Closing Entry in Accounting: How to Record & Examples

What is Closing Entry?

A closing entry is an accounting term that refers to journal entries made at the end of an accounting period to close temporary accounts. The purpose of closing entries is to transfer the balances from temporary accounts (revenues, expenses, dividends, and withdrawals) to a permanent account (retained earnings or owner's equity). This process resets the balances of the temporary accounts to zero, preparing them for the next accounting period and accurately reflecting the financial performance and position of the company.

What are Temporary Accounts?

Temporary accounts, also known as nominal accounts, are accounts that track financial transactions and activities over a specific accounting period. These accounts are "temporary" because they start each accounting period with a zero balance and are used to accumulate data for that period only. At the end of the accounting period, the balances in these accounts are transferred to permanent accounts, resetting the temporary accounts to zero for the next period.

Types of Temporary Accounts Include:

• Revenue Accounts: These accounts record income earned from the sale of goods or services during the accounting period. Examples include Sales Revenue, Service Revenue, and Interest Revenue.
• Expense Accounts: These accounts record costs incurred to generate revenue during the accounting period. Examples include Rent Expenses, Salaries Expenses, Utilities Expenses, and Depreciation Expenses.
• Dividends or Withdrawals Accounts: For corporations, dividends represent the distribution of earnings to shareholders. For sole proprietorships or partnerships, withdrawals represent the amounts taken out by the owners for personal use. Examples include Dividends Declared and Owner’s Draw.

Example of Temporary Accounts

Suppose a company has the following transactions during an accounting period:

1. Earned $50,000 in service revenue.
2. Incurred $30,000 in salaries expense.
3. Declared $5,000 in dividends.

Solution:

At the end of the period, the temporary accounts will have the following balances:

1. Service Revenue: $50,000 (credit balance)
2. Salaries Expense: $30,000 (debit balance)
3. Dividends Declared: $5,000 (debit balance)

What is Income Summary?

The Income Summary is a temporary account used during the closing process of an accounting period to facilitate the transfer of balances from temporary accounts (revenues and expenses) to a permanent account (typically Retained Earnings). The Income Summary account is crucial because it serves as an intermediary step, ensuring that all revenue and expense accounts are accurately closed and their balances are correctly transferred to reflect the net income or net loss for the period.

Characteristics of the Income Summary Account:

• Temporary: It is only used during the closing process and does not appear on any financial statements.
• Balance Calculation: The balance in the Income Summary account after closing revenues and expenses represents the net income (if credit balance) or net loss (if debit balance) for the period.
• Zeroed Out: After its purpose is served, the balance in the Income Summary account is transferred to the Retained Earnings account, and the Income Summary is closed with a zero balance.

What are Permanent Accounts?

Also known as real or balance sheet accounts, these are general ledger entries that do not close at the end of an accounting period but are instead carried forward to subsequent periods . Real accounts, also known as permanent accounts, are quite different compared to their temporary equivalents. They persist from one accounting period to the next and maintain their balances over time unlike temporary accounts which are closed at the end of the period. These permanent files include assets, liabilities and equity sections making them very useful in showing the company’s financial position that lasts long.

Characteristics of Permanent Accounts:

• Persistence: Permanent accounts persist from one accounting period to the next. Their balances are not reset or closed out at the end of each period.
• Long-Term Focus: These accounts maintain their balances over time, providing a continuous record of the company's financial position and performance.
• Reflect Financial Position: Permanent accounts, being balance sheet accounts, reflect the company's financial position rather than its performance during a specific period.
• Include Assets, Liabilities, and Equity: Permanent accounts encompass various types of accounts, including assets, liabilities, and equity, which together depict the company's financial health and resources.

How to Record a Closing Entry?

Here are the steps typically involved in making closing entries:

1. Close Revenue Accounts: Transfer the balances of all revenue accounts to the Income Summary account.

• Debit each revenue account.
• Credit the Income Summary account.

2. Close Expense Accounts: Transfer the balances of all expense accounts to the Income Summary account.

• Debit the Income Summary account.
• Credit each expense account.

3. Close the Income Summary Account: Transfer the balance of the Income Summary account to the Retained Earnings account (or Owner's Equity account for sole proprietorships).

• If the Income Summary has a credit balance (net income), debit the Income Summary and credit Retained Earnings.
• If the Income Summary has a debit balance (net loss), debit Retained Earnings and credit the Income Summary.

4. Close Dividends or Withdrawals Accounts: Transfer the balance of the Dividends or Withdrawals account to the Retained Earnings account.

• Debit Retained Earnings.
• Credit the Dividends or Withdrawals account.

Example of Closing Entry

Assume the following balances at the end of an accounting period:

• Revenue: $10,000
• Expenses: $6,000
• Dividends: $1,000

Solution:

The closing entries would be:

1. Close Revenue Accounts:

• Debit Revenue: $10,000
• Credit Income Summary: $10,000

2. Close Expense Accounts:

• Debit Income Summary: $6,000
• Credit Expenses: $6,000

3. Close the Income Summary Account:

• The Income Summary now has a credit balance of $4,000 (Revenue - Expenses = Net Income).
• Debit Income Summary: $4,000
• Credit Retained Earnings: $4,000

4. Close Dividends Account:

• Debit Retained Earnings: $1,000
• Credit Dividends: $1,000

After these entries, all temporary accounts (revenue, expenses, dividends) will have zero balances, and the net income and dividends will be reflected in the Retained Earnings account.

Conclusion

In other words, the closing entry is a method of making repayments on all the costs incurred within a given financial year. To complete, this method involves transfer of funds from revenue-generating accounts such as wages payable and interest receivable to an intermediary account known as income summary. Therefore, we can calculate either profit margin for this company or how much it lost over the year. After this, these amounts go directly into items like company profits that are not moved anymore."Temporary accounts are reset to zero, permanent accounts retain their balances. This ensures financial statement accuracy and offers a clear picture of how a company has done over the years."