Closing Entry

What Is a Closing Entry?

A closing entry is a journal entry made at the end of accounting periods that involves shifting data from temporary accounts on the income statement to permanent accounts on the balance sheet. Temporary accounts include revenue, expenses, and dividends, and these accounts must be closed at the end of the accounting year.

Understanding Closing Entries

The purpose of the closing entry is to reset the temporary account balances to zero on the general ledger, the record-keeping system for a company's financial data.

Temporary accounts are used to record accounting activity during a specific period. All revenue and expense accounts must end with a zero balance because they are reported in defined periods and are not carried over into the future. For example, $100 in revenue this year does not count as $100 of revenue for next year, even if the company retained the funds for use in the next 12 months.

Permanent accounts, on the other hand, track activities that extend beyond the current accounting period. They are housed on the balance sheet, a section of the financial statements that gives investors an indication of a company’s value, including its assets and liabilities. 

Any account listed on the balance sheet, barring paid dividends, is a permanent account. On the balance sheet, $75 of cash held today is still valued at $75 next year, even if it is not spent.

As part of the closing entry process, the net income (NI) is moved into retained earnings on the balance sheet. The assumption is that all income from the company in one year is held onto for future use. Any funds that are not held onto incur an expense that reduces NI. One such expense that is determined at the end of the year is dividends. The last closing entry reduces the amount retained by the amount paid out to investors.

Income Summary Account

Temporary account balances can either be shifted directly to the retained earnings account or to an intermediate account known as the income summary account beforehand.

Income summary is a holding account used to aggregate all income accounts except for dividend expenses. Income summary is not reported on any financial statements because it is only used during the closing process, and at the end of the closing process the account balance is zero.

Income summary effectively collects NI for the period and distributes the amount to be retained into retained earnings. Balances from temporary accounts are shifted to the income summary account first to leave an audit trail for accountants to follow. 

Recording a Closing Entry

There is an established sequence of journal entries that encompass the entire closing procedure:

1. First, all revenue accounts are transferred to income summary. This is done through a journal entry debiting all revenue accounts and crediting income summary. 
2. Next, the same process is performed for expenses. All expenses are closed out by crediting the expense accounts and debiting income summary.
3. Third, the income summary account is closed and credited to retained earnings.
4. Finally, if a dividend was paid out, the balance is transferred from the dividends account to retained earnings.

Important

Modern accounting software automatically generates closing entries.

Special Considerations

If a company’s revenues are greater than its expenses, the closing entry entails debiting income summary and crediting retained earnings. In the event of a loss for the period, the income summary account needs to be credited and retained earnings reduced through a debit.

Finally, dividends are closed directly to retained earnings. The retained earnings account is reduced by the amount paid out in dividends through a debit, and the dividends expense is credited.