Closing Entries as Part of the Accounting Cycle

The closing entries process is done at the end of the accounting cycle as a set of journal entries. The purpose of the closing entries is to transfer the balances of these temporary accounts to the permanent entries in the company’s financial statements. The balances of the temporary accounts are reset to zero, in preparation for the start of the next accounting period.

Purpose of Closing Entries

The term “clearing” is commonly used to refer to the closing entries of the company’s accounts. Accountants make closing entries to reset the balances of the temporary accounts for revenues and expenses and withdrawals to zero in preparation for the new accounting period.

Closing entries are also recorded so that last year’s profits account shows the actual increase in revenues and displays any decreases from dividends and expenses payments.

Last year’s earnings refer to those earnings that have not been distributed to shareholders as dividends but have been retained for future investments, often in advertising, sales, production, and equipment.

Temporary Summary Account

The temporary summary account acts as a temporary account used only during the closing process. It contains all of the company’s revenues and expenses for the current accounting period. In other words, it contains the net income or the figure that remains after deducting all operating expenses, depreciation, debt service expenses, and taxes. The temporary summary account is not factored into the financial statements because its sole purpose is for use during the closing process.

Four Steps to Complete Closing Entries

The closing entries are completed using the following steps:

1. Identify the revenue accounts in the trial balance, which contains all revenue and capital accounts in the company’s ledger. You will see that it has a debit balance. To reset them to zero, you must make a debit entry for each revenue account to transfer the balance to the temporary summary account.
2. Identify the expense accounts in the trial balance. You will see that it has a credit balance. Make a credit entry for each expense account to transfer the total expense account balance to the temporary summary account to reset the expense account balance to zero.
3. If the temporary summary account has a debit balance after completing the entries, or if the amounts of the credit entries exceed the debit amounts, then the company has net income. If the debit balance exceeds the credit amounts, then the company has a net loss.
4. Now, the temporary summary account should be closed to the last year’s profits account. Make a debit entry to the temporary summary account and a credit entry to the last year’s profits account.
5. The final step involves closing the dividends account to the last year’s profits account. The dividends account naturally has a debit balance. Add a credit to the dividends account and a debit to the last year’s profits account. The last year’s profits account now reflects the appropriate amount of net income attributed to it.

For most companies, the accounting cycle for the current time period is completed with this step.

Closing Entries Shortcuts and Software Processing

The four-step method outlined above works well because it provides a clear audit trail. For small businesses, it may make sense to skip the temporary summary account and instead close the temporary entries directly to the last year’s profits account.

The end result is equally accurate, as the temporary accounts are closed to the last year’s profits account to present it in the company’s financial statements.

In some cases, accounting software may automatically handle the transfer of balances to the temporary summary account as soon as the user closes the accounting period. The entries happen “behind the scenes,” and the temporary summary account often does not appear in the chart of accounts or other transaction records.

Frequently Asked Questions

What are closing entries?

Closing entries are entries made at the end of the accounting cycle to transfer the balances of temporary accounts to the permanent entries in your company’s financial statements.

What are the four closing entries in order?

The four closing entries are, in general, revenue accounts to the temporary summary account, expense accounts to the temporary summary account, the temporary summary account to last year’s profits, and dividend accounts to last year’s profits.

Source:

https://www.thebalancemoney.com/closing-entries-as-part-of-the-accounting-cycle-393003