4.7: Closing Entries

Let’s review our accounting cycle again. We have completed the first two columns and now we have the final column which represents the closing (or archive) process.

Accounting Cycle
1. Analyze Transactions	5. Prepare Adjusting Journal Entries	9. Prepare Closing Entries
2. Prepare Journal Entries	6. Post Adjusting Journal Entries	10. Post Closing Entries
3. Post journal Entries	7. Prepare Adjusted Trial Balance	11. Prepare Post-Closing Trial Balance
4. Prepare Unadjusted Trial Balance	8. Prepare Financial Statements

Accounts are two different groups:

• Permanent – balance sheet accounts including assets, liabilities, and most equity accounts. These account balances roll over into the next period. So, the ending balance of this period will be the beginning balance for next period.
• Temporary – revenues, expenses, dividends (or withdrawals) account. These account balances do not roll over into the next period after closing. The closing process reduces revenue, expense, and dividends account balances (temporary accounts) to zero so they are ready to receive data for the next accounting period.

Accountants may perform the closing process monthly or annually. The closing entries are the journal entry form of the Statement of Retained Earnings. The goal is to make the posted balance of the retained earnings account match what we reported on the statement of retained earnings and start the next period with a zero balance for all temporary accounts.

Remember how at the beginning of the course we learned that net income is added to equity. This is the process to make that happen!

The following video summarizes how to prepare closing entries.

 

In accounting, we often refer to the process of closing as closing the books. Only revenue, expense, and dividend accounts are closed—not asset, liability, Common Stock, or Retained Earnings accounts. The four basic steps in the closing process are:

• Closing the revenue accounts—transferring the credit balances in the revenue accounts to a clearing account called Income Summary.
• Closing the expense accounts—transferring the debit balances in the expense accounts to a clearing account called Income Summary.
• Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account.
• Closing the Dividends account—transferring the debit balance of the Dividends account to the Retained Earnings account.

Let’s review what we know about these accounts:

	Increase with	Decrease with
Revenue	Credit	Debit
Expense	Debit	Credit
Dividends	Debit	Credit

If we want to make the account balance zero, we will decrease the account. We use a new temporary closing account called income summary to store the closing items until we get close income summary into Retained Earnings. To close means to make the balance zero. We will look at the following information for MicroTrain from the adjusted trial balance:

	Debit	Credit
Retained Earnings		$ 6,100
Service Revenue		36,500
Interest Revenue		600
Salaries Expense	18,360
Rent Expense	1,200
Utilities Expense	500
Insurance Expense	200
Supplies Expense	7,000
Depreciation Expense	750

Notice how the retained earnings balance is $6,100? On the statement of retained earnings, we reported the ending balance of retained earnings to be $15,190. We need to do the closing entries to make them match and zero out the temporary accounts.

Step 1: Close Revenue accounts

Close means to make the balance zero. We see from the adjusted trial balance that our revenue accounts have a credit balance. To make them zero we want to decrease the balance or do the opposite. We will debit the revenue accounts and credit the Income Summary account. The credit to income summary should equal the total revenue from the income statement.

	Debit	Credit
Service Revenue	36,500
Interest Revenue	600
Income Summary		37,100

Step 2: Close Expense accounts

The expense accounts have debit balances so to get rid of their balances we will do the opposite or credit the accounts. Just like in step 1, we will use Income Summary as the offset account but this time we will debit income summary. The total debit to income summary should match total expenses from the income statement.

	Debit	Credit
Income Summary	28,010
Salaries Expense		18,360
Rent Expense		1,200
Utilities Expense		500
Insurance Expense		200
Supplies Expense		7,000
Depreciation Expense		750

Step 3: Close Income Summary account

At this point, you have closed the revenue and expense accounts into income summary. The balance in income summary now represents $37,100 credit – $28,010 debit or $9,090 credit balance…does that number seem familiar? It should — income summary should match net income from the income statement. We want to remove this credit balance by debiting income summary. What did we do with net income? We added it to retained earnings in the statement of retained earnings. How do we increase an equity account in a journal entry? We credit!

	Debit	Credit
Income Summary (37,100 – 28,010)	9,090
Retained Earnings		9,090

If expenses were greater than revenue, we would have net loss. A net loss would decrease retained earnings so we would do the opposite in this journal entry by debiting Retained Earnings and crediting Income Summary.

Step 4: Close Dividends (or withdrawals) account

After we add net income (or subtract net loss) on the statement of retained earnings, what do we do next? We subtract any dividends to get the ending retained earnings. This will be the journal entry form of doing this calculation but be careful because you do not want to use the amount of retained earnings but DIVIDENDS. We want to decrease retained earnings (debit) and remove the balance in dividends (credit) for the amount of the dividends. MicroTrain did not pay dividends this year but the entry would appear as:

	Debit	Credit
Retained Earnings	Div Amt
Dividends		Div Amt

Div Amt means we will use the DIVIDEND amount and not the balance in retained earnings.

Anytime we complete journal entries, we always need to post to the same ledger cards or T-accounts we have been using all along. When we post, we do not change anything from the journal entries — we debit (left side) where we did in the entries and credit (right side) wherever we did in the entries. The ledger card for income summary and retained earnings would look like this:

Account: Income Summary	Debit	Credit	Balance
(1) Close Revenues		37,100	37,100
(2) Close Expenses	28,010		9,090
(3) Close Income Summary	9,090		0

Account: Retained Earnings	Debit	Credit	Balance
Beginning Balance			6,100
(3) Close Income Summary		9,090	15,190
(4) Close Dividends	0		15,190

The balance in dividends, revenues and expenses would all be zero leaving only the permanent accounts for a post closing trial balance. The trial balance shows the ending balances of all asset, liability and equity accounts remaining. The main change from an adjusted trial balance is revenues, expenses, and dividends are all zero and their balances have been rolled into retained earnings. We do not need to show accounts with zero balances on the trial balances.

MicroTrain’s post closing trial balance would be:

	Debit	Credit
Cash	10,000
Accounts Receivable	25,000
Interest Receivable	600
Supplies	1,500
Prepaid Insurance	2,200
Trucks	40,000
Accum. Depreciation-Trucks		750
Accounts Payable		25,000
Unearned Revenue		3,000
Salaries Payable		360
Common Stock		35,000
Retained Earnings		15,190
TOTALS	79,300	79,300

Notice how only the balance in retained earnings has changed and it now matches what was reported as ending retained earnings in the statement of retained earnings and the balance sheet.

Congratulations! You made it through the complete accounting cycle.

CC licensed content, Shared previously

• Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project . License: CC BY: Attribution

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• How to Prepare Closing Entries (Financial Accounting Tutorial #27). Authored by: NotePirate. Located at: https://youtu.be/4H_ImqWR5f4?list=PL_PmoCeUoNMIX3zP2yYSAq8gi6irBVh-1. License: All Rights Reserved. License Terms: Standard Youtube License