Closing Entries

  • Identify permanent and temporary accounts
  • Prepare closing entries

 

Types of Accounts

Remember the income statement is like a moving picture of a business, reporting revenues and expenses for a period of time (usually a year). 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. We call those permanent accounts.

  • Permanent accounts: balance sheet accounts including assets, liabilities, and equity accounts (except for withdrawals). These account balances roll over into the next period. The ending balance of this period will be the beginning balance for next period.
  • Temporary accounts: revenues, expenses, and withdrawals accounts. These account balances do not roll over into the next period after closing. The closing process reduces revenue, expense, and withdrawals account balances (temporary accounts) to zero so they are ready to accumulate data for the next accounting period.

Now you know a bit about permanent and temporary accounts. Let’s move on to learn about how to record closing those temporary accounts.

Preparing a Closing Entry

Step 8. Prepare Closing EntriesAs we previously discussed, some computerized accounting systems, such as QuickBooks™ don’t actually create or post closing entries, but within the system, when you run a report, the software treats the accounts as if they were closed at the end of all the prior periods. Other accounting software, such as Oracle’s PeopleSoft™, post closing entries to a special accounting period that keeps them separate from all of the other entries. So, even though the process today is slightly (or completely) different than it was in the days of manual paper systems, the basic process is still important to understand.

We won’t be using NeatNiks as an example of closing entries for two reasons:

  1. It’s not the end of the year for NeatNiks, just the end of a month, and
  2. NeatNiks is probably going to switch to a computerized system before the end of the year anyway, such as Quickbooks, and that particular system (which is representative of most of the others) doesn’t actually 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. Also, there are only a handful of transactions each year.

Notice that in the beginning, everything is zero. Then our business owner makes a deposit and things get rolling. By the end of 2019, there is only one asset, which is the $14,800 in our checking account that includes $5,000 in debt to the bank, so equity is $9,800 ([latex]\text{A}-\text{L}=\text{E}[/latex]). Revenues for the year were $10,500 and expenses were $500, so net income was $10,000. The owner put in $1,000 at the beginning of the year and took out $1,200 on December 31, leaving equity of $9,800.

Checking account Liabilities Equity Owner Withdrawals Annual Revenue Annual Expense
1/1/19 – = – – – –
2/5/19 1,000 = – 1,000 – –
3/25/19 2,000 = 2,000
5/18/19 (500) = (500)
6/19/19 5,000 = 5,000
9/2/19 8,500 8,500
12/31/19 (1,200) = (1,200)
End of year 14,800 = 5,000 1,000 (1,200) 10,500 (500)
Closing entries 8,800 1,200 (10,500) 500
1/1/20 14,800 = 5,000 9,800 – – –
5/18/20 5,000 = – 5,000 –
6/30/20 2,000 = 2,000
9/20/20 (4,700) = (4,700)
10/31/20 (5,000) = (5,000)
11/4/20 6,100 6,100
12/31/20 (7,400) = (7,400)
End of year 10,800 = – 9,800 (7,400) 13,100 (4,700)
Closing entries 1,000 7,400 (13,100) 4,700
1/1/21 10,800 = – 10,800 – – –

In accounting, we often refer to the process of closing as closing the books. The four basic steps in the closing process are:

  1. Closing the revenue accounts: transferring the credit balances in the revenue accounts to a clearing account called Income Summary.
  2. Closing the expense accounts: transferring the debit balances in the expense accounts to a clearing account called Income Summary.
  3. Closing the Income Summary account: transferring the balance of the Income Summary account to the owner’s capital account.
  4. Closing the withdrawal account: transferring the debit balance of the owner withdrawal account to the capital account.

Let’s look at this process for MacroAuto’s 2020 information using T accounts that will stand in for the full ledgers. Notice that the 2019 ending balances carry forward to become 2020 beginning balances and that we start fresh in the revenue, expense, and withdrawal accounts (because we closed the books on 12/31/2019):

MacroAuto

General Ledger (represented by T accounts)

As of 12/31/2020

Permanent Accounts                                                                           Temporary Accounts

Two T accounts side by side. On the left is a checking account. On the debit side, there's a balance carried forward on January 1st of 14,800 dollars. On May 18th, there is a debit entry of 5,000 dollars. On June 30th, there is a debit entry of 2,000 dollars. On November 4th, there is a debit entry of 6,100 dollars. On the credit side, there is an entry of 4,700 dollars on September 20th. On October 31st, there is a credit entry of 5,000 dollars. On December 31st, there is a credit entry of 7,400 dollars. There is a total debit balance on December 31st of 10,800 dollars. On the right side is a Service Revenue chart. There is a balance carried forward of 0 dollars on January 1st. There's a credit entry of 5,000 dollars. On June 30th, there is a credit entry of 2,000 dollars. On November 4th, there is a credit entry of 6,100 dollars. On December 31st, there is a total credit balance of 13,100 dollars.

Two T accounts side by side. On the left side is a Due To Bank account. It has a credit balance carried forward on January 1st of 5,000 dollars. On October 31st, there is a debit entry of 5,000 dollars. On December 31st, the total balance is 0. On the right side is a Wage Expense account. It has a debit balance carried forward on January 1st of 0 dollars. On September 20th, there is a debit entry of 4,700 dollars. On December 31st, there is a total debit balance of 4,700 dollars.

Two T accounts next to each other. On the left is the Owner's Capital account. It has a credit balance carried forward on January 1st of 9,800 dollars. There is a total credit balance on December 31st of 9,800 dollars. On the right side is the Owner's Withdrawals account. On January 1st, it has a debit balance carried forward of 0 dollars. On December 31st, it has a debit entry of 7,400 dollars, which is also the total debit balance on December 31st.

