How to close the curtain on accounting with closing entries definition
We all love the journal entries, but all good things must come to an end, and it is the same for accounting, right?
Well, that is the case of closing entries definition, which puts an end to your accounting season. But, first I am pretty sure you’d want to know what it stands for and how to do it. You’ll simply have to read the article to know more.
Don’t panic, it’s easy peasy lemon squeezy.
The closing entries definition
A closing entry is a journal entry made at the end of an accounting period to relocate data, balances from a temporary account to a permanent one. The transfer is done so that companies can reset their temporary accounts (revenues, expenses and dividends) to zero on the account ledger. It also completes the last stage of the accounting cycle and prepare the books for the next period.
Why are closing entries necessary?
As closing entries are used to shift a company’s revenue, expense, etc. from a temporary to a permanent one. To understand the true purpose of a closing entry, we must understand the temporary and permanent account that both play a role in the meaning of a closing entry.
1. Temporary account
A temporary account is used to record accounting activities, such as transactions, posting, journal entries, etc. during a specific period. However, by the end of a fiscal year, all accounts must be at zero because they are reported in fixed periods, which is eventually used to construct a statement.
Once the statement is done, the balances of these accounts are transferred to the income summary, which is also a temporary account that is finally used to transfer the balances of temporary account to a permanent one. The permanent account is known as retained earnings on the balance sheets.
2. Permanent account
Permanent accounts are used to track businesses’ transactions that occur beyond the current accounting period. They appear in a section of the financial statements to give investors an idea of the company’s assets and liabilities and Owner’s equity (or retained earnings).
The net income is moved to the retained earnings, permanent account on the balance sheet.
How do you do closing entries?
There are different steps to take when carrying out a closing entry. They are:
1. First, you’ll need to transfer all your revenue accounts to the income summary. It is done by debiting all revenue accounts and crediting income summary through a journal entry.
2. Then, step 2, the same process must be done for your expenses, which is to credit the expense accounts and debit the income summary.
3. The income summary account is closed and credited to the retained earnings.
4. Lastly, if a dividend was paid, you transfer your balance from dividends account to retained earnings.
Example of closing entry
Here is an example of how closing entries is performed:
1. Close revenue accounts
Your business has generated $20,000 worth of revenue during a month. You then shift the balance of the revenue account by debiting revenue and crediting income summary.
2. Close expense accounts
Your expense amount was $10,000 for the month. You debit the income summary and credit the corresponding expenses.
3. Close income summary
You close the income summary account by debiting income summary and crediting retained earnings. You simply shift the $10,000 net profit balance in the income summary account to the retained earnings account:
4. Close dividends (withdrawal) account
Close dividends account by debiting retained earnings and crediting dividends.