Imagine you own a bakery business, and you’re starting a new financial year on March 1st. The next and final step in the accounting cycle is to prepare one last post-closing trial balance. 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). 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.

Companies use closing entries to reset the balances of temporary accounts − accounts that show balances over a single accounting period − to zero. By doing so, the company moves these balances into permanent accounts on the balance sheet. The permanent accounts in which balances are transferred depend upon the nature of business of the entity. For example, in the case of a company permanent accounts are retained earnings account, and in case of a firm or a sole proprietorship, owner’s capital account absorbs the balances of temporary accounts. Now that all the temporary accounts are closed, the income summary account should have a balance equal to the net income shown on Paul’s income statement. Now Paul must close the income summary account to retained earnings in the next step of the closing entries.

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Lastly, if we’re dealing with a company that distributes dividends, we have to transfer these dividends directly to retained earnings. The income statement reflects your net income for the month of December. Closing entry to account for draws taken for the month, for sole proprietors and partnerships.

How to post closing entries?

We’ll use a company called MacroAuto that creates and installs specialized exhaust systems for race cars. Here are MacroAuto’s accounting records simplified, using positive numbers for increases and negative numbers for decreases instead of debits and credits in order to save room and to get a higher-level view. Well, dividends are not part of the income statement because they are not considered an operating expense. In other words, they represent the long-standing finances of your business. That’s exactly what we will be answering in this guide –  along with the basics of properly creating closing entries for your small business accounting.

Closing entries, on the other hand, are entries that close temporary ledger accounts and transfer their balances to permanent accounts. The purpose of closing entries is to merge your accounts so you can determine your retained earnings. Retained earnings represent the accrual method of accounting amount your business owns after paying expenses and dividends for a specific time 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.

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

1. For example, the revenues account records the amount of revenues earned during an accounting period—not during the life of the company.
2. To close revenue accounts, you first transfer their balances to the income summary account.
3. Since dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account.
4. The income summary account is then closed to the retained earnings account.
5. The assumption is that all income from the company in one year is held for future use.

On the statement of retained earnings, we reported the ending balance of retained earnings to be $15,190. We need to do the closing entries to make them match and zero out the temporary accounts. We see from the adjusted trial balance that our revenue account has a credit balance. To make the balance zero, debit the revenue account and credit the Income Summary account. At the end of an accounting depreciation and amortization on the income statement period when the books of accounts are at finalization stage, some special journal entries are required to be passed.

Which types of accounts do not require closing entries?

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. First, all the various revenue account balances are transferred to the temporary income summary account. This is done through a journal entry that debits revenue accounts and credits the income summary. 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. You begin the closing process by transferring revenue and expense account balances to the income summary account, a temporary account used specifically to transfer revenue and expense account balances.

Another essential component of the Highradius suite is the Journal Entry Management module. This module automates the creation and management of journal entries, ensuring consistency and accuracy in your financial statements. Organizations can achieve up to 95% journal posting automation with a pre-filled template, reducing errors and discrepancies and providing a reliable view of financial data. Now that the journal entries are prepared and posted, you are almost ready to start next year. Remember, modern computerized accounting systems go through this process in preparing financial statements, but the system does not actually create or post journal entries. ‘Retained earnings‘ account is credited to record the closing entry for income summary.