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Closing the Books: Learn the Basics and How to Close the Books

It is the end of the year, December 31, 2018, and you are reviewing your financials for the entire year. You see that you earned $120,000 this year in revenue and had expenses for rent, electricity, cable, internet, gas, and food that totaled $70,000. 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. Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is equal to all income minus all expenses.

Purpose of Closing Entries

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. When dividends are https://www.bookkeeping-reviews.com/ declared by corporations, they are usually recorded by debiting Dividends Payable and crediting Retained Earnings. Note that by doing this, it is already deducted from Retained Earnings (a capital account), hence will not require a closing entry.

Step 2: Close all expense accounts to Income Summary

The income summary account acts as a temporary holding place for the net income or loss for the period. This accounts list is identical to the accounts presented on the balance sheet. This makes sense because all of the income statement accounts have been closed and no longer have a current balance. The Income Summary is very temporary since it has a zero balance throughout the year until the year-end closing entries are made. Starting with zero balances in the temporary accounts each year makes it easier to track revenues, expenses, and withdrawals and to compare them from one year to the next.

Preparing a Closing Entry

  1. For example, you could choose all entries in 2024, or it could be for the month of January 2024 only.
  2. At the start of the new accounting period, the closing balance from the previous accounting period is brought forward and becomes the new opening balance on the account.
  3. The goal is to make theposted balance of the retained earnings account match what wereported on the statement of retained earnings and start the nextperiod with a zero balance for all temporary accounts.
  4. General Finance and Financial Accounting encompasses accounting journals, ledgers and ledger accounts, revenue and spend categories, and the Period Close business process.

This is the adjusted trial balance that will be used to make your closing entries. One of the most important steps in the accounting cycle is creating and posting your closing entries. The records are used to generate reports that tell an owner how much money flows in and out of their business. Businesses often use professional bookkeeping services to ensure they are on track financially, are tax-season ready, and are able to continue to grow and thrive. Get started here if you want to speak to a professional about your business cash flow.

Order To Cash

The business has been operating for several years but does not have the resources for accounting software. This means you are preparing all steps in the accounting cycle by hand. In this chapter, we complete 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. Steps 1 through 4 were covered in Analyzing and Recording Transactions and Steps 5 through 7 were covered in The Adjustment Process. This adjusted trial balance reflects an accurate and fair view of your bakery’s financial position.

All accounts can be classified as either permanent (real) or temporary (nominal) (Figure 5.3). Answer the following questions on closing entries and rate your confidence to check your answer. We have completed the first two columns and now we have the final column which represents the closing (or archive) process. This challenge becomes even more daunting as your business expands.

To make them zero we want to decrease the balance or dothe opposite. We will debit the revenue accounts and credit theIncome Summary account. The credit to income summary should equalthe total revenue from the income statement. The income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet. Closing journal entries are made at the end of an accounting period to prepare the accounting records for the next period. They zero-out the balances of temporary accounts during the current period to come up with fresh slates for the transactions in the next period.

Adjusting entries ensure that revenues and expenses are appropriately recognized in the correct accounting period. The balance in dividends, revenues and expenseswould all be zero leaving only the permanent accounts for a postclosing trial balance. The trial balance shows the ending balancesof all asset, liability and equity accounts remaining.

Remember the income statement is like a moving picture of a business, reporting revenues and expenses for a period of time (usually a year). We want income statements to start every year from zero, but for accounts like equipment, debt, and cash accounts—reported on the balance sheet—we want to keep a running balance from the beginning of the business. As mentioned, temporary accounts in the general ledger consist of income statement accounts such as sales or expense accounts. When the income statement is published at the end of the year, the balances of these accounts are transferred to the income summary, which is also a temporary account.

Suppose a business had the following trial balance before any closing journal entries at the end of an accounting period. In this example we will close Paul’s Guitar Shop, Inc.’s temporary accounts using the income summary account method from his financial statements in the previous example. All temporary accounts eventually get closed to retained earnings and are presented on the balance sheet. Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step.

Business owners can close their books by zeroing out their income and expense accounts and then plugging net profit (or loss) into the balance sheet. Instead, the basic closing step is to access an option in the software to close the reporting period. Doing so automatically populates the retained earnings account for you, and prevents how to successfully manage culture change in the workplace any further transactions from being recorded in the system for the period that has been closed. Once adjusting entries have been made, closing entries are used to reset temporary accounts and transfer their balances to permanent accounts. We see fromthe adjusted trial balance that our revenue accounts have a creditbalance.

Temporary (nominal) accounts are accounts that are closed at the end of each accounting period, and include income statement, dividends, and income summary accounts. These accounts are temporary because they keep their balances during the current accounting period and are set back to zero when the period ends. Revenue and expense accounts are closed to Income Summary, and Income Summary and Dividends are closed to the permanent account, Retained Earnings.

When you close the books monthly, that means you make journal entries to ensure all transactions for the month have been captured. This makes it easier to do monthly tasks like bank reconciliation, sending sales tax reports to the state, paying your suppliers, and generating customer statements. These finalized reports show a business’s financial position over a certain accounting period—whether a month or an entire year. Sum your general ledger accounts again to take into account the adjusted entries from the last step, and then add them all together to make a new trial balance, making sure your debits and credits are again equal. In order to produce more timely information some businesses issue financial statements for periods shorter than a full fiscal or calendar year. Such periods are referred to as interim periods and the accounts produced as interim financial statements.

This means that it is not an asset, liability, stockholders’ equity, revenue, or expense account. The account has a zero balance throughout the entire accounting period until the closing entries are prepared. Therefore, it will not appear on any trial balances, including the adjusted trial balance, and will not appear on any of the financial statements. To further clarify this concept, balances are closed to assure all revenues and expenses are recorded in the proper period and then start over the following period.

On the statement of retained earnings, we reported the ending balance of retained earnings to be $15,190. This is no different from what will happen to a company at the end of an accounting period. A company will see its revenue and expense accounts set back to zero, but its assets and liabilities will maintain a balance. In summary, the accountant resets the temporary accounts to zero by transferring the balances to permanent accounts. Closing entries are journal entries used to empty temporary accounts at the end of a reporting period and transfer their balances into permanent accounts.

Other accounting software, such as Oracle’s PeopleSoft™, post closing entries to a special accounting period that keeps them separate from all of the other entries. So, even though the process today is slightly (or completely) different than it was in the days of manual paper systems, the basic process is still important to understand. 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. At the end of the period, temporary or nominal accounts are closed; these include expense, revenue, and owner withdrawing accounts. This process zeros out the account balances so that the balance of the transactions in each account reflects only the transactions of a particular period. The purpose of the closing process for each period is to avoid incorrectly recording income or expenses in previous periods.

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. Now, all the temporary accounts stand tall with their respective figures, showcasing the revenue your bakery has generated, the expenses it has incurred, and the dividends declared throughout the past year. These permanent accounts form the foundation of your business’s balance sheet. The next and final step in the accounting cycle is to prepare one last post-closing trial balance.

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It effortlessly sifts through large amounts of data and generates closing entries automatically. This ensures that your financial operations infrastructure can scale with your business’s growth. The Income Summary balance is ultimately closed to the capital account. This entry zeros out dividends and reduces retained earnings by total dividends paid. Most small companies close their books monthly, though some only do so at year’s end.

Income summary effectively collects net income (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. If the income summary account has a credit balance after completing the entries, or the credit entry amounts exceeded the debits, the company has a net income. If the debit balance exceeds the credits the company has a net loss. The income summary account serves as a temporary account used only during the closing process. It contains all the company’s revenues and expenses for the current accounting time period.

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