4.7: The closing process

In Chapter 2, you learned that revenue, expense, and dividends accounts are nominal (temporary) accounts that are merely subclassifications of a real (permanent) account, Retained Earnings. You also learned that we prepare financial statements for certain accounting periods. The closing process transfers (1) the balances in the revenue and expense accounts to a clearing account called Income Summary and then to Retained Earnings and (2) the balance in the Dividends account to the Retained Earnings account. The closing process reduces revenue, expense, and Dividends account balances to zero so they are ready to receive data for the next accounting period. Accountants may perform the closing process monthly or annually.

The Income Summary account is a clearing account used only at the end of an accounting period to summarize revenues and expenses for the period. After transferring all revenue and expense account balances to Income Summary, the balance in the Income Summary account represents the net income or net loss for the period. Closing or transferring the balance in the Income Summary account to the Retained Earnings account results in a zero balance in Income Summary.

Also closed at the end of the accounting period is the Dividends account containing the dividends declared by the board of directors to the stockholders. We close the Dividends account directly to the Retained Earnings account and not to Income Summary because dividends have no effect on income or loss for the period.

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

• Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account called Income Summary.

• Closing the expense accounts—transferring the 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 balance of the Dividends account to the Retained Earnings account.

Revenues appear in the Income Statement credit column of the work sheet. The two revenue accounts in the Income Statement credit column for MicroTrain Company are service revenue of USD 13,200 and interest revenue of USD 600 (Exhibit 20). Because revenue accounts have credit balances, you must debit them for an amount equal to their balance to bring them to a zero balance. When you debit Service Revenue and Interest Revenue, credit Income Summary (Account No. 600). Enter the account numbers in the Posting Reference column when the journal entry has been posted to the ledger. Do this for all other closing journal entries.

MICROTRAIN COMPANY                                                            General Journal                                                        Page 4
Date		Account Titles and Explanation	Post. Ref.	Debit							Credit
2010		Closing Entries
Dec.	31	Service Revenue	400		1	3	2	0	0
		Interest Revenue	418				6	0	0
		Income Summary	600									1	3	8	0	0
		To close the revenue accounts in the Income Statement credit
		column to Income Summary.

After the closing entries have been posted, the Service Revenue and Interest Revenue accounts (in T-account format) of MicroTrain appear as follows. Note that the accounts now have zero balances.

			Service Revenue
		(Dr)	Account No. 400			(Cr.)
		2010			Bal. before closing	13,200
		Dec. 31	To close to
Decreased			Income
by $13,200			Summary13,200
					Bal. after closing	—0—
			Interest Revenue
			Account No. 418			(Cr.)
		2010			Bal. before closing	600
		Dec. 31	To close to
	Decreased		Income
	by $600		Summary 600
					Bal. after closing	—0—

As a result of the previous entry, you would credit the Income Summary account for USD 13,800. We show the Income Summary account in Step 3.

Expenses appear in the Income Statement debit column of the work sheet. MicroTrain Company has eight expenses in the Income Statement debit column. As shown by the column subtotal, these expenses add up to USD 6,510. Since expense accounts have debit balances, credit each account to bring it to a zero balance. Then, make the debit in the closing entry to the Income Summary account for USD 6,510. Thus, to close the expense accounts, MicroTrain makes the following entry:

MICROTRAIN COMPANY                                                        General Journal                                                  Page 4
Date		Account Titles and Explanation	Post. Ref.	Debit							Credit
2010 Dec.	31	Income Summary	600			6	5	1	0
		Advertising Expense	505												5	0
		Gas and Oil Expense	506											6	8	0
		Salaries Expense	507										3	7	8	0
		Utilities Expense	511											1	5	0
		Insurance Expense	512											2	0	0
		Rent Expense	515											4	0	0
		Supplies Expense	518											5	0	0
		Depreciation Expense—Trucks	521											7	5	0
		To close the expense accounts appearing in the Income

 

The debit of USD 6,510 to the Income Summary account agrees with the Income Statement debit column subtotal in the work sheet. This comparison with the work sheet serves as a check that all revenue and expense items have been listed and closed. If the debit in the preceding entry was made for a different amount than the column subtotal, the company would have an error in the closing entry for expenses.

After they have been closed, MicroTrain's expense accounts appear as follows. Note that each account has a zero balance after closing.

Advertising Expense (Dr)                   Account No. 505			(Cr.)
Bal. before closing	■ 50	2010    ■ ■ Dec. 31 To close to Income
					Decreased
		Summary	50		by $50
Bal. after closing	—0—
Gas and Oil Expense (Dr.)                   Account No. 506			(Cr.)
Bal. before closing	680	2010
		Dec. 31 To close to Income			Decreased
		Summary	680		by $680
Bal. after closing	—0—
(Dr.)	Salaries Expense Account No. 507		(Cr.)
Bal. before closing	3,780	2010 Dec. 31 To close to Income
					Decreased
		Summary	3,780		by $3,780
Bal. after closing	—0—
(Dr.)	Utilities Expense Account No. 511		(Cr.)
Bal. before closing	150	2010
		Dec. 31 To close to Income			Decreased
		Summary	150		by $150
Bal. after closing	—0—
(Dr.)	Insurance Expense Account No. 512		(Cr.)
Bal. before closing	200	2010
		Dec. 31 To close to Income			Decreased
		Summary	200		by $200
Bal. after closing	—0—
(Dr.)	Rent Expense Account No. 515		(Cr.)
Bal. before closing	400	2010
		Dec. 31 To close to Income			Decreased
		Summary	400		by $400
Bal. after closing	—0—
(Dr.)	Supplies Expense Account No. 518		(Cr.)
Bal. before closing	500	2010
		Dec. 31 To close to Income			Decreased
		Summary	500		by $500
Bal. after closing	—0—
Depreciation Expense-Trucks (Dr.)                     Account No. 521			(Cr.)
Bal. before closing	■ 750'	2010 "
		Dec. 31 To close to Income			Decreased
		Summary	750		by $750
Bal. after closing	—0—

 

The expense accounts could be closed before the revenue accounts; the end result is the same.

