What Is a Closing Entry?
A closing entry is a journal entry made at the end of an accounting period. It involves shifting data from temporary accounts on the income statement to permanent accounts on the balance sheet.Temporary accounts include revenue, expenses, and dividends. These accounts must be closed at the end of the accounting year.
Key Takeaways:
- A closing entry is a journal entry that's made at the end of the accounting period.
- It involves shifting data from temporary accounts on the income statement to permanent accounts on the balance sheet.
- The purpose of the closing entry is to reset the temporaryaccount balancesto zero on the general ledger.
- All income statement balances are eventually transferred to retained earnings.
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Understanding Closing Entries
The purpose of the closing entry is to reset temporaryaccount balancesto 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're reported in defined periods. They're not carried over into the future. A hundred dollars in revenue this year doesn't count as $100 in revenue for next year even if the company retained the funds for use in the next 12 months.
Permanent accounts track activities that extend beyond the current accounting period. They're housed on the balance sheet, a section of financial statements that gives investors an indication of a company’s value including its assets and liabilities.
Any account listed on the balance sheet is a permanent account, barring paid dividends. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent.
The net income (NI) is moved into retained earnings on the balance sheet as part of the closing entry process. The assumption is that all income from the company in one year is held for future use. Any funds that aren't held incur an expense that reduces NI. One such expense that's 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 be shifted directly to the retained earnings account or an intermediate account known as the income summary account.
Income summary is a holding account used to aggregate all income accounts except for 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.
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
An established sequence of journal entries encompasses the entire closing procedure:
- All revenue accounts are transferred to income summary. This is done through a journal entry debiting all revenue accounts and crediting income summary.
- The same process is performed for expenses. All expenses are closed out by crediting the expense accounts and debiting income summary.
- The income summary account is closed and credited to retained earnings.
- The balance is transferred from the dividends account to retained earnings if a dividend was paid out.
Important
Modern accounting software automatically generates closing entries.
Special Considerations
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.
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.
What Is an Accounting Period?
An accounting period is any duration of time that's covered by financial statements. There's no requisite timeframe. It can be a calendar year for one business while another business might use a fiscal quarter. The term should be used consistently in either case. A company shouldn't bounce back and forth between timeframes.
What Are Retained Earnings?
Retained earnings are defined as a portion of a business's profits that isn't paid out to shareholders but is rather reserved to meet ongoing expenses of operation.
What Is Net Income?
The term "net" relates to what's left of a balance after deductions have been made from it. Individuals have net income as do businesses.
An individual might define their net income as the portion of their paycheck they can spend on discretionary expenses after taxes have been withheld and they're reserved an adequate portion to meet their monthly budget. The term can also mean whatever they receive in their paycheck after taxes have been withheld.
The same premise holds in the business world. Net income is the portion of gross income that's left over after all expenses have been met.
The Bottom Line
A closing entry is a journal entry that’s made at the end of the accounting period that a business elects to use. It’s not necessarily a process meant for the faint of heart because it involves identifying and moving numerous data from temporary to permanent accounts on the income statement. This can affect dividends and can be important to investors.
