Closing entries are journal entries made at the end of an accounting period which transfer the balances of temporary accounts to permanent accounts. Closing entries are based on the account balances in an adjusted trial balance.
Temporary accounts include:
- Revenue, Income and Gain Accounts
- Expense and Loss Accounts
- Dividend, Drawings or Withdrawals Accounts
- Income Summary Account
The permanent account to which balances are transferred depend upon the type of business. In case of a company, retained earnings account, and in case of a firm or a sole proprietorship, owner's capital account receives the balances of temporary accounts.
Income summary account is a temporary account which facilitates the closing process.
Closing entries are better explained via an example.
The following example shows the closing entries based on the adjusted trial balance of Company A.
|1||Jan 31||Service Revenue||85,600|
|2||Jan 31||Income Summary||77,364|
|3||Jan 31||Income Summary||8,236|
|4||Jan 31||Retained Earnings||5,000|
- Service revenue account is debited and its balance it credited to income summary account. If a business has other income accounts, for example gain on sale account, then the debit side of the first closing entry will also include the gain on sale account and the income summary account will be credited for the sum of all income accounts.
- Each expense account is credited and the income summary is debited for the sum of the balances of expense accounts. This will reduce the balance in income summary account.
- Income summary account is debited and retained earnings account is credited for the an amount equal to the excess of service revenue over total expenses i.e. the net balance in income summary account after posting the first two closing entries. In this case $85,600 − $77,364 = $8,236. Please note that, if the balance in income summary account is negative at this stage, this closing entry will be opposite i.e. debit to retained earnings and credit to income summary.
- The last closing entry transfers the dividend or withdrawal account balance to the retained earnings account. Since dividend and withdrawal accounts are contra to the retained earnings account, they reduce the balance in the retained earnings.
Written by Irfanullah Jan