As the result of closing the revenues and expenses of MicroTrain, the total revenues and expenses have been transferred to the Income Summary account.

Income Summary
If total expenses exceed total revenues, the account has a debit balance, which is the net loss for the period	Total expenses w	Total revenues	If total revenues exceed total expenses, the account has a credit balance, which is the net income for the period.

MicroTrain's Income Summary account now has a credit balance of USD 7,290, the company's net income for December.

(Dr)	Income Summary			(Cr.)
2010 Dec. 31	From closing the expense accounts	6,510	2010 Dec. 31 From closing the revenue accounts	13,800
			Bal. before closing this account (net income)	7,290

Next, close MicroTrain's Income Summary account to its Retained Earnings account. The journal entry to do this is:

 

MICROTRAIN COMPANY                                                      General Journal                                                    Page 4
Date		Account Titles and Explanation	Post. Ref.	Debt							Credit
2010 Dec.	31	Income Summary	600			7	2	9	0
		Retained Earnings	310										7	2	9	0
		To close the Income Summary account to the Retained
		Earnings account.

After its Income Summary account is closed, the company's Income Summary and Retained Earnings accounts appear as follows:

Income Summary (Dr.)                  Account No. 600			(Cr.)
2010 Dec. 31 From closing the expense accounts	6,510	"2010  Dec. 31 From closing The revenue accounts	13,800
		Bal. before closing this account (net income)	7,290
Dec. 31 To close this account to Retain ed Earnings	7,290
		Bal. after closing	—0—

 

	Retained Earnings
(Dr)	Account No. 310		(Cr.)
		Bal. before closing	-0-
		Process
		2010
		Dec. 31 From Income Summary	7,290	Decreased by $7,290

The last closing entry closes MicroTrain's Dividends account. This account has a debit balance before closing. To close the account, credit the Dividends account and debit the Retained Earnings account. The Dividends account is not closed to the Income Summary because it is not an expense and does not enter into income determination. The journal entry to close MicroTrain's Dividends account is:

MICROTRAIN COMPANY                                                        General Journal                                                     Page 4
Date		Account Titles and Explanation	Post. Ref.	Debit							Credit
2010 Dec.	31	Retained Earnings (-SE)	310			3	0	0	0
		Dividends (+SE)	320										3	0	0	0
		To close the Dividends account to the Retained Earnings
		account.

After this closing entry is posted, the company's Dividends and Retained Earnings accounts appear as follows:

Dividends (Dr.)                  Account No. 320 (Cr.)
Bal. before closing  3,000	2010 Dec. 31 To close to Retained Earning		3000
			Decreased by $3,000
Bal. after closing —0—
Retained Earnings (Dr.)                   Account No. 310 (Cr.)
2010		Bal. before closing process ^-0-
Dec. 31 From dividends 3,000		2010 Dec. 31 From Income Summary 7,290
		Bal. after closing process is complete 4,290

After you have completed the closing process, the only accounts in the general ledger that have not been closed are the permanent balance sheet accounts. Because these accounts contain the opening balances for the coming accounting period, debit balance totals must equal credit balance totals. The preparation of a post-closing trial balance serves as a check on the accuracy of the closing process and ensures that the books are in balance at the start of the new accounting period. The post-closing trial balance differs from the adjusted trial balance in only two important respects: (1) it excludes all temporary accounts since they have been closed; and (2) it updates the Retained Earnings account to its proper ending balance.

A post-closing trial balance is a trial balance taken after the closing entries have been posted. The only accounts that should be open are assets, liabilities, capital stock, and Retained Earnings accounts. List all the account balances in the debit and credit columns and total them to make sure debits and credits are equal.

Look at Exhibit 24, a post-closing trial balance for MicroTrain Company as of 2010 December 31. The amounts in the post-closing trial balance are from the ledger after the closing entries have been posted.

The next section briefly describes the evolution of accounting systems from the one-journal, one-ledger manual system you have been studying to computerized systems. Then, we discuss the role of an accounting system.

An accounting perspective:

Uses of technology

If you are studying in the US, you may want to visit the American Institute of Certified Public Accountants website at:

http://www.aicpa.org

You will find information about the CPA exam, about becoming a CPA, hot accounting topics, and various other topics, such as the US states that have passed a 150-hour requirement to sit for the CPA exam. You can also learn such things as the states that have approved limited liability companies (LLCs) and limited liability partnerships (LLPs). These forms of organization serve to place limits on accountants' liability. You can also find the phone numbers and mailing addresses of State Boards of accountancy and State Societies of CPAs. Browse around this site to investigate anything else that is of interest. Similar sites are available in other countries as well.