What are closing entries in accounting? Closing entries are journal entries that reduce the balances of all revenue and expense accounts to zero.
Since income statement accounts are temporary accounts, their balances don’t transfer from one accounting period to another. Instead, they always start each period at a zero balance by debiting revenue and crediting expenses to the income summary account. Think of it as a fresh start!
Once temporary accounts (revenues and expenses) are closed, the income summary account is then closed to owner’s equity or retained earnings. You may generate a post-closing trial balance to test the equality of debits and credits before the start of the next accounting period.
Closing journal entries are a remnant of manual accounting systems and are no longer necessary when using accounting software. The accounting software will automatically accumulate income and expenses according to the accounting period you specify while also making adjustments to the owner’s equity section of the balance sheet. This is the equivalent of closing journal entries with the benefit of not being permanent—you can simply specify a prior accounting period to see the previous income and expense balances.
Closing Temporary Accounts
A temporary account is an account that doesn’t carry over to the next accounting period, which means that we have to close it before starting a new accounting period. Remember that all income statement accounts are temporary accounts, so all closing journal entries will focus on revenue and expense accounts.
Let’s see the pro forma entries for closing temporary accounts.
Debiting Revenues to Income Summary
The normal balance of revenue is credit. When we credit revenue, we increase its balance. During the closing stage, we need to reduce it to zero balance. Hence, we debit revenues and credit a holding account called income summary.
We can also say that the normal balance of income summary is credit.
Why is that? Remember that the goal of every business is to generate profit, so normally, we expect businesses to yield net income every accounting period. Otherwise, there must be a problem if the business is consistently at a loss.
Debiting Expense to Income Summary
Just like revenue, we need to close all expenses. The normal balance of expenses is debit. Debiting expenses means that we increase its balance. During the closing stage, we credit expense accounts to reduce them to zero balance. With that, we also debit the income summary account to balance out the journal entry.
Closing Income Summary
After putting all temporary accounts in the income summary, we need to ultimately close the income summary account to the capital account. Note that the balance of the income summary account should be equal to the current period’s net income. Let’s examine the T-account below.
If the debits in the T-account exceed the credits, then the T-account has a debit balance representing a net loss for the period. If the credits exceed the debits, the T-account has a credit balance representing net income for the period.
Regardless of net income or loss, the income summary account must be closed to retained earnings. The closing journal entries for income summary are the following:
- If it results in net income (income summary has a credit balance)
- If it results in net loss (income summary has a debit balance)
Retained earnings is an equity account unique to corporations. It is the accumulation of undistributed net income of a corporation over the company’s life. Learn more about owner’s equity.
Creating the Post-closing Trial Balance
At the end of the closing process, you may create a post-closing trial balance to test the equality of debits and credits. A post-closing trial balance is also a good accounting report if you want an overview of all balance sheet accounts after closing.
A post-closing trial balance only contains the permanent accounts (assets, liabilities, and equity). To make a post-closing trial balance, all you need to do is gather all non-zero accounts after the closing process and then assemble them in a trial balance format similar to the format below:
If the trial balance doesn’t balance, there must be an arithmetical problem. Review the figures, and recompute them if necessary.
Closing Journal Entries: Comprehensive Example
To illustrate the closing process and closing journal entries, let’s use the trial balance of Petrichor Consulting as of December 29, 2023. The cells highlighted in light yellow are the accounts that we need to close. These are income statement accounts.
First, we close the revenue accounts by making the closing entry below:
Once this entry is posted, the income summary account will have a credit balance of $322,520.
Second, we close the expense accounts by making the closing entry below:
After posting, the net balance of the income summary account is $128,520. The T-account below shows the effect of the journal entries above:
Ultimately, we close the income summary account to the retained earnings account.
The balance of the income summary account is now zero. The post-closing trial balance of Petrichor Consulting is shown below:
Notice that there are no longer income statement accounts present. The updated balance of the owner’s capital is now $510,520 after adding the net income of $128,520.
Frequently Asked Questions (FAQs)
The three major closing journal entries are (1) closing revenues to income summary; (2) closing expenses to income summary; and (3) closing income summary to equity.
They are performed several days before the end of the accounting period.
Bottom Line
Closing journal entries are part of the full accounting cycle and is the second to last step. For manual accounting, closing entries are important. Otherwise, most accounting software makes the closing process easy. With just a few clicks, you can close the accounting books and start with the new accounting period.
