Which accounts are closed at the end of an accounting period?

There are two main types of accounts in accounting- temporary and permanent.

Temporary accounts, also called nominal accounts, record transactions for only a single accounting period, such as one year. All income statement accounts, which show a company’s revenues and expenses, are temporary. These include:

• Revenue accounts like sales, service revenue, interest income, etc.
• Expense accounts like rent, salaries, utilities, advertising, depreciation, etc.

The balances in temporary accounts are zeroed out at the end of each accounting period by transferring them to the income summary account and then to the retained earnings account. This is called “closing the books.”

Why temporary accounts are closed each period

Temporary accounts are zeroed out at the end of each accounting period for a few key reasons:

1. It allows a company to calculate its net income or net loss for that specific period by subtracting total expenses from total revenues. The net income is then transferred to the retained earnings account on the balance sheet.
2. Resetting the temporary accounts to zero lets a company start fresh in the new accounting period, making it easier to compare performance across periods.
3. Closing temporary accounts reduces the chance of errors being carried over from period to period in the income statement accounts.

On the other hand, permanent accounts track activities spanning multiple accounting periods. Their balances carry over from period to period. These accounts are reported on the balance sheet and include:

• Asset accounts like cash, accounts receivable, inventory, fixed assets
• Liability accounts like accounts payable, loans payable, unearned revenue
• Equity accounts like common stock retained earnings

The balances in permanent accounts are not closed at the end of an accounting period. Instead, they keep accumulating until transactions are made to increase or decrease their balances.

The accounting cycle and closing entries

Closing temporary accounts is part of the accounting cycle, which involves recording and analyzing a company’s financial transactions.

Steps in the accounting cycle

The main steps in the accounting cycle are:

1. Transactions are recorded in the books
2. Journal entries are posted to the general ledger
3. A trial balance is prepared to check debits and credits
4. Adjusting entries are made for accruals and deferrals
5. An adjusted trial balance is prepared
6. Financial statements are created
7. Closing entries are made to zero out temporary accounts
8. A post-closing trial balance is prepared

Closing entries are made after the financial statements are prepared before the post-closing trial balance. They are a crucial last step in the accounting cycle.

The four closing entries

There are four main types of closing entries:

1. Closing revenue accounts to income summary
   • Credits all revenue accounts and debits the income summary account
2. Closing expense accounts to income summary
   • Debits all expense accounts and credits the income summary account
3. Closing income summary to retained earnings
   • Credits income summary and debits retained earnings for a net income
   • Debits income summary and credits retained earnings for a net loss
4. Closing dividends to retained earnings
   • Credits the dividends account and debits retained earnings

After these closing entries are made, all temporary accounts will have a zero balance and be ready to start the next accounting period. The net income or loss from the income summary account is absorbed into the retained earnings account, a permanent account on the balance sheet.

Temporary accounts after closing entries

After the closing process, all revenue and expense accounts will have a zero balance. If a company had $100,000 in revenues and $70,000 in expenses, its income statement might look like this before closing:

Revenues       $100,000
Expenses            $70,000  
Net Income          $30,000

After closing entries, the income statement accounts would look like this:

Revenues            $0
Expenses                 $0
Income Summary           $0

The $30,000 net income gets transferred to the retained earnings account on the balance sheet. The income summary account is also set back to zero, as it is a temporary clearing account used only in the closing process.

Importance of closing temporary accounts

There are several reasons why it’s important to close temporary accounts at the end of each accounting period:

1. To provide an accurate picture of a company’s financial performance for that specific period. Starting with a “clean slate” each period, the income statement will only reflect that period’s revenues and expenses.
2. This will make it easier to compare a company’s performance over time. With closed accounts, you can look at a company’s income statements from various periods and see how their revenues, expenses, and profits have changed.
3. To update the retained earnings account on the balance sheet. Net income flows into retained earnings, part of a company’s equity. Closing entries ensure that the balance sheet and income statement are articulate.
4. To catch errors before they are carried over to the next period. Making closing entries can reveal any discrepancies or adjustments that need to be made.
5. To fulfill the matching principle of accrual accounting. This principle states that expenses should be recorded in the same period as the revenues they helped generate, regardless of when cash was exchanged. Closing the books resets everything for the new period.

Temporary accounts and financial statements

A company’s financial statements reflect the closing out of temporary accounts at the end of the period.

The income statement, which reports revenues, expenses, and profits for a specific period, will start with zero balances in all accounts in the new reporting period. The previous period’s net income or loss will not be included.

However, the retained earnings statement, which acts as a bridge between the income statement and the balance sheet, will start with the ending balance from the previous period. The current period’s net income from the income statement is closed to the retained earnings account and becomes the period’s opening balance.

The closing process doesn’t affect the balance sheet’s assets, liquidity, and most equity accounts. Those are permanent accounts that carry over their balances from period to period. Retained earnings are the only equity account that receives a closing entry.