Finalizing the Accounting Process: Closing Entries

The purpose of closing entries in the accounting process with specific examples
illustrating how to prepare closing entries.
Several steps have been taken during the accounting period to arrive at a point where
closing entries are necessary. Usually these steps occur in the following order:
Analyzing and recording business transactions
Posting business transaction amounts to the ledger
Preparation of an unadjusted trial balance
Preparing, recording, and posting adjusting entries to the ledger
After posting adjusting entries an adjusted trial balance is prepared
The adjusted trial balance data may be used to prepare financial statements
Recording closing entries in the ledger
Preparing a post-closing trial balance
The Purpose of Closing Entries
A business chart of accounts may be divided into two categories: permanent and
temporary
Permanent accounts are all balance sheet accounts and their balances are continually
carried forward from year to year. Examples of these accounts would be assets such as
cash, accounts receivable, and equipment; liabilities such as accounts payable; and owners
capital which represents the difference between the total assets and total liabilities.
Temporary accounts are non-balance sheet accounts usually found on the income
statement. Examples of these would be revenues and expenses. The owners drawing
account, while not an income statement item, is also a temporary account. Temporary
accounts balances are not carried forward from year to year but must be closed (leaving a
zero balance) as part of the year-end accounting process.
How to Prepare Closing Entries
This process is relatively easy to master once the accounts to be closed are identified
and a separate temporary account termed income summary is created. All expense and
revenue accounts are closed into the income summary account. Drawing is closed into the
owners capital account. This process may be broken down into steps:
1. Close all revenue accounts. Since a revenue account has a normal credit balance,
each revenue account must be debited for that balance (leaving a zero balance in the
account), and the income summary is credited for that amount.
2. Close all expense accounts. Since an expense account has a normal debit balance,
each expense account must be credited for that balance (leaving a zero balance in
each expense account), and the income summary is debited for each amount.
3. Close the owners drawing account. This is achieved by crediting the drawing
account for the same amount as its debit balance and then debiting the owners
capital account for the same amount.
4. Close the income summary account: If the income summary account has a credit
balance after closing all revenue and expense accounts (which represents net
income), it must be debited for its credit balance (giving it a zero balance) and the
owners capital account is credited for the same amount.
5. If the income summary ends up with a debit balance (net loss) then the opposite of
the above is done (credit the income summary account and debit the owners capital
account).

Closing entries effectively move all revenue and expense balances into one individual
account: the income summary. The final balance of the income summary represents the
business net income (if a credit balance) or a net loss (if a debit balance). This account
may also be used to prepare the income statement since all revenue and expense final
balances are itemized in this account. Now that all revenue and expense accounts have zero
balances a new accounting cycle may begin.
Source: Warren et. al. Financial Accounting. South-Western 2009.


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