Closing Entries Explained

Closing entries are something a bookkeeper typically does once the month is over and every time the accounting period comes to an end. It is a mandatory procedure in accounting without which a bookkeeper cannot start recording entries for the next period. Before we dive into the topic of closing entries, though, let’s first review fundamental concepts you should know to be able to close the books of a business correctly.

Permanent Bookkeeping Accounts

Balance Sheet accounts are bookkeeping account types that stay on the books for as long as the company exists and their balance changes with business activity. The only exception would be the Dividends account.

Temporary Bookkeeping Accounts

An opposite type of accounts that you would also see in the General ledger or the Trial Balance is commonly referred to as temporary. An easy way to remember these is using the acronym R-E-D (Revenue, Expense, and Dividends). Simply put, this is a red flag and you need to take care of these accounts. A bookkeeper has to close these accounts through closing entries, whether every month or on yearly basis.

You might wonder why would someone remove accounts that are necessary to be able to record business transactions. This is not so. It is just the balances that are getting removed not the actual accounts themselves. With the help of closing entries and then opening entries, a bookkeeper forwards these accounts to be used in the next year. Thus, you have to memorize this part to ensure that no account is missed.

The reason why a bookkeeper would need to record closing entries is to make it possible to start again from scratch with temporary account balances eliminated. You can think of balances as game scores. Every new game starts with zeroes for each team no matter what the scores were the previous game was being played.

This procedure allows any user of the accounting data to see how much money came in and how much money came out of the business just for the last month or year without looking at the data for the company’s whole existence thrown into one account.

Income Summary Bookkeeping Account

During this whole process, bookkeepers typically use yet another temporary account where they simply dump all the balances of the temporary accounts. This is partially why an Income Summary is called a summary account. Of course, to make sure the accounting balance is maintained, the amounts are either debited or credited to this account, depending on what account balance you are closing at the moment.

A Guide to Closing Entries

As explained above, you only need to transfer the balances of all the accounts that do not stay on the books permanently. Let’s review the whole process, including example closing entries.

  • Step 1 Although not mandatory, your first step when recording the closing entries is to retrieve the Trial Balance and go through it, noting all the temporary accounts. So, you would be looking for all the accounts that go on the company’s Income Statement (revenue and rent, wages, insurance, utilities, office supplies, and various other expenses).Step 2
  • Now, the actual closing starts, and the first accounts that get closed are revenue accounts. If the company made a profit, this account has a credit balance, so you need to add a debit entry to zero out the balance. If there was a loss, an opposite closing entry is recorded. The Income Summary is used to accumulate the balances and maintain the accounting balance. There might be several sources of revenue and the accounts might be called something else, say something like sales, earnings, etc.
  • Step 3 Next, you need to look for all the expenses. Typically, you would have at least several of those, and the bigger the entity is, the more accounts you have to close. Unlike with the previous account, the closing entries would entail a credit entry to each expense for the amount the same as the final balance on that account and a debit to the aforementioned Income Summary. You can make separate entries for each expense or create one journal entry like the one presented below, debiting the total balance to the Income Summary.
  • Step 4Now, you need to find the final balance amount recorded in the Income Summary. You credit the difference to the RE. If the particular entity did not manage to make a profit, opposite closing entries are added to the books.
  • Step 5Finally, you get the balance of the Dividends down to zero. If the business is not publicly traded, this would be the Owner’s Withdrawals account. The bookkeeping entry for this is presented below.

Special considerations

The process we have described above is often simplified. Some companies choose a more timesaving method and simply credit the Revenue balance to the RE (given it was a profitable year). The expenses are also debited to the RE, skipping the temporary helping account altogether. No matter which method you choose to go with, the result is not any different, so new entries can be made as soon as the closing process is completed.

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