What is a Closing Entry?
Financial records don’t just “end” when the fiscal year does. Companies often have a variety of accounts still open and active. To “close the books” on the period and establish the baseline for the next one, companies need to close active accounts using a closing entry.
A closing entry is a journal entry made at the end of an accounting period to zero-out temporary accounts and shift their balances to permanent accounts. These temporary accounts can be revenue, expenses and dividends—all of which can be closed out at the end of the fiscal year. The process of closing these accounts is relatively simple, yet takes extremely close attention to detail and due process to ensure financial transparency and accounting accuracy.
Here’s what it means to record closing entries and how to close the books at the end of a financial period.
What Does “Closing the Books” Mean?
Closing the books involves moving balances from outstanding accounts to permanent accounts, to establish “fresh” books for the new period. Effectively, it zeroes accounts so the company begins the next period with no balances. In doing so, the company updates the balance sheet.
Closing the books is an essential part of compliance with Generally Accepted Accounting Principles (GAAP). It follows double entry accounting practices to ensure the company accounts for transactions in the period in which they occurred. Closing the books is an important step in the preparation of financial statements, such as IRS Form 10-K.
It’s important to realize that companies close their books at different times. A fiscal accounting period is a consecutive 12-month stretch, and companies need to close their books at the same time each year to maintain the integrity of reporting. For example, the United States Federal Government runs a fiscal year that starts October 1 and ends September 30.
Temporary vs. Permanent Accounts
Businesses have many different types of accounts on their books: some short-term, others long-term. Temporary accounts typically represent current assets and liabilities, which means they’re closed within the fiscal period. This is in contrast to permanent accounts, which represent ongoing, long-term assets and liabilities.
Also called “real accounts,” permanent accounts have continuity through periods and can stay open for as long as dictated by their nature. These can include inventory, owners’ equity and loans, for example. Permanent accounts live on the balance sheet, which is why there’s no need to close them at the end of the fiscal period.
Types of Temporary Accounts
Temporary accounts close at the end of the fiscal year to properly segment periods. There are three types of temporary accounts:
- Revenues. How much the company earns in a given year.
- Expenses. How much it costs to keep the company operation in a given year.
- Dividends. How much the company distributes to shareholders in a given year.
Consider the ramifications of not closing a temporary account. If ABC Company earns $100,000 in revenue in 2018, $20,000 in 2019 and $5,000 in 2020 without closing its revenue account, it would show $125,000 in revenue for 2021, despite three-year declines. It paints an incorrect picture of the business. Thus, temporary accounts close each fiscal year to “reset” the books, for a more accurate view of the business.
The Process for Closing Accounts
Recording closing entries is a matter of debiting and crediting temporary accounts, to move balances over to the income summary and then the balance sheet. The process for closing the books for a public company is as follows:
- First, close revenue accounts by debiting revenue and crediting income summaries.
- Next, close expense accounts by debiting income summaries and crediting expenses.
- Close income summary by debiting income summary and crediting retained earnings.
- Close dividends by debiting retained earnings and crediting dividends.
What happens if a company isn’t profitable for the period? In the event of a loss, the company would credit the income summary and debit retained earnings.
Each closing entry is important because it a) follows the double entry accounting standard and b) creates a clear and specific paper trail. Independent auditors can follow these accounts to the balance sheet and account for them accordingly. Above all else, debits and credits need to be identical.
Why is the Income Summary Account Important?
In recording closing entries, accountants effectively move revenues and expenses to the income summary. This is an important step in closing the books. The income summary account aggregates temporary accounts (sans dividends) during the closing process and thus isn’t reported on any financial statements. As CPAs complete the closing process, the income summary account balance falls to zero. It’s an intermediary account that facilitates closing entries and helps ensure transparency as they’re debited.
Closing Entries Signal the Period’s End
Every company needs to have a clean end and a fresh beginning as the fiscal year ends. To establish this break means closing the books, and to facilitate that closing, CPAs need to record a closing entry for all temporary accounts. Revenue, expenses and dividends all need to move to the balance sheet, leaving behind a zero balance.
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A closing entry—combined with the income summary account—marks financial transparency for a company using double entry accounting. As a company shores up its books and seeks to maintain GAAP compliance, each closing entry needs meticulous accuracy. This is the benefit of working with a qualified CPA. Done right, it’s the path to a fresh start in a new period.