At the end of each accounting period, accountants must ensure that the income finances align with the business performance. The closing entries steps are the most critical part of the accounting cycle. The main purpose is to reset temporary accounts and allow a new, fresh start for the next period. Also, this whole process makes sure that the incomes accurately reflect the outcome.
In this blog, you will understand how to record and understand the closing entries so your financial statements are accurate and relevant.
What Are Closing Entries?
Closing entries are journal entries made at the end of each accounting period to transfer information from temporary accounts to permanent accounts. Organisations use these entries to reset balances to zero. They evaluate accounts that show balances from a single period and move them into a permanent account on the balance sheet. The main purpose of transferring to a permanent account is that it shows a company’s long-term financial situation more accurately.
Key Factors of Closing Journal Entries
Closing journal entries are a crucial part of the accounting period because they:
- Ensure incomes reflect the expenses over a single period.
- Transfer data to permanent accounts.
- Reset temporary accounts to zero.
- Maintains the integrity of financial periods.
- Provide accurate opening balances for the next period.
In financial accounting, closing entries are a fundamental procedure. Without them, it would be challenging to evaluate the company's performance over separate periods.
The Difference Between Temporary and Permanent Account
In the general ledger, temporary accounts are used to record transactions during a single accounting period. At the end of the year, the income statement is eventually created using the balances of these accounts. An organisation's financial performance and operations within a single year are depicted in the income statement. This is why "Year ended" is written on the date line of the annual income statement.
On the other hand, permanent accounts maintain the long-term financial balances over different accounting periods within a company. The balance sheet is an example of a permanent account. Unlike temporary accounts, permanent accounts are not closed at the end of the period. They provide a continuous record of the company’s financial position, helping track assets, liabilities, and equity over time.
How to Do Closing Entries: Step by Step
Following the whole process is specific and important because the temporary accounts must be prepared and accurately reset so the balances are transferred to the right permanent accounts. After completing all these steps properly, the accounts will have zero balances and will be ready for the next period. Let’s explain each step in detail:
1. Close Revenue Accounts
The first step involves closing revenue accounts. All revenue accounts are closed by transferring their balances to the income summary. This resets all revenue accounts to zero and records the total income earned during the period. It ensures revenues don’t carry over into the next accounting cycle.
2. Close Expense Accounts
Next, you should transfer all expense account balances to the income summary. This clears all expense accounts and shows the total costs for the period. Also, it keeps expenses separate from the next period’s activity.
3. Close Income Summary
After completing the first two steps, the next step is to close the income summary by transferring the net income or loss to retained earnings or owner’s capital. This ensures the income summary has no balance and updates equity. It finalises the profit or loss for the period.
4. Close Dividends or Drawings
As a final step of this process, close dividends or drawings by transferring their balances to retained earnings. It reduces equity and resets the account to zero for the next period. Furthermore, it reflects the distribution made to owners or shareholders.
A Closing Entries Example Explained
Assume the following balances at the end of the period:
- Revenue: $10,000
- Expenses: $6,000
- Dividends: $1,000
Step 1: Close Revenue Accounts
- Debit Revenue $10,000
- Credit Income Summary $10,000
Step 2: Close Expense Accounts
- Debit Income Summary $6,000
- Credit Expenses $6,000
Step 3: Close Income Summary
(Net income = Revenue − Expenses = $10,000 − $6,000 = $4,000)
- Debit Income Summary $4,000
- Credit Retained Earnings $4,000
Step 4: Close Dividends
- Debit Retained Earnings $1,000
- Credit Dividends $1,000
This clears all temporary accounts and updates retained earnings for the next period.
Automating Closing Entries with Aico
While traditional manual methods are prone to more mistakes, which impacts the finance records, modern automated solutions like Aico can help in streamlining the process more accurately, while reducing errors, costs and downtime. Aico offers a comprehensive financial close automation platform that streamlines the journal entry process, ensuring accuracy and efficiency.
By integrating directly with ERP systems, Aico enables real-time validation and posting of journal entries, reducing manual errors. Closing journal entries are central to the financial close process, making it faster, accurate, and reliable.
Final Words
Closing entries are an important part of the accounting cycle. They help keep financial records accurate and separate each period. By closing revenues, expenses, the income summary, and dividends, businesses reset temporary accounts and transfer results to permanent accounts, preparing for the next period. Instead of manually recording and transferring balances, automated software can automatically post recurring entries, adjust accounts, and move net income or dividends to permanent accounts.