1. I
   Introduction to Accounting
2. II
   Fundamental Accounting Concepts
3. III
   The Financial Statements
4. IV
   Analyzing, Recording, and Classifying Transactions
5. V
   Adjusting Entries
6. VI
   How to Prepare Financial Statements
7. VII
   Closing Entries
8. VIII
   Post-Closing Trial Balance
9. IX
   Reversing Entries

Closing Entries

What are Closing Entries?

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.

What are Temporary Accounts?

Temporary accounts include all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole proprietorships and partnerships (dividends for corporations).

Take note that closing entries are prepared only for temporary accounts. Permanent accounts are never closed.

Four Steps in Preparing Closing Entries

1. Close all income accounts to Income Summary
2. Close all expense accounts to Income Summary
3. Close Income Summary to the appropriate capital account
   • Owner's capital account for sole proprietorship
   • Partners' capital accounts for partnerships, based on ratio agreed
   • Retained earnings for corporations
4. Close withdrawals/distributions to the appropriate capital account

Closing Entries: Example

Prepare the closing entries using the following information:

Step 1: Close all income accounts to Income Summary

In the given data, there is only 1 income account, i.e. Service Revenue. It has a credit balance of $9,850. To close that, we debit Service Revenue for the full amount and credit Income Summary for the same.

The Income Summary account is temporary. It is used to close income and expenses. As you will see later, Income Summary is eventually closed to capital.

Step 2: Close all expense accounts to Income Summary

To close expenses, we simply credit the expense accounts and debit Income Summary.

Step 3: Close Income Summary to the appropriate capital account

Now for this step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited it in step 2 for $8,790. It would then have a credit balance of $1,060.

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.

The Income Summary balance is ultimately closed to the capital account.

For partnerships, each partners' capital account will be credited based on the agreement of the partnership (for example, 50% to Partner A, 30% to B, and 20% to C). For corporations, Income Summary is closed entirely to "Retained Earnings".

What if Income Summary had a debit balance? It means that the company had a net loss. This is closed by doing the opposite – debit the capital account (decreasing the capital balance) and credit Income Summary.

Step 4: Close withdrawals to the capital account

For sole proprietorships and partnerships:

In a sole proprietorship, a drawing account is maintained to record all withdrawals made by the owner. In a partnership, a drawing account is maintained for each partner. All drawing accounts are closed to the respective capital accounts at the end of the accounting period.

Our example is a sole proprietorship business. Mr. Gray's withdrawals are recorded in Mr. Gray, Drawing. To close the drawing account to the capital account, we credit the drawing account and debit the capital account. Notice that drawings decrease capital.

For corporations:

When dividends are 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.

However, some corporations use a temporary clearing account for dividends declared (let's use "Dividends"). 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.

Conclusion

The purpose of closing entries is to prepare the temporary accounts for the next accounting period. In other words, the income and expense accounts are "restarted".

After preparing the closing entries above, Service Revenue will now be zero. The expense accounts and withdrawal account will now also be zero. Effectively, the balances of these accounts have been absorbed by the capital account – Mr. Gray, Capital, which now has a balance of $7,260 ($13,200 beginning balance + $1,060 in step #3 for net income - $7,000 in step #4 for withdrawals).