say your business wants to create month-end closing entries. During the accounting period, you earned $5,000 in revenue and had $2,500 in expenses. You did not pay any dividends.

First, transfer the $5,000 in your revenue account to your income summary account. Debit revenue and credit income summary.

Next, transfer the $2,500 in your expense account to your income summary account. Debit the income summary account and credit expense account.

Finally, you are ready to close the income summary account and transfer the funds to the retained earnings account.

After crediting your income summary account $5,000 and debiting it $2,500, you are left with $2,500 ($5,000 – $2,500). Because this is a positive number, you will debit your income summary account and credit your retained earnings account. This adds the $2,500 to your retained earnings account.

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This article is updated from its original publication date of March 15, 2018.

This is not intended as legal advice; for more information, please click here.

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