Before we do closing entries, let’s run an adjusted trial balance:

Adjusted trial balance as of 12/31/2020. Permanent Accounts: Checking debit of 10,800, Due to Bank no value in debit or credit field, Owner's Capital credit 9,800. Temporary Accounts: Owner Withdrawals debit 7,400, Service Revenue credit 13,100, Wages Expense debit 4,700. Final entry in debit column is 22,900 with a double underline underneath and final entry in credit column is 22,900 with a double underline underneath.

From this trial balance, as we learned in the prior section, you make your financial statements. After the financial statements are finalized and you are 100 percent sure that all the adjustments are posted and everything is in balance, you create and post the closing entries. The closing entries are the last journal entries that get posted to the ledger.

Below are the T accounts with the journal entries already posted.

Permanent Accounts                                                                           Temporary Accounts

Two side-by-side T accounts. On the left is the Checking account. There is a debit balance carried forward on January 1st of 14,800 dollars. On May 18th, there is a debit entry of 5,000 dollars. There is a debit entry on June 30th for 2,000 dollars. On September 20th, there's a credit entry for 4,700 dollars and on October 31st, there is a credit entry for 5,000 dollars. There's a debit entry for 6,100 dollars on November 11th. On December 31st, there is a credit entry for 7,400 dollars. There is a total debit balance on December 31st of 10,800 dollars. On the right side is the Service Revenue account. It has a credit balance carried forward of 0 dollars. On May 18th, there is a credit entry of 5,000 dollars. There's a credit entry for 2,000 dollars on June 30th. On November 4th, there is a credit entry of 6,100 dollars. On December 31st, there is a total credit balance of 13,100. On the debit side is closing entry A, which is 13,100 dollars, leaving a total balance on December 31st of 0 dollars.

Two T accounts next to each other. On the left is the Due to Bank account, with a credit balance carried forward on January 1st of 5,000 dollars. On October 31st, there is a debit entry of 5,000 dollars. There is a total balance of 0 dollars on December 31st. On the right side is the Wage Expense Account. It has a balance carried forward on January 1st of 0 dollars. On September 20th, there is a debit entry for 4,700 dollars. There is a total debit balance of 4,700 dollars. On the credit side is closing entry B of 4,700 dollars. On December 31st, there is a total balance of 0 dollars.

Two T accounts side-by-side. On the left is the Owner's Capital account. On January 1st, it has a credit balance carried forward of 9,800 dollars. There is a total credit balance of 9,800 dollars on December 31st before closing entries. Closing entry C is on the credit side, with a value of 8,400 dollars. Closing entry D is on the debit side and has a value of 7,400 dollars. The total credit balance on December 31st after closing entries is 10,800 dollars. On the right side is the Owner Withdrawals account. It has a balance carried forward on January 1st of 0 dollars. On December 31st, there is a debit entry of 7,400 dollars. There is a debit total of 7,400 dollars before closing entries. Closing entry D is on the credit side and has a value of 7,400 dollars. There is a total balance on December 31st of 0 dollars.

A T account of an Income Summary. On the debit side is closing entry B, with a value of 4,700 dollars, as well as closing entry C, with a value of 8,400 dollars. On the credit side is closing entry A, with a value of 13,100 dollars.

Let’s go through these closing entries step by step.

Step 1: Close Revenue accounts

To close an account means to make the balance zero. 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. We’ll call this closing entry A, just to keep track of it.

Journal
Date Description Post. Ref. Debit Credit
2020
Dec 31 Service Revenue 13,100
Dec 31       Income Summary 13,100

Step 2: Close Expense accounts

The expense accounts have debit balances. To get rid of their balances, we will do the opposite or credit the accounts. Just as in step one, we will use Income Summary as the offset account, but this time we will debit income summary. The total debit to income summary should match total expenses from the income statement. In this case, we just have one expense account. We’ll label this “closing entry B.”

Journal
Date Description Post. Ref. Debit Credit
2020
Dec 31 Income Summary 4,700
Dec 31       Wage Expense 4,700

Step 3: Close Income Summary account

At this point, you have closed the revenue and expense accounts into income summary. The balance in the income summary account would now be an $8,400 credit ($13,100 debit minus $4,700 credit) and income summary should now match net income from the income statement. We want to remove this credit balance by debiting income summary. What did we do with net income on the statement of owner’s equity? We added it to the capital account. We’re now making a journal entry to do this in the books. We’ll call this “closing entry C.”

Journal
Date Description Post. Ref. Debit Credit
2020
Dec 31 Income Summary 8,400
Dec 31       Owner’s Capital   8,400

If expenses were greater than revenue, we would have net loss. A net loss would decrease owner’s capital, so we would do the opposite in this journal entry by debiting the capital account and crediting Income Summary.

Step 4: Close withdrawals account

After we move the balances in the revenue and expense accounts (net income or loss) to owner’s equity, we close the withdrawal account as well (closing entry D):

Journal
Date Description Post. Ref. Debit Credit
2020
Dec 31 Owner’s Capital 7,400
Dec 31       Owner Withdrawals 7,400

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.

Here’s a summary of this section:You can view the transcript for “How to Prepare Closing Entries (Financial Accounting Tutorial #27)” here (opens in new window).

 

The next and final step in the accounting cycle is to prepare one last post-closing trial balance. But first, check your understanding of this process.