Closing Entry Definition, Explanation, and Examples

Afterwards, withdrawal or dividend accounts are also closed to the capital account. When dividends are declared by corporations, they are usually recorded by debiting Dividends Payable and crediting Retained Earnings. Note that by doing this, it is already deducted from Retained Earnings (a capital account), hence will not require a closing entry. To close the drawing account to the capital account, we credit the drawing account and debit the capital account. All of Paul’s revenue or income accounts are debited and credited to the income summary account.

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2. This is no different from what will happen to a company at the end of an accounting period.
3. 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.
4. We see from the adjusted trial balance that our revenue account has a credit balance.

The Second Step of Closing Entries is closing the Expense Account. To complete the Expense account, you must credit all the Accounts and debit the Income Summary account once again. Doing this would bring the balances of the Expenses Account to zero. However, the hard part of Closing Entries is remembering and knowing which accounts to close and how you complete them. That’s why most business owners avoid the struggle by investing in cloud accounting software instead. Lastly, if we’re dealing with a company that distributes dividends, we have to transfer these dividends directly to retained earnings.

Introduction: The Accounting Cycle

The information needed to prepare closing entries comes from the adjusted trial balance. You might be asking yourself, “is the Income Summary account even necessary? ” Could we just close out revenues and expenses directly into retained earnings and not have this extra temporary account? We could do this, but by having the Income Summary account, you get a balance for net income a second time. This gives you the balance to compare to the income statement, and allows you to double check that all income statement accounts are closed and have correct amounts. If you put the revenues and expenses directly into retained earnings, you will not see that check figure.

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. 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.

Purpose of Closing Entries

Instead, declaring and paying dividends is a method utilized by corporations to return part of the profits generated by the company to the owners of the company—in this case, its shareholders. The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting the entries to the ledger. Now for this step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited it in step 2 for $8,790. Remember that all revenue, sales, income, and gain accounts are closed in this entry. If the Post-Closing Trial Balance is not balanced and the Pre-Closing Trial Balance is balanced, then there were errors in the Closing Entry Process.

Practice Questions: Types of Accounts

These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. Closing your accounting books consists of making closing entries to transfer temporary account balances into the business’ permanent accounts. Your closing journal entries serve as a way to zero out temporary accounts such as revenue and expenses, ensuring that you begin each new accounting period properly. The purpose of closing entries is to prepare the temporary accounts for the next accounting period. The income summary is used to transfer the balances of temporary accounts to retained earnings, which is a permanent account on the balance sheet. Whether you’re posting entries manually or using accounting software, all revenue and expenses for each accounting period are stored in temporary accounts such as revenue and expenses.

In other words, they represent the long-standing finances of your business. That’s exactly what we will be answering in this guide –  along with the basics of properly creating closing entries for your small closing entries example business accounting. If your expenses for December had exceeded your revenue, you would have a net loss. When closing expenses, you should list them individually as they appear in the trial balance.