By the time you reached the end of the accounting year, you probably feel like you’ve done
it all.
You’ve recorded journal entries for revenue recognition, inventory movements, payroll.
You’ve made your adjusting entries for accruals and prepaids.
You produced a trial balance and made error corrections.
Prepared the financial statements.
That’s pretty much it, right?
No, there’s one more thing you need to do before you can start the new accounting period:
preparing the closing entries.
It’s the accounting equivalent of saying “Happy New Year”!
In a previous video, I covered understanding debits and credits in accounting by using
DC ADE LER. DC Debits and Credits.
ADE Assets Dividends Expenses, accounts that usually have a debit balance.
LER Liabilities Equity Revenue, accounts that usually have a credit balance.
Let’s group the accounts slightly differently: into permanent accounts and temporary accounts.
Assets, Liabilities and Equity are permanent accounts, their account balance carries over
to the next period.
Dividend, Expenses and Revenue are temporary accounts, these accounts have to be reset
to zero prior to starting a new accounting period.
That’s what closing entries do: closing the temporary accounts to a balance of zero,
and transferring the outstanding balance to one of the permanent accounts
(more specifically Equity).
Permanent accounts.
Temporary accounts.
The starting point for our closing entries is this example of a trial balance after corrections.
A trial balance is a listing of all ledger accounts along with their respective debit
or credit balances for the period.
Let’s classify each of the accounts in the trial balance as either permanent (P) or temporary (T).
Cash, accounts receivable, inventory and plant and equipment are all asset accounts, these
are permanent accounts.
Accounts payable and debt are liabilities accounts, these are permanent accounts.
Equity is an equity account, a permanent account.
In real life, a company could have multiple equity accounts:
common stock, additional paid in capital, retained earnings,
accumulated other comprehensive income, noncontrolling interest.
But we are keeping it simple here!
Revenue is a revenue account, a temporary account.
In real life, a company probably has more detail to the revenue section as well: revenue
from products, revenue from services, subscription revenue, etc.
Once again, we are keeping it very simple here.
Cost of goods sold, compensation and benefits, depreciation, interest expense, and provision
for income taxes are expense accounts, these are temporary accounts.
The temporary accounts are the ones that we need to close.
Let’s prepare our closing entries using T accounts, visual representations of accounts
for optimal understanding of the accounting flows.
Here are the six temporary accounts and their balances that we need to close: revenue, cost
of goods sold, compensation and benefits, depreciation, interest expense, and provision
for income taxes.
One of them (revenue) has a credit balance,
the other five (expense accounts) have a debit balance.
In order to close the temporary accounts for this accounting year, we are going to transfer
the balances to the income summary account.
Let me show you.
Revenue has a credit balance of 200, we need to record a debit of 200 to revenue and a
credit of 200 to the income summary account, in order to make the net account balance in
revenue zero.
Cost of goods sold has a debit balance of 100, we need to record a credit of 100 to
cost of goods sold and a debit of 100 to the income summary account, in order to make the
net account balance in cost of goods sold zero.
Compensation and benefits has a debit balance of 20, we need to record a credit of 20 to
Compensation and benefits and a debit of 20 to the income summary account, in order to
make the net account balance in Compensation and benefits zero.
Depreciation has a debit balance of 20, we need to record a credit of 20 to Depreciation
and a debit of 20 to the income summary account, in order to make the net account balance in
Depreciation zero.
Interest expense has a debit balance of 10, we need to record a credit of 10 to Interest
expense and a debit of 10 to the income summary account, in order to make the net account
balance in Interest expense zero.
Provision for income taxes has a debit balance of 10, we need to record a credit of 10 to
Provision for income taxes and a debit of 10 to the income summary account, in order
to make the net account balance in Provision for income taxes zero.
All our temporary accounts are now closed, their balances are reset to zero.
The balances were transferred to the income summary account.
The balance in this income summary account is a credit of 40, this needs to be validated
versus the net income that was reported in the income statement.
When correct, we can take the next step: closing out the income summary account by debiting
it for 40 and crediting the retained earnings account on the balance sheet for 40.
In the example, the company did not pay any dividends.
If the company would have paid dividends of x, which is a debit balance, the way to close
out that account is to credit dividends paid by x, and debit retained earnings by x.
Revenue and expense accounts get closed out by transferring the balance to the income
summary account, which in turn is closed out to retained earnings.
Dividend accounts get closed out directly to retained earnings.
Next is an update of the trial balance, from pre-close to post-close.
All temporary accounts at the bottom of the post-close trial balance now have an account
balance of zero, and are ready to go for the new accounting period.
Most of the permanent accounts have unchanged balances, the only one that changed due to
the closing entries is equity (as retained earnings rolls up into this section).
Equity has gone up from 100 pre-close to 140 post-close.
What’s important to note is that the sum of the debits still equals the sum of the
credits, so we are still compliant with the accounting equation.
Permanent versus temporary accounts.
Accounts whose balance is carried over, versus accounts that need to be reset to zero through
closing entries to start a new accounting period.