Closing journal entries are used at the end of the accounting cycle to close the temporary accounts for the accounting period, and transfer the balances to the retained earnings account.
Temporary and Permanent Accounts
A temporary account is an income statement account, dividend account or drawings account. It is temporary because it lasts only for the accounting period. At the end of the accounting period, the balance is transferred to the retained earnings account, and the account is closed with a zero balance. For each temporary account there will be a closing journal entry.
In contrast, a permanent account is a balance sheet account. It is permanent because it is not closed at the end of each accounting period. At the start of the new accounting period, the closing balance from the previous accounting period is brought forward and becomes the new opening balance on the account. Other than the retained earnings account, closing journal entries do not affect permanent accounts.
Year End in Accounting
The term year end refers to the date on which the annual accounting period ends. For example, if the accounting period for the business is the year to 31 December 2019, then the year-end date is 31 December 2019.
Financial statements are referenced to the year-end date. If the year end is 31 December 2019 then the balance sheet, which is drawn up at a point in time, will be headed ‘Balance Sheet at 31 December 2019’, and the income statement, which is for an accounting period will be headed ‘Income Statement for the year ended 31 December 2019’.
In order to avoid having the year-end coincide with a busy trading period, the date chosen as the year end by the business will depend on its industry and tax environment, for example a retailer will normally be busy during the Christmas period and may therefore chose an alternative date such as 31 January as its year-end date. An accounting year-end which is not the calendar year end is sometimes referred to as a fiscal year end.
Interim Financial Periods
In order to produce more timely information some businesses issue financial statements for periods shorter than a full fiscal or calendar year. Such periods are referred to as interim periods and the accounts produced as interim financial statements. Interim periods are usually monthly, quarterly, or half-yearly.
Closing Journal Entries Process
The year end closing entries all follow a similar format. If a temporary account has a debit balance it is credited to bring it to zero, and the retained earnings account is credited to balance the closing entry. Likewise, if a temporary account has a credit balance, it is debited to bring it to zero and the retained earnings account is credited. The closing entries are dated in the journal as of the last day of the accounting period.
Typical closing journal entries for a generic temporary account are shown below:
Closing Journal Entries Example
Suppose a business had the following trial balance before any closing journal entries at the end of an accounting period.
|Cost of sales||3,600|
|Balance sheet accounts||8000|
The retained earnings account balance of 6,800 is the amount brought forward from the previous accounting period, and for the sake of this example, the other balance sheet (permanent accounts) are shown as one balance, as they are not part of the closing journal entries process.
The closing journal entries required to transfer the balance on each of these accounts to the retained earnings account is as follows:
|Cost of sales||3,600|
Notice that the effect of this closing journal entry is to credit the retained earnings account with the amount of 1,400 representing the net income (revenue – expenses) of the business for the accounting period.
After the closing journal entries the balance on these temporary accounts will be zero ready for the next accounting period, the balance on the permanent balance sheet accounts will remain unchanged, and the balance on the retained earnings account will have increased by the net income for the period of 1,400.
Dividend Accounts and Closing Journal Entries
Although it is not an income statement account, the dividend account is also a temporary account and needs a closing journal entry to zero the balance for the next accounting period.
In the above example the balance on the dividend account was a debit of 200, to close the dividend account the following closing entry is made:
After the closing journal entry, the balance on the dividend account is zero, and the retained earnings account has been reduced by 200.
Movement on the Retained Earnings Account
The movement on the retained earnings account as a result of the closing journal entries is summarized in the table below:
The net effect on the retained earnings account is 1,400 – 200 = 1,200 which is the net income less the dividend or the retained earnings for the accounting period.
The retained earnings account balance has now increased to 8,000, and forms part of the trial balance after the closing journal entries have been made. This trial balance gives the opening balances for the next accounting period, and contains only balance sheet accounts including the new balance on the retained earnings account as shown below.
|Balance sheet accounts||8000|
Use of an Income Summary Account
While the net effect of closing journal entries is to transfer temporary account balances to the retained earnings account, some businesses particularly those with manual accounting systems, use an intermediate step in the closing journal entries process, and transfer the temporary income statement type account balances (revenue and expenses) to an income summary account.
The purpose of the income summary is to show the net income (revenue less expenses) of the business in more detail before it becomes part of the retained earnings account balance.
The process of using of the income summary account is shown in the diagram below.
The income summary account is in itself a temporary account and an additional closing journal entry is made to zero the account at the end of the accounting period, and transfer the balance (the net income for the period) to the retained earnings account as before.
Drawings Accounts and Closing Journals
A sole proprietor or partnership often uses a separate drawings account to record withdrawals of cash by the owners. Although the drawings account is not an income statement account, it is still classified as a temporary account and needs a closing journal entry to zero the balance for the next accounting period.
As the drawings account is a contra equity account and not an expense account, it is closed to the capital account and not the income summary or retained earnings account.
Suppose for example, the balance on the drawings account was a debit of 1,300, to close the account the following closing entry is made:
After the closing journal entry, the balance on the drawings account is zero, and the capital account has been reduced by 1,300.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.