Understanding Closing Entries: A Step-by-Step Guide with Examples

In this guide, we delve into what closing entries are, including examples, the process of journalizing and posting them, and their significance in financial close management. In short, we can clear all temporary accounts to retained earnings with a single closing entry. By debiting the revenue account and crediting the dividend and expense accounts, the balance of $3,450,000 is credited to retained earnings. Only temporary accounts require closing entries because they represent performance measures for a specific timeframe. Without closing entries, these accounts would continuously accumulate balances from period to period, making it impossible to accurately measure performance for each distinct accounting period. For example, if revenue accounts weren’t closed, the business would appear to generate increasingly large revenues each period, providing misleading information about actual performance.

Close all dividend or withdrawal accounts

These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. 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. Permanent accounts, such as asset, liability, and equity accounts, remain unaffected by closing entries. For example, closing an income summary involves transferring its balance to retained earnings.

Start by debiting each revenue account for its total balance, effectively reducing the balance to zero. Then, credit the income summary account with the total revenue amount from all revenue accounts. Once all the adjusting entries are made the temporary accounts reflect the correct entries for revenue, expenses, and dividends for the accounting year.

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• All drawing accounts are closed to the respective capital accounts at the end of the accounting period.
• This step initially closes all revenue accounts to the income summary account, which is further closed to the retained earnings account in step 3 below.
• ‘Total expenses‘ account is credited to record the closing entry for expense accounts.

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• There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again.
• Eventually, after following the above steps, the temporary account balance will be emptied into the balance sheet accounts.
• They reset temporary accounts, enabling accurate tracking of financial performance over time.
• By debiting the revenue account and crediting the dividend and expense accounts, the balance of $3,450,000 is credited to retained earnings.
• On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent.

Take note that closing entries are prepared only for temporary accounts. Once we have made the adjusting entries for the entire accounting year, we have obtained the adjusted trial balance, which reflects an accurate and fair view of the bakery’s financial position. In Wafeq, the closing process is streamlined and secure, allowing financial professionals to maintain full control and audit readiness with minimal effort. Whether you’re a CFO, an external auditor, or a small business accountant, mastering closing entries helps reinforce transparency, discipline, and compliance in your financial reporting. Dividend account is credited to record the closing entry for dividends.

Accounts Payable

In other words, revenue, expense, and withdrawal accounts always have a zero balance at the start of the year because they are always closed at the end of the previous year. Accounts are considered “temporary” when they only accumulate transactions over one single accounting period. Temporary accounts are closed or zero-ed out so that their balances don’t get mixed up with those of the next year.

By implementing automated closing processes, businesses ensure greater accuracy while freeing valuable resources for strategic financial activities. ABC Ltd. earned ₹ 1,00,00,000 from sales revenue over the year 2018 so the revenue account has been credited throughout the year. At the end of the year, it needs to be zeroed out by debiting it and crediting the Income summary account. Thus, the income summary temporarily holds only revenue and expense balances.

Processing

We don’t want the 2015 revenue account to show 2014 revenue numbers. Failing to make a closing entry, or avoiding the closing process altogether, can cause a misreporting of the current period’s retained earnings. It can also create errors and financial mistakes in both the current and upcoming financial reports, of the next accounting period.

And so, the amounts in one accounting period should be closed so that they won’t get mixed with those in the the city of next period. As you will see later, Income Summary is eventually closed to capital. LiveCube Task Automation is designed to automate repetitive tasks, improve efficiency, and facilitate real-time collaboration across teams.

Automating Closing Entries with Accounting Software

For example, in the case of a company permanent accounts are retained earnings account, and in case of a firm or a sole proprietorship, owner’s capital account absorbs the balances of temporary accounts. When making closing entries, the revenue, expense, and dividend account balances are moved to the retained earnings permanent account. If you own a sole proprietorship, you have to close temporary accounts to the owner’s equity instead of retained earnings.

Having an intermediate income summary account proves helpful to the accountant here as it provides a trail of accounting closing entries for each financial transaction. The net income (NI) is moved into retained earnings on the balance sheet as part of the closing entry process. The assumption is that all income from the company in one year is held for future use. One such expense that’s determined at the end of the year is dividends.

To close the drawing account to the capital account, we credit the drawing account and debit the capital account. This is closed by doing the opposite – debit the capital account (decreasing the capital balance) and credit Income Summary. Automation transforms the process of closing entries in accounting, making it more efficient and accurate. By leveraging automated systems, businesses can ensure that all tasks related to closing entries are handled seamlessly, reducing manual effort and minimizing errors. Now, all the temporary accounts have their respective figures allocated, showcasing the revenue the bakery has generated, the expenses it has incurred, and the dividends declared throughout the past year.

All expenses can be closed out by crediting the expense accounts and debiting the income summary. Temporary Accounts entries are only used to record and accumulate the accounting or financial transactions over the accounting year, and they do not reflect the company’s financial performance. Since dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account.

Companies could close each income statement account to the owner’s capital immediately while making closing entries. Companies generally journalize and post-closing entries only at the end of the annual accounting period, in contrast to the steps in the cycle. The $9,000 of expenses generated through the accounting period will be shifted from the income summary to the expense account. In this example, the business will have made $10,000 in revenue over the accounting period. In this example, it is assumed that there is just one expense account.

The accounting monthly close process doesn’’t have to be so painful. Learn about common challenges and see how to overcome them with ease. Download our data sheet to learn how you can manage complex vendor and customer rebates and commission reporting at scale. Download our data sheet to learn how to automate your reconciliations for increased accuracy, speed and control. To better understand how closing entries work in practice, let’s follow a complete example for SmartTech Solutions, a small consulting firm, at the end of their fiscal year on December 31, 2024. Net income is the portion of gross income that’s left over after all expenses have been met.

We can also see that the debit equals credit; hence, it adheres to the accounting principle of double-entry accounting. ‘Total expenses‘ account is credited to record the closing entry for expense accounts. Closing entries are journal entries required to close all nominal or temporary accounts at the end of a financial or accounting period or